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. 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.
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.
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 Barnes & Noble today without considering how the proliferation of electronically delivered books and magazines will continue to affect the demand for retail book stores.
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.
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:
- the "income" approach, which involves the conversion of expected future cash flow into a present value;
- the "market" approach, which determines value by comparison with transactions in similar businesses or business interests; and
- 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.
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.