I have written about many valuation related topics. Some were updates on important changes impacting the industry. Some topics were more detailed and focused on technical valuation issues or new case law. I am taking a cue from my clients for the next few articles and going back to basics. Allow me to explain. In every valuation engagement, I make the time to meet with my clients and review a draft of the valuation. I want to make sure they understand the “why’s and how’s” behind what I am doing by explaining the valuation process using terms and examples they can relate to. My goal is for them to leave the meeting with a better understanding of the valuation process.
With that said, I think it’s time to go back to some basics and explain the three basic approaches that can be used in valuing a business. These include the Market Approach, the Asset Approach, and the Income Approach. Below are a few highlights of each.
The Market Approach uses the value of comparable companies from either a Public Market or recent transactions to develop pricing multiples to apply to a subject business. The multiple can be developed by taking the transaction price or value of a Public company and dividing that by an appropriate metric such as free cash flow, EBITDA (earnings before interest, taxes, depreciation, and amortization), sales, or a few other metrics. The multiple is then applied to the same metric of the subject business to determine its value. The Market Approach can be applied to a minority or a controlling ownership interest, but if the multiple was based on a controlling transaction, then appropriate discounts would need to be considered. The theory behind this approach is that the market will determine what price is acceptable based on the chosen metric. Generally, this approach is difficult to use because guideline transactions are difficult to find, and even if a similar company is found, an amount of time has usually passed and the market has changed. Finding a guideline public company that is truly comparable to a much smaller privately owned business can be difficult at best. Another difficulty when using this method is not knowing the motivation of the buyer or seller. A buyer could pay a higher-than-normal price because they are motivated to enter a particular market; or they might have excess capacity they need to use; or there might be synergies available to them that may not be available to other buyers. The end result could be an overstated multiple that shouldn’t be used. Conversely, an owner may be forced to sell their business quickly and might not receive the same price if they had a longer period of time to sell.
The Asset Approach uses the value of a company’s assets to determine the value of a business. This approach considers the fair value of the assets (both tangible and intangible) and liabilities of a company and uses the difference between the two as the value. It does not take into account the value of unrecorded intangible assets or the earnings stream of the company. This approach is typically used when valuing a controlling interest and when the value of a company lies more in its assets than its cash flow. An example of this approach would be a company investing in real estate or an equipment leasing company with a large inventory of equipment that is not being leased. It also may be appropriate for a business operating in a dying or underperforming industry where the timeframe for a turnaround can’t reasonably be determined. A company owning a building with corporate office space for lease that has a high vacancy rate is another good example. The cash flow it produces might not be sufficient to carry the debt service and expenses.
The Income Approach considers the cash flow an investor will receive from their ownership interest. The cash flow needs to be “normalized” future cash flow. Working capital needs, capital expenditures, taxes, and debt service requirements must be considered. The discount rate used to convert the cash flow to value must consider the risks of receiving the cash flow. The required rate of return will be higher for a riskier investment. The Income Approach can be applied to a minority or a controlling ownership interest. For a typical business, estimating the future cash flow is speculative, so historical data is generally used as the starting point for deriving future cash flows. There are two main methods used in the Income Approach. These are the Capitalization of Benefits Method and the Discounted Future Benefits Method. If the cash flows of the company have been stable and are expected to be constant or grow at a predictable rate, the Capitalization of Benefits Method is the preferred method for determining value. If the cash flows are expected to be significantly different in the future when compared with past and current amounts, then the Discounted Future Benefits Method is preferred. The Discounted Future Benefits Method is a powerful approach that can allow you to model expected changes in future cash flows, changing tax rates, changing capital expenditure requirements, and other factors such as the expected recovery time from the COVID-19 pandemic.
There is no requirement to use any particular approach, as that decision is left up to the professional opinion of the valuator. I believe each method should be considered, but there are many factors that can influence the selection of a method. More than one method can be used to value a business. When done correctly, I believe the methods will produce reasonably comparable values. If the values are not comparable then the valuator may need to revisit the assumptions used and determine if the methods selected were appropriate.
For more information on McKonly & Asbury’s Business Valuation Services, click here to visit our webpage. Should you have questions about the three approaches to valuing a business, or business valuation in general, don’t hesitate to contact me, T. Eric Blocher CPA, ASA, CVA, at firstname.lastname@example.org.