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Objective
The objective of the business valuation is to estimate the Fair Market Value. Which is defined as the price, in terms of cash or equivalent, that a buyer could reasonably be expected to pay, and a seller could reasonably be expected to accept, if the business was exposed for sale on the open market for a reasonable period of time, with both buyer and seller being in possession of the pertinent facts and neither being under any compulsion to act.
When is A Valuation Needed?
Business Valuations can be required for many reasons, to determine a price tag of a business, market planning, attracting investors, aid in estate and gift planning for closely held and family owned businesses, or to meet government requirements in regards to employee stock ownership plans, conversion of C to S corporations, divorce situations, and partners disputes.
The Factors
There is a large number of factors to consider when estimating the common stock value of any business entity. These factors vary for each valuation depending on the unique circumstances of the business enterprise and general economic conditions that exist at the effective date of the valuation. However, fundamental guidelines of the factors to consider in any valuation have been established. The most commonly used valuation guidelines are derived from the Internal Revenue Service’s Revenue Ruling 59-60. Revenue Ruling 59-60 states that in the valuation of the stock of closely held businesses, the following factors, although not all inclusive, are fundamental and require careful consideration in each case:
a) The nature of the business and the history of the enterprise from its inception. b) The economic outlook in general and the condition and outlook of the specific industry in particular. c) The book value of the stock and the financial condition of the business. d) The earning capacity of the company. e) The dividend-paying capacity. f) Whether or not the enterprise has goodwill or other intangible value. g) Sales of the stock and the size of the block of stock to be valued. h) The market price of stocks of corporations engaged in the same or a similar line of business having their stocks actively traded in a free and open market, either on an exchange or over-the-counter.
In addition to providing general valuation guidelines, Revenue Ruling 59-60 outlines other considerations and techniques for valuing the stock of closely held businesses. The techniques are commonly divided into general approaches, i.e., the Asset, Income, Market, and Other approaches. Specific methods are then used to estimate the value of the total business entity under each approach. Our conclusion of Fair Market Value is determined based on the results of these methods and the specific circumstances surrounding the interest being valued.
Overview of Valuation Approaches and Methods
Various approaches are used in valuing a business. These approaches, described below, are:
1) Asset Approach
2) Income Approach
3) Market Approach
4) Other methods.
The Asset Approach
The Asset Approach is generally considered to yield the minimum benchmark of value for an operating enterprise. The most common methods within this approach are Book Value, Net Asset Value and Liquidation Value. Book Value represents the net equity of the business based upon generally accepted accounting principles (GAAP). Net Asset Value represents net equity of the business after assets and liabilities have been adjusted to their fair market values. Lastly, the Liquidation Value of the business represents the net present value of cash flows from liquidating the Company's assets and paying off its liabilities.
The Income Approach
The Income Approach serves to estimate the value of a specific income stream with consideration given to the risk inherent in that income stream. The most common methods under this approach are Capitalization of Earnings and Discounted Future Earnings. Under the Capitalization of Earnings method, normalized historic earnings are capitalized at a rate that reflects the risk inherent in the expected future growth in those earnings. The Discounted Future Earnings method discounts projected future earnings back to present value at a rate that reflects the risk inherent in the projected earnings.
The Market Approach
The Market Approach compares the subject company to the prices of similar companies operating in the same industry that are either publicly traded or, if privately owned, have been sold recently. A common problem for privately owned businesses is a lack of publicly available comparable data.
The Other methods consist of valuation methods that cannot be classified into one of the previously discussed approaches. The methods utilized in the Other Approach are Capitalization of Excess Earnings and Multiple of Discretionary Earnings. Commonly referred to as the “formula method,” the Capitalization of Excess Earnings method determines the value of tangible and intangible assets separately and combines these component values for an indication of total entity value. Under the Multiple of Discretionary Earnings method, the entity is valued based on a multiple of “discretionary earnings,” i.e., earnings available to the owner who is also a manager. Both of these methods are normally used to value small businesses and professional practices.
The methods utilized under each approach are presented and discussed in the following sections.
Book Value
The Book Value is defined as Total Equity from the most recent balance sheet after normalization adjustments have been made. As a valuation method, Book Value has many disadvantages. Balance sheets prepared in accordance with generally accepted accounting principles state assets and liabilities at historical cost and do not necessarily reflect individual values. In periods of increasing prices, the longer an asset or liability has been on the books, the less likely it is to reflect current value. See the Normalized Balance Sheet, most recent year for the Total Equity figure and the Balance Sheet Adjustments for a listing and description of each adjustment.
Net Asset Value
The Net Asset Value method estimates value as the net cash remaining if all assets are sold in an attempt to get the best possible price for each asset and all liabilities are paid with the proceeds. In our analysis, assets and liabilities from the most recent historic, unadjusted balance sheet are adjusted to their individual tax bases. Assets and liabilities are further adjusted to their individual appraised values. A tax adjustment is then estimated based on the difference between the appraised value and the tax basis of assets and liabilities using an effective tax rate. The net result is the total entity value.
Liquidation Value
The Liquidation Value is defined as the present value of the net cash remaining if all assets are sold in a quick and orderly, piecemeal sale and all liabilities are paid at face value with the proceeds. In our analysis, the appraised value of individual assets, and liabilities are adjusted to reflect the value that could be obtained in a quick and orderly liquidation. A tax adjustment is then estimated based on the difference between the appraised value and the tax basis of assets and liabilities using an effective tax rate. In addition, estimated liquidation costs are deducted. The net result is the total entity value.
Discount & Capitalization Rate Estimates
For purposes of the analysis, various risk rates applicable to historic and projected earnings are estimated. Generally stated, these risk-adjusted rates reflect the expected rate of return attainable on alternative investment opportunities with comparable risk.
First, a Discount Rate applicable to the Discounted Future Earnings valuation method is calculated. This Discount Rate is then converted into a Capitalization Rate for use in the Capitalization of Earnings valuation method.
In developing the Discount and Capitalization Rates to apply to the benefit stream of a business, the Capital Asset Pricing Model (CAPM) is used. The Capital Asset Pricing Model is based on a combination of risk factors including a Risk-Free Rate, a Comparable Company Equity Risk Premium, a Size Premium and other identifiable risk factors specific to the subject company. When added together, these risk factors provide an indication of the Discount Rate for the subject company. This Discount Rate represents the total return, in terms of cash flows and appreciation in value that an investor would require in order to make an equity investment in the subject company.
A debt-free earnings base, EBT, EBIT or Free Cash Flow is selected to be used in the Capitalization of Earnings, Capitalization of Excess Earnings, Discounted Future Earnings and Price to Earnings Multiple valuation methods. This base measures earnings before considering the capital structure of the company (i.e., before interest payments on debt and before dividend payments on equity). Therefore, the Capitalization Rates and Discount Rate are modified to incorporate both the Weighted Average Cost of Debt and the Weighted Average Cost of Equity.
The resultant Debt-Free Value in the valuation methods will be an estimate of the value of Total Invested Capital (i.e., value of the entity as if it had no debt). Therefore, in the Capitalization of Earnings, Capitalization of Excess Earnings and Discounted Future Earnings methods, total interest-bearing debt is deducted as a final step to arrive at an estimate of Total Entity Value.
Capitalization of Earnings
The Capitalization of Earnings method arrives at an estimate of value by dividing historic, normalized earnings, which are weighted and averaged to approximate future earnings expectations, by a capitalization rate. In the Capitalization of Earnings method, weighted average, normalized is divided by the capitalization rate, to determine Total Entity Value
Interest-bearing debt is deducted to arrive at Total Entity Value under this valuation method. This is done when Debt Free Earnings are capitalized, because the resultant value assumes that the company has no debt.
Net non-operating assets are added in the determination of Total Entity Value under this method because net non-operating assets do not contribute to the earnings capacity of the business and will be appraised separately.
Discounted Future Earnings
The Discounted Future Earnings method arrives at an estimate of value by determining expected future earnings and then discounting those earnings back to present value using a discount rate that reflects the uncertainty inherent in those earnings.
To determine the expected future income stream, we use projections of the financial statements for the first five years after the valuation date.
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