Business valuation


Business valuation is a process and a set of procedures used to estimate the economic value of an owner's interest in a business. Here various valuation techniques are used by financial market participants to determine the price they are willing to pay or receive to effect a sale of the business. In addition to estimating the selling price of a business, the same valuation tools are often used by business appraisers to resolve disputes related to estate and gift taxation, divorce litigation, allocate business purchase price among business assets, establish a formula for estimating the value of partners' ownership interest for buy-sell agreements, and many other business and legal purposes such as in shareholders deadlock, divorce litigation and estate contest.
Specialized business valuation credentials include the Chartered Business Valuator offered by the CBV Institute, ASA and CEIV from the American Society of Appraisers, and the Certified Valuation Analyst by the National Association of Certified Valuators and Analysts; these professionals may be known as business valuators.
In some cases, the court would appoint a forensic accountant as the joint-expert doing the business valuation. Here, attorneys should always be prepared to have their expert's report withstand the scrutiny of cross-examination and criticism.
Business valuation takes a different perspective as compared to stock valuation,
which is about calculating theoretical values of listed companies and their stocks, for the purposes of share trading and investment management.
This distinction derives mainly from the use of the results: stock investors intend to profit from price movement, whereas a business owner is focused on the enterprise as a total, going concern.
A second distinction is re corporate finance: when two corporates are involved, the valuation and transaction is within the realm of "mergers and acquisitions", and is managed by an investment bank, whereas in other contexts, the valuation and subsequent transactions are generally handled by a business valuator and business broker respectively.

Estimates of business value

The evidence on the market value of specific businesses varies widely, largely depending on reported market transactions in the equity of the firm. A fraction of businesses are publicly traded, meaning that their equity can be purchased and sold by investors in stock markets available to the general public. Publicly traded companies on major stock markets have an easily calculated market capitalization that is a direct estimate of the market value of the firm's equity. Some publicly traded firms have relatively few recorded trades. A much larger number of firms are privately held. In these firms—which include corporations, partnerships, limited liability companies, and other organizational structures—equity interests are typically traded privately and often infrequently. As a result, previous transactions offer limited insight into a private company's current value. This is because business value fluctuates over time, and share prices are subject to significant uncertainty due to limited market visibility and high transaction costs.
A number of stock market indicators in the United States and other countries provide an indication of the market value of publicly traded firms. The Survey of Consumer Finance in the U.S. also includes an estimate of household ownership of stocks, including indirect ownership through mutual funds. The 2004 and 2007 SCF indicate a growing trend in stock ownership, with 51% of households indicating a direct or indirect ownership of stocks, with the majority of those respondents indicating indirect ownership through mutual funds. Few indications are available on the value of privately held firms. Anderson recently estimated the market value of U.S. privately held and publicly traded firms, using Internal Revenue Service and SCF data. He estimates that privately held firms produced more income for investors, and had more value than publicly held firms, in 2004.

Standard and premise of value

Before the value of a business can be measured, the valuation assignment must specify the reason for and circumstances surrounding the business valuation. These are formally known as the business value standard and premise of value.
The standard of value is the hypothetical conditions under which the business will be valued. The premise of value relates to the assumptions, such as assuming that the business will continue forever in its current form, or that the value of the business lies in the proceeds from the sale of all of its assets minus the related debt. When done correctly, a valuation should reflect the capacity of the business to match a certain market demand, as it is the only true predictor of future cash flows.

Standards of value

  • Fair market value – a value of a business enterprise determined between a willing buyer and a willing seller both in full knowledge of all the relevant facts and neither compelled to conclude a transaction.
  • Investment value – a value the company has to a particular investor. The effect of synergy is included in valuation under the investment standard of value.
  • Intrinsic value – the measure of business value that reflects the investor's in-depth understanding of the company's economic potential.

    Premises of value

  • Going concern – value in continued use as an ongoing operating business enterprise.
  • Assemblage of assets – value of assets in place but not used to conduct business operations.
  • Orderly disposition – value of business assets in exchange, where the assets are to be disposed of individually and not used for business operations.
  • Liquidation – value in exchange when business assets are to be disposed of in a forced liquidation.
Premise of value for fair value calculation
  • In use – if the asset would provide maximum value to the market participants principally through its use in combination with other assets as a group.
  • In exchange – if the asset would provide maximum value to the market participants principally on a stand-alone basis.
Business valuation results can vary considerably depending upon the choice of both the standard and premise of value. In an actual business sale, it would be expected that the buyer and seller, each with an incentive to achieve an optimal outcome, would determine the fair market value of a business asset that would compete in the market for such an acquisition. If the synergies are specific to the company being valued, they may not be considered. Fair value also does not incorporate discounts for lack of control or marketability.
However, it is possible to achieve the fair market value for a business asset that is being liquidated in its secondary market. This underscores the difference between the standard and premise of value.
These assumptions might not, and probably do not, reflect the actual conditions of the market in which the subject business might be sold. However, these conditions are assumed because they yield a uniform standard of value, after applying generally accepted valuation techniques, which allows meaningful comparison between businesses which are similarly situated.

Elements

Economic conditions

A business valuation report generally begins with a summary of the purpose and scope of business appraisal as well as its date and stated audience. Following is then a description of national, regional and local economic conditions existing as of the valuation date, as well as the conditions of the industry in which the subject business operates. A common source of economic information for the first section of the business valuation report is the Federal Reserve Board's Beige Book, published eight times a year by the Federal Reserve Bank. State governments and industry associations also publish useful statistics describing regional and industry conditions. Valuators use these as well as other published surveys and industry reports. The net present value for similar companies may vary depending on the country because of the different time-value of money, country risk and risk-free rate.

Financial analysis

The financial statement analysis generally involves common size analysis, ratio analysis, trend analysis and industry comparative analysis. This permits the valuation analyst to compare the subject company to other businesses in the same or similar industry, and to discover trends affecting the company and/or the industry over time. By comparing a company's financial statements in different time periods, the valuation expert can view growth or decline in revenues or expenses, changes in capital structure, or other financial trends. How the subject company compares to the industry will help with the risk assessment and ultimately help determine the discount rate and the selection of market multiples.
It is important to mention that among the financial statements, the primary statement to show the liquidity of the company is cash flow. Cash flow shows the company's cash in and out flow.

Normalization of financial statements

The key objective of normalization is to identify the ability of the business to generate income for its owners. A measure of the income is the amount of cash flow that the owners can remove from the business without adversely affecting its operations. The most common normalization adjustments fall into the following four categories:
  • Comparability adjustments. The valuer may adjust the subject company's financial statements to facilitate a comparison between the subject company and other businesses in the same industry or geographic location. These adjustments are intended to eliminate differences between the way that published industry data is presented and the way that the subject company's data is presented in its financial statements.
  • Non-operating adjustments. It is reasonable to assume that if a business were sold in a hypothetical sales transaction, the seller would retain any assets which were not related to the production of earnings or price those non-operating assets separately. For this reason, non-operating assets are usually eliminated from the balance sheet.
  • Non-recurring adjustments. The subject company's financial statements may be affected by events that are not expected to recur, such as the purchase or sale of assets, a lawsuit, or an unusually large revenue or expense. These non-recurring items are adjusted so that the financial statements will better reflect the management's expectations of future performance.
  • Discretionary adjustments. The owners of private companies may be paid at variance from the market level of compensation that similar executives in the industry might command. In order to determine fair market value, the owner's compensation, benefits, perquisites and distributions must be adjusted to industry standards. Similarly, the rent paid by the subject business for the use of property owned by the company's owners individually may be scrutinized.