As a business owner, determining the value of your company is a crucial prerequisite to making many significant business decisions. Understanding your company’s true value can help you make informed decisions about selling your business, acquiring new business assets, optimizing your tax strategy, or even securing financing. However, the process of how to value a business can be complex, requiring careful consideration of various factors and methods. Abrams Valuation Group, Inc. has broken down the business valuation process so you can understand how the experts value a business.
The 2 Premises of Value
The Premises of Value form the foundation of a business valuation. They influence which valuation methods the expert employs as well as the final valuation calculation. They are:
- Going Concern vs. Liquidation—We are determining whether the business is worth more dead or alive. Often, it is difficult to tell without delving into the calculations. Therefore, the appraiser will perform the valuation both ways to determine which valuation premise produces a higher result.
- Value in Exchange vs. Value to the Holder—We are determining to whom the asset is valuable. Value in Exchange is the market price that a buyer would be willing to pay to acquire the asset.
Value in Exchange is an objective measure of value. In contrast, Value to the Holder is a subjective measure of value.
Premises of Business Values Examples:
To illustrate this concept, let us consider the value of a medical doctor’s license. The license holder cannot sell it to someone else, so it has a $0 value in exchange. However, the license allows the doctor to legally practice medicine, giving it millions of dollars in value to the holder.
The valuation purpose and the appropriate Standard of Value (determined in Stage 2 of the Valuation Process) will answer which premise of value best fits the valuation scenario.
The Business Valuation Process
There are three stages to a business valuation:
- Valuation Stage 1: Preliminary Valuation. The appraiser selects the applicable approaches and valuation methods to calculate the business’s approximate value.
- Valuation Stage 2: Valuation Adjustments. The appraiser adjusts the approximate value to the appropriate Level of Value (LOV) for the subject interest. The appraiser applies valuation discounts or premiums for differences in control or marketability of the subject interest compared to the preliminary valuation data sources.
- Valuation Stage 3: Reconciliation of Value: The appraiser calculates the final valuation based on the indications of value from the various company valuation methods.
Sometimes, it is more efficient to combine Valuation Stages 2 & 3. In that case, the reconciliation of value will also reflect the correct Level of Value.
Business Value Definitions
The International Glossary of Business Valuation Terms defines a valuation approach as “a general way of determining a value indication of a business… using one or more valuation methods.” A valuation method is “within approaches, a specific way to determine value.” In the first stage of a business valuation, the appraiser assesses the available data about the subject company and selects the appropriate valuation approaches and methods to determine the business’s value.
How to Value a Business Using The Three Valuation Approaches:
- Asset approach – The appraiser determines a value indication of the business by measuring the value of the tangible and intangible assets net of liabilities
- Market approach- The appraiser determines a value indication by comparing the subject company to other businesses or business interests that have sold at current market value.
- Income approach- The appraiser determines a value indication by converting anticipated income into a present single amount.
The Income and Market approaches are the primary methods for assessing the business as a going concern. The asset approach assesses a business’s liquidation value.
Determining the proper valuation approach helps the appraiser reach the most accurate value representation of the business.
Business Valuation Methods
Valuation methods refer to the specific techniques used to determine the value of a business. Each of the three main valuation approaches has several different methods that fall under it. Not every valuation approach or method is relevant in every valuation assignment. The appraiser must decide how to calculate the value of a business by applying the appropriate approaches and methods.
Income Approach Valuation Methods
The Income Approach method rely on the concept that a business’s value is best measured by the present value of the net income, cash flow, or dividend streams it can generate in the future. The appraiser forecasts the future income and then adjusts these figures based on the time value of money as well as associated business and economic risks of the company.
The following methods are all subsets of the Income Approach:
- Discounted Future Net Income
- Discounted Cash Flow
- Discounted Dividends Method
Probabilistic Methods can also be categorized under the income approach, including:
- Monte Carlo Simulation
- First Chicago Method
When using Income Approach methods to value a business, it is important to note that cash flow is the primary currency the appraiser examines over net income. Businesses can only pay their bills and avoid bankruptcy with cash flow, not net income. Therefore, the appraiser may forecast both cash flow and net income, but will only discount cash flow to the present value.
Market Approach Valuation Methods
The Market Approach involves comparing the subject company to similar firms for which transaction data are available, known as Guideline Companies (GCs). Various methods fall under the Market Approach, including:
- Guideline Public Company Method
- Guideline Merger & Acquisition Method
- Direct Market Data Method
- Prior Sales of Company Stock Method
The guideline companies should ideally be in the same business as the subject company. However, when such data are unavailable, it is possible to use guideline companies in similar businesses or businesses with similar risk and growth characteristics.
The challenge is finding comparable companies when using the Guideline Company Method, where the information about each company is usually rich and readily available. In contrast, the data available for each transaction in the Guideline Merger & Acquisition Method is limited, and the data for the Direct Market Data Method is even more limited.
Asset Approach Valuation Methods
The asset approach results in a balance sheet. The appraiser can choose to use the
- market value
- liquidation value
- or book value
of business assets on the balance sheet.
A Hybrid Approach: The Excess Earnings Method
The Excess Earnings Method is a hybrid asset and income approach. The appraiser calculates a reasonable return to demand for the firm’s tangible assets and subtracts that from the actual income, the difference being “excess returns.”
One would then capitalize the excess returns at a rate of return appropriate for intangible assets, which is higher than that for the firm’s total income or cash flows. The result of that calculation would be the value of the firm’s intangible assets. One would then add the intangible value to the tangible assets to obtain the monetary value of all assets.
This valuation method has five significant disadvantages.
- It requires calculating two rates of return instead of the usual one.
- The return on intangible assets is not directly observable in the marketplace, while returns on investment are directly observable. Return on tangible assets is also somewhat controversial.
- Tangible assets are not well defined (going concern, replacement cost, book value, tax affected, net of depreciation, net of current liabilities, net of all liabilities, etc.).
- Revenue Ruling 68-609 does not specify which earnings should be used (net income, pre-tax, EBIT, cash flow)
- The Internal Revenue Service disparaged this approach in Revenue Ruling 68-609, saying it may only be used if no better basis is available.
Because of these disadvantages, Abrams Valuation Group, Inc. appraisers do not use or recommend the Excess Earnings Method.
Selecting the Business Valuation Methods
In general, the valuation of an operating business involves all three valuation approaches when data are available. However, the valuation of an interest in a business that owns stocks, bonds, or real estate and in which intangible assets are of minimal value often primarily involves the asset approach methods, while the first two valuation approaches are often irrelevant.
Once the appraiser selects the most applicable business valuation approaches and methods for the subject interest, s/he can perform calculations to reach a preliminary valuation. This number is the foundation of the valuation, but it is raw, inconclusive, and must be further refined in the second stage of the valuation.
In conclusion, business valuation is a complex process that requires careful consideration of various factors and methods. Different valuation methods are relevant in different valuation assignments, and understanding them can help you make more informed decisions about your business. If you need help calculating an accurate and empirical business value for tax, litigation, transaction, or other purposes, contact Abrams Valuation Group, Inc. (AVGI). Our valuation experts are ready and happy to assist you.
Learn more about the Business Valuation Process in Part 2 >>
