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Introduction
Article By: Gary Parker
“What do you think my company is worth?” is the
question we are most commonly asked by our clients and prospects
who are considering the sale of their companies. Answering this
question is an important step in determining whether the timing
might be right to sell a particular company. Although there are
many other factors that will affect whether a business owner
should pursue a transaction, this article provides an overview
of the most common approaches and methods used in business
valuation.
The leading business valuation associations, the American
Society of Appraisers (ASA), the Institute of Business
Appraisers (IBA), and the National Association of Certified
Valuation Analysts (NACVA), all agree on three major approaches
to business valuation: the Income Approach, the Market Approach,
and the Cost Approach. Under each of these approaches there are
several methods that might be employed depending on the specific
nature of the company being valued. A brief description of the
standard approaches and most commonly used methods under each
approach follows below. We conclude with the True Value
Approach.
Valuation Approaches and Methods
Income Approach.
The Income Approach involves
valuation methods that convert future anticipated economic
benefits (e.g., cash flow) into a single present dollar amount.
Depending on the valuation method used, “Income” might be
represented by after-tax profit, pre-tax profit, EBIT (earnings
before interest and taxes), EBITDA (EBIT plus depreciation and
amortization), or other cash flow measures. The two most
commonly used methods under this approach are the Single Period
Capitalization Method and the Multiple Period Capitalization
Method.
- Single Period Capitalization Method
– This method involves converting representative income for a
single period into present dollar value through the use of a
capitalization rate (expressed as a percentage). The
capitalization rate factors in the risk of achieving the future
income as well as a projected growth rate for the specific
company being valued. The key assumptions required in order to
use this method include stable earnings, a constant growth rate,
and the prospect for continued growth for a long time period.
-
Multiple Period Discounting Method
(aka Discounted Cash Flow
Method) – This method uses financial projections to determine
future income for several periods into the future including a
terminal value and a discount rate to convert those future
values back to a present value. The advantage of this method is
that it can be used for companies with unstable earnings and
nonconstant growth rates. It is important that the discount rate
being used is appropriate for the “income” being discounted as
small changes in the discount rate can have considerable impact
on the present value.
Market Approach.
The Market Approach involves valuation
methods that use transactional data to help determine a
company’s value. These methods might involve private company
transactions, public company transactions, as well as public
company valuation measures using current stock market data. The
theory behind this approach is that valuation measures of
similar companies that have been sold in arms-length
transactions should represent a good proxy for the specific
company being valued. Depending on the source of data available
and the underlying company being valued, a variety of valuation
measures might be used including Enterprise Value (EV) to Sales,
EV to EBITDA, EV to EBIT, Price to Earnings, etc.
- Merger and Acquisition Method (aka Comparable Sales)
– This
method involves reviewing transactions for companies that are in
the same or similar line of business as the company being valued
and then applying the relevant pricing multiples to the subject
company to determine its value. Proprietary data bases of
private company sales are often utilized in this method. In
addition, some public company transaction data is available.
Adjustments are commonly made to these valuation measures before
applying to the subject company to ensure an “apples-to-apples”
comparison. One or many comparable sales might be considered
under this method depending on the data available and the degree
of similarity to the company being valued.
- Guideline Public Company Method
– This method involves using
market multiples derived from market prices of stocks for
companies that are engaged in the same or similar industries as
the subject company. This can be a helpful tool in valuing
private companies, but these public company multiples usually
need to be discounted significantly to reflect the higher risks
(e.g., customer concentration, management depth, access to
financing, etc.) inherent in most smaller private companies as
well as the “lack of marketability” of private company stock.
Cost Approach.
The Cost Approach, also known as the
Asset-based Approach, involves methods of determining a
company’s value by analyzing the market value of a company’s
assets. This valuation approach often serves as a valuation
floor since most companies have greater value as a going concern
than they would if liquidated, i.e., the present value of future
cash flows generated by the assets usually far exceed the
liquidation value of those assets. This difference between the
asset value and going concern value is commonly referred to as
“goodwill”. An exception to this might be a low-margin business
in a competitive industry that owns its real estate, which has
appreciated over time due to its development value. In this
case, the asset value may exceed the going concern value of the
business.
- Adjusted Book Value Method –
This method involves reviewing
each asset on the company’s balance sheet and adjusting it to
reflect its estimated market value. Depending on the mix of
assets owned by the company, other types of appraisers (e.g.,
real estate, machinery and equipment) might need to be consulted
as part of the valuation process. In addition, it is important
to consider intangible items that might not necessarily be
reflected on the balance sheet, but which might have
considerable value to a buyer, such as trade names, patents,
customer lists, etc.
Conclusion
The valuation methods discussed above represent some of the
most commonly used by business valuation professionals to
generate an opinion of value. Although considerable time and
effort is involved in preparing formal business valuations,
unfortunately the results may or may not reflect the “real
world” value of a specific company if it were formally offered
for sale.
“Real World” or True Value.
True value of a company is that
which a real, live buyer would be willing to pay if it were
formally offered for sale. Depending on the unique aspects of
each individual company, the true value may vary significantly
from a valuation determined by any of the methods discussed
above.
Consulting a professional investment banker can best help you
assess the true value of your company. These professionals will
assess your company’s strengths and weaknesses and employ some
of the commonly used valuations methods used by business
valuators. They will also leverage their insight into the
current marketplace to help determine financing availability and
assess many other factors to determine your company’s potential
value in the market place.
Gary Parker is a Principal in the Charlotte office of
Corporate Finance Associates and holds the Chartered Financial
Analyst (CFA) designation. Before joining Corporate Finance
Associates he worked for a well-known Southeast business
valuation firm as a Certified Business Appraiser (CBA).
Call your nearest CFA office to discuss the value of your
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