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April 2005 Top-Down Process: Understanding Business Valuation
Properly performed,
business valuation is a complex process that requires
a consistent approach and
incorporates specific steps and analyses
It is intriguing to consider the lay person’s
general impressions as to the breadth of analysis that is necessary to value a
privately held company. In many instances, they presume that the value of a
business can be simplistically determined or that the valuation of a specific
business can be performed by focusing on a very narrow aspect of the company. In reality,
however, valuation is a process that requires a consistent approach and
incorporates certain specific steps and analyses. If the overall valuation
process is better understood and each valuation is judged in the context of the
overall process, I believe that this will lead to a more informed understanding
of the value conclusion. There are a significant number
of factors to consider when estimating the value of any business entity. These
factors vary for each valuation assignment depending on the unique circumstances
of the business enterprise and general economic conditions that exist at the
effective date of the valuation. Valuation is essentially a top-down process
that starts with a broad analysis of the overall economic trends and ends with a
check of the reasonableness of the overall value conclusion. This philosophy is
embodied in the most commonly used valuation guideline, IRS Revenue Ruling
59-60, which states that in the valuation of the stock of closely held
businesses, certain factors are fundamental and
require careful consideration in each case.
The following factors provide a useful framework that can be applied to the
valuation of an operating business..
Purpose, Standard and Level of Value Different
purposes, standards of value, and levels of value will lead to different value
conclusions, and it is therefore important to carefully define each one of these
items at the beginning of an engagement. In marital
dissolution cases the standard of value is a significant issue that is sometimes
overlooked. There are typically two standards of value that can be applied.
Fair market value is defined as the price, expressed in terms of cash
equivalents, at which property would change hands between a hypothetical willing
and able buyer and a hypothetical willing and able seller, acting at arm’s
length in an open and unrestricted market, when neither is under compulsion to
buy or sell and when both have reasonable knowledge of the relevant facts
(As defined by the American Society of Appraisers’ Business Valuation Standards.
The objective of the fair market value standard is to determine a likely value
for a business or business interest at which it may be sold. However, in the
case of a non-marketable interest in a closely held business, the value is
hypothetical especially if there is no contemplated sale. Fair value (also
known as investment value) refers to a standard of value of a business to a
particular investor without regard to a sale or exchange, and typically excludes
application of discounts for lack of control and marketability. This is also
known as value to the holder and does not assume a hypothetical sale and is
typically more relevant for the value of a professional practice where there is
no contemplated sale and often no market for that type of practice. Economic Analysis No business can
be valued in a vacuum, as the performance of a business is dependent on overall
economic conditions. Depending on the nature of the subject company, some
aspects of the overall economy may be more relevant. For instance, for companies
that operate in the construction sector, interest rates and demographic trends
can significantly influence the outlook for the business. When determining
value, a prospective investor will temper the
use of historical and prospective financial Industry Analysis Knowledge of an
industry’s prospects and risks are also an
integral aspect of the valuation process, as the performance of a business is
dependent on industry trends, conditions and other external factors. When
determining value, a prospective investor will again temper the use of
historical and prospective financial information on the basis of the anticipated
outlook for the particular industry. This is probably truer today than when
Revenue Ruling 59-60 was issued, as the pace of change in the business
world has accelerated tremendously, and technological advances can have a huge impact on the outlook for a
company. For example, an appraiser or analyst could not accurately value Kodak
today without considering how the proliferation of digital cameras may affect
the demand for film products. Company Analysis Another important aspect
of any valuation assignment is gaining an understanding of the
company's competitive and financial position history, the nature of its products
and services, its customer base and other
qualitative factors. The valuation analysis should therefore address the
qualitative characteristics of the company and provide an in-depth
understanding of the company's current
operations, future outlook, and growth prospects. Financial Statement Analysis
Financial performance and volatility
provide essential insight into what an investor might reasonably expect from
future performance, and it offers an overview of the company's risk profile. The
key to a thorough valuation, though, is to not just compute various ratios and
financial gauges but to actually use them to assess the company's risk. This
part of the process is highly integrated with other parts of the valuation,
particularly the industry and company analyses. A valuation report should convey
to the user of the report how and why a company's financial results and
financial position influence the company's risk. SWOT Analysis The "Strengths, Weaknesses,
Opportunities & Threats" (SWOT) analysis is an integral part of the valuation
process. It is the culmination of the risk assessment process and is based on an
analysis of a company's qualitative characteristics, historical operating
results, the outlook for the industry or industries in which the company
operates, and the national and local economic trends that directly impact the
company. The analysis of these factors provides an understanding of the
company's overall risk profile and facilitates the determination of an
appropriate required rate of return for an investment in the business and the
selection of relevant market multiples. At the completion of this process the
valuation specialist is ready to apply the valuation approaches. Application
of Valuation Approaches There are three traditional
approaches utilized to value an interest in a closely held entity. Within each
approach, various methods and
methodologies are typically used. The three valuation approaches are:
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the "income" approach, which involves the
conversion of expected future cash flow into a present value;
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the "market" approach, which determines
value by comparison with transactions in similar businesses or business
interests; and
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the "asset based" approach, which
incorporates the valuation of all the company's assets and liabilities (the
asset values are totaled and the liabilities subtracted to determine an
adjusted net equity value of the business).
Valuation Synthesis and Conclusion In reaching the overall conclusion of
value, the appraiser considers the indicated values derived from each valuation
approach in relation to the relative merits of each approach based on the
specific facts and circumstances of each analysis. One primary advantage of multiple approaches is that they force the
business appraiser to reconcile differences in the value conclusions. The
reconciliation process allows the valuation specialist to revisit the
assumptions and judgment calls made during the valuation process. It is through
this reconciliation process that the appraiser develops a comfort level with the
applicability of the various methods, and this is eventually reflected in the
weightings applied to the various value conclusions derived using different
methods. Reasonableness Tests One of the final steps in the valuation
process is a "reasonableness check." The final value conclusion should always be
assessed on the basis of "Is it
reasonable?" To address the reasonableness of the value conclusion, the
appraiser performs an analysis of financial feasibility, implied
valuation multiples, and implied intangible value. Armed with this general
understanding of the many essential analyses that comprise a defensible business
valuation, all stakeholders in the valuation of a company can appreciate the
folly of unduly simplifying or narrowing the scope of the work to be performed.
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