In business, it is commonly known that “valuation is an art, not a science.” This essentially means that when creating a valuation analysis, it important to go beyond the numerical analysis and get to the story “behind the numbers”. This also refers to the “art” of valuation analysis, as there are a variety of important areas of judgment that will affect the ultimate conclusion. The business valuation process also provides an opportunity to assess and identify business risks and related areas of improvement that could lead to future value enhancement.
There are a variety of approaches and methods used in business valuation. However, the most common approaches used at Corrigan Krause are the asset approach, income approach and market approach. Under these approaches there are a number of valuation methods that are assessed based on the facts and circumstances for the company being valued. The values determined in each applicable method are then reconciled based on facts and informed judgment to arrive at the estimate of value.
The Asset Approach
The primary valuation method under the asset approach is known as the adjusted net assets method. This method is used to value a business based on the difference between the fair market value of a company’s assets and its liabilities. Assets are adjusted from their book value to their estimated fair market values, and the total adjusted assets are then reduced by recorded and unrecorded liabilities.
This method is most commonly used with a holding or investment company (such as real estate holdings) or capital intensive company, for businesses that continuously generate losses, or when valuation methods based on a company’s cash flow indicates a value lower than its net asset fair market value.
The Income Approach
In its simplest form, business value is the conversion of expected future benefits into a present value, based on the perceived risk of those benefits being received. Thus, under the income approach, value is determined by assessments of the business’ income or cash flow stream and the risk-based rate of return that an investor would want on their business investment. Since value (V) = benefits (B) ÷ risk rate (R), with an increase in the cash flow stream (for example, from new, more-efficient machinery or technology) the company’s value is enhanced as the B numerator increases. On the flip slide, if the company’s risk increases (such as from the loss of a major customer or key employee), value declines based on the R denominator increasing, as the “hypothetical investor” wants a higher rate of return to compensate for the incremental risk.
There are two common methods used within the income approach: the capitalization of cash flows (CCF) method and the discounted cash flows (DCF) method, also referred to as discounted future earnings method. A primary difference between the two methods is that the CCF method focuses on analyses of historical earnings that can be estimated as being “representative” of the expected future benefit streams, while the DCF relies on projections of future cash flow. The CCF is often used when a company’s future growth trend is estimated to be linear or stable.
The discounted cash flows method is used to estimate the value of a business by discounting the projected annual future cash flows to a present value using a discount rate (again based on risk). The DCF then adds a second layer by adding the present value of the terminal value, which is the company’s estimated value at the end of the projection period. As a result, the DCF is often referred to a two-stage valuation model, as opposed to the CCF which is a single-stage model. The DCF method can be utilized when a company’s future growth trend is projected to be non-linear, such as growth at 20% in year 1, 15% in year 2 and 5% in year 3.
The Market Approach
The market approach relies on comparable companies in similar industries to make a comparison of estimated value. Two types of methods under this approach are based on the source of comparable company data, the guideline transaction method and guideline public company method. The guideline transaction method utilizes databases of comparable companies that consummated a sale transaction and have reported data for valuation multiples, as well as insightful information on other operating statistics for the companies and the dataset as a whole. Such information is especially useful when valuing small to medium-sized companies.
The Significant Benefits of the Valuation Process on Business Planning
There are several important business planning areas where a valuation can greatly enhance the corporate or individual planning. These include:
- Buy-sell agreement planning and the related critical provisions for what will happen upon the departure of a shareholder, either in an emergency situation or a planned transition
- Succession planning, for the important planning for eventual ownership transition to the next family generation or key employees
- Business financing
- Planning for potential acquisitions to know an estimated value baseline if that “knock on the door” comes from an industry player. This latter acquisition planning could also be the owner(s) succession planning if there are no family members able to take over and/or key employees able to purchase the business.
Overall, the valuation process enhances decision-making and can identify areas of strengths to capitalize upon, risks and weaknesses to address, and/or other areas to improve business operations. Related to this, and perhaps most importantly, a valuation can identify “value drivers” and other issues to manage and minimize risk, in order to enhance the value of the business that owners put so much effort and passion into building.