February 2004

Reconciling Conflicting Value Estimates

The valuation of a business is more art than science, and the reconciliation of
differing value conclusions is an invaluable step in the valuation process

A thorough business valuation will consider three approaches to value:

• the income approach,

• the market approach, and

• the asset approach.

Each may have one or more methodologies that are utilized in estimating the value of a business; thus, an appraiser may end up using multiple methodologies in the process of arriving at a value.

In a perfect world, all of the methods used would result in the same value. Unfortunately, given the nature of business valuation, it is inevitable that each methodology will generate a unique value estimate that differs from each of the other methodologies. Sometimes the differences are minor, but in many cases the contrast in value estimates can be quite significant. This article attempts to explain the manner in which a business appraiser should reconcile these differences and explain the reconciliation process to the reader of a business appraisal report.

Weighting vs. Not Weighting

Some business appraisers maintain that it is not appropriate to “weight” the various value conclusions in determining the final estimated value of the business, as they believe that for each valuation there is one methodology that provides the best measure of the subject company’s value. These appraisers often cite I.R.S. Revenue Ruling 59-60, which states:

“Because valuations cannot be made on the basis of a prescribed formula, there is no means whereby the various applicable factors in a particular case can be assigned mathematical weights in deriving the fair market value. For this reason, no useful purpose is served by taking an average of several factors (for example, book value, capitalized earnings and capitalized dividends) and basing the valuation on the result. Such a process excludes active consideration of other pertinent factors, and the end result cannot be supported by a realistic application of the significant facts in the case except by mere chance.”

It is our viewpoint, and the opinion of many other business appraisers, that Revenue Ruling 59-60 appears to discourage a straight mathematical average or a prescribed, “one size fits all” formula that is used to weight valuation conclusions for each and every valuation engagement. However, a weighting that takes into account the specific facts and circumstances of the particular company can and should be used. This is supported by the American Society of Appraisers’ Business Valuation Standards, which state:

“The appraiser must use informed judgment when determining the relative weight to be accorded to indications of value reached on the basis of various methods, or whether an indication of value from a single method should dominate. The appraisers judgment may be presented either in general terms or in terms of mathematical weighting of the indicated values reflected in the conclusion. In any case, the appraiser should provide the rationale for the selection or weighing of the methods or methods relied on in reaching the conclusion.”

Additionally, the American Society of Certified Public Accountants (AICPA) has released draft business valuation standards that also stipulate the appropriateness of using weighting in determining a value conclusion.

The Reconciliation Process

A major advantage of weighting the various value conclusions is that it forces the business appraiser to reconsider the methods used and to develop supportable justifications for including or excluding certain methods, as well as determining reasons why certain methods may be more relevant than others. The valuation of a business is more art than science, and the reconciliation of value conclusions is an invaluable step in the valuation process.

The valuation conclusions that are initially determined using the various methods provide feedback to the appraiser, and the value conclusions first determined are almost never the final conclusions presented to the client. The reconciliation process forces the appraiser to revisit the assumptions and judgment calls made during the initial process, and the initial value conclusions can provide a roadmap to refining certain assumptions. It is through this reconciliation process that the appraiser develops a comfort level with the relevance and applicability of the various methods, and this is eventually reflected in the weightings applied.
Furthermore, as long as the reasons for weighting some methods more heavily than others are documented within the valuation report, the reader should have a greater understanding of the strengths and weaknesses of each methodology. Conversely, if an appraiser always relies on only one value conclusion, it could be very easy for that appraiser to simply pick one method without fully understanding why other value conclusions may be significantly different.

Suffice it to say that, if the appraiser does not fully grasp the underlying reasons why the various value conclusions are significantly different, the reader of the valuation report will also not understand these differences.

Summary

The valuation of a business is a complex process involving the application of professional judgments by the appraiser at various points in the process. While it would be convenient if the value of a business could be determined by simply entering data into a “black box” that generates a valid value conclusion, the intricacies of the real world prohibit such a simplistic process.

The development of a single point value derived from the multiple value estimates of various methodologies is just one more step in which the appraiser must use sound judgment and rationale. Sometimes one method may be, by far, the most relevant and supportable among the various methods used, and in such a case it may be appropriate to use only that method in estimating the final value conclusion. However, in many cases, more than one of the various methodologies will have some degree of relevance and reliability, and in such cases the value conclusions determined by these methods should not be ignored.

After all, actual buyers and sellers of businesses use a wide variety of techniques in deciding on a price for a company, and the sale of stock or an entire business is just as likely to happen at a value derived from a weighted analysis as from the value of a single valuation method. As one business valuation book succinctly states, “There is no magical formula to the weighting process. It is entirely up to the appraiser’s good judgment as to where the final value estimate will come in.” ■