Business valuation is a booming industry and many companies are entering this service field to
provide business evaluations. The range of reasons a business needs to be evaluated can range as can the
type of business that is being evaluated. Sometimes evaluations are needed for mergers, income tax
purposes, buy/see agreements, business planning, compensation, stock options, and disputes. These
evaluations can be done by analysts, appraisers, public accountants and investment bankers, however it is
important to note, “The AICPA unofficially estimates that tens of thousands of certified public
accountants (CPAs) perform business valuations on at least a part-time basis”,[ CITATION BUSI534 \l
1033 ]. Providing a valuation will be determined by the reason for the valuation which is why the analyst
who will provide the evaluation must determine the reasoning first before being able to determine the
method used. According to the author of the text, “the standard of value is closely related to and
determined by the purpose of the valuation”.[ CITATION BUSI534 \l 1033 ].
There are only three actual approaches to value and asset or business; income approach, market
approach, and asset approach. However, the issue lies in that each of these approaches has numerous
methods in which an analyst can consider performing the evaluation. For example, the income approach
can use the Discounted Cash Flow method or perhaps the capitalized cash flow method or even direct
equity verses invested capital method. The Market Approach can use guidelines for public companies or
guidelines that are derived from both public and private companies. The Asset Approach also has various
methods depending on the whether the valuation is for tangible assets, individual intangible assets, or all
intangible assets which will help determine the best method for the valuation. Since there is so much
information readily available to anyone, valuation can sometimes become very controversial because the
valuations can vary based on who is performing them and methods used. There are times when these
evaluations are used for buying and selling a business or paying taxes or even helping current investors
determine the value of owning its stock. Since accuracy is essential it is important that the evaluation
start with the research and planning stage to determine which method would produce the desired outcome
for each individual circumstance.[ CITATION BUSI534 \l 1033 ] In this paper we will look at some of
these evaluation methods and determine how and why one might be used and what the general purpose is
for one verse another.
The income approach will involve estimating the income stream and determining the
capitalization or discount rate and then applying that rate to the income stream to help determine the value
of the asset. When trying to determine which method will work best, again it would depend on the
company. As a general rule, “if the growth in revenues and earnings is relatively stable, the capitalized
returns method is most appropriate and if is expected that the business will experience some time of
unsustainable growth rates, the discounted future returns method is more appropriate”[ CITATION
IncomeApproach \l 1033 ]. When gathering the financial information, the analyst will need to trust the
documents sources so be sure to gather financial for a reliable and credible source and will first need to be
adjusted paying close attention to how intangible assets are used and documented in the financials. In the
capitalized returns method, it would be determined the financial statements gathered can help predict
future earnings and those earnings are expected to grow at a constant rate. The next step is to find the
capitalization rate using the risk free rate on US Government 20 year securities[ CITATION
IncomeApproach \l 1033 ], then use equity risk premium rate and subtract the growth rate. This rate is
then used to capitalize the growth stream. “The value of the business is estimated by dividing the
earnings stream by the capitalization rate: Estimated Value of Business=Earnings Stream /
Capitalization Rate, with the rate of return being based on stock market returns”.[ CITATION
IncomeApproach \l 1033 ].
In the Discounted Cash Flows method, the analyst would begin in the same way by gathering
financials and adjusting them appropriately for evaluation. However, this method would be more
appropriate to use when it is determined future earnings are not predictable and cannot determine the
expected rate of growth and will be necessary to estimate the year in which growth rates will level out and
is referred to as the “terminal year” [ CITATION IncomeApproach \l 1033 ]. DCF is essentially the net
present value or (NPV) of the cash flows projected by the company and based on the idea that the
business value is intrinsically based on the amount of revenue or cash that it is able to generate.
[ CITATION BUSI534 \l 1033 ]. With this theory in the analyst is relying more on the fundamental
business operating principles to generate cash instead of what the market might say is the businesses
ability to generate cash. Calculating NPV requires the to first determine the Present Value or PV and use
this to calculate expected future cash flows. “ The disadvantage to this technique is an estimation of future
cash flow and terminal year value along with the appropriate risk adjusted discounted rate”[ CITATION
IncomeApproach \l 1033 ].
In steps in discounted cash flow start with finding the (FCFF) free cash flow to the firm, next cost
of debt and equity, which should give the WACC (weighted average cost of capital). Next determine
NPV, company value, equity value and Intrinsic Share Price. Although the steps are straight forward
there are many subjective estimations that can make this evaluation vary from one to another, and which
one is correct? For example, consider forecasting estimated on two years verses four years or possible
cost of capital as this can vary greatly from one valuation to the next and no simple method exists to
estimate most accurate cost of equity.
“The market approach is based on the concept of substitution. Transactions from publicly traded
companies, closely held comparable companies, and prior arms-length transactions of the subject
company‘s equity provides the appraiser with earnings multiples to apply to the subject company to arrive
at an indication of value. This method is frequently used as a “reasonableness test” to the income
approach”[ CITATION Cat16 \l 1033 ]. The market approach relies on outside date and available
information and differs from the income approach because it is not using financial statements and analysis
of those statements to determine the valuation. Instead it uses sales transactions of the business,
information on other publicly traded companies, and sales of interest and uses this information to reach
valuations. Some of the methods used in this approach are Guideline Public Company Method—based
on reasonably comparable publicly traded companies. Guideline Company Transaction Method—
based on transactions of private companies, Direct Market Data Method—based on private transactions,
and Guideline Sales of Interests in Subject Company—which is based on prior transactions of interest.[
CITATION BUSI534 \l 1033 ].
Each of these approaches uses simple math and is based on a basic format that only changes
based on the parameters that are being used. Some of the parameters could be sales, net income, book
value, and can be a combination of current years or historical information. However, a key to application
of public multiples is consistency with the calculations. “If multiples of invested capital have been
calculated from guideline companies, their application to the subject company will provide an invested
capital value.”[ CITATION BUSI534 \l 1033 ]. Transaction method involves looking at previous
transactions of similar companies in that same industry and based on the idea that maybe companies
financials are not readily available to the general public but instead their transactions are easily attainable.
Again, a key here is to make sure the companies are comparable in the subject matter that is being
evaluated. This can sometimes be a challenge due to the lack of information in the public spectrum or in
public databases. Some factors that the analyst can look for when determining comparability is if the
companies are in the same industry, if the size is similar, determine the product of service to be of a
similar nature, determine if they are in multiple locations, who the competitors are, and finally profits
should be similar.
As with all valuation methods this one too has advantages and disadvantages. Some advantages
to using this approach is it is easily understandable and can be easily calculated because it is using actual
data and not based on hypothetical calculations. The income approach has methods that must be created
but the methods in Market approach draws conclusions from actual ratios based on similar companies.
This approach also includes all the business’s assets as like the income approach but unlike the income
approach, this approach will include all the operating assets which sometimes is not possible to do in the
income approach. That is because things like goodwill, and tradenames are intangible and hard to
determine value on these.[ CITATION BUSI534 \l 1033 ]. Because future growth is already in the data
being used and does not need to be projected or forecasted this method differs greatly from the income
method because it is based on assumptions or projections that may or may not be correct. Some
disadvantages to using the Market Method compared to income method is the flexibility to adapt. In the
income method the calculations can reflect changes that are occurring in the market with the assumptions
and forecasting, however with the market approach this is not possible since the data is set in stone and
does not take into account any special circumstance that may be effecting the data. Another big
disadvantage to using the Market Method compared to the Income Method is the “no good guideline
companies exist”[ CITATION BUSI534 \l 1033 ] and it may prove hard to find similar companies to
compare the valuation with because of the complexity and diversity of all companies today.
The Asset Approach has many methods to help determine a companies value but the most
commonly used valuation approach for asset is the Adjusted Net Asset Method which used the companies
balance sheet to compare differences between the fair market value and what the assets and liabilities are
on the balance sheet. The companies historical book values are adjusted to reflect fair market values by
adjusting fixed assets to their respective fair market values, reducing accounts receivable for potential
uncollectible balances, and taking into consideration any unrecorded liabilities such as judgements or
lawsuits. (Saari, 2016). The Asset Approach will also consider the adjusted net asset method for holding
companies or a capital-intensive company because losses are generally part of the business model. That
is why when using this method over say an income method it is important to keep in mind when income
based approach valuations indicate higher valuation than the adjusted net asset method it is because
income methods provides a much more accurate reflection of goodwill and intangible value of the
company. (Saari, 2016)
In general, when determining a valuation method to be used the analyst must do the due diligence
to research the company first to determine which method would produce the most appropriate valuation
also based on what the valuation is being used for. Since there are so many different methods and each
analysis will apply explicit weights to the values based on the method it will also be important to consider
the reputation of the agency being used. The experience and accreditation of the company may times will
help to give the valuation more creditability and reduce the need to question its accuracy. “Regardless of
the approach, the concluded value should be reconciled and supported by the valuation method that was
used” (Saari, 2016).
References
Durham, C. J. (2016). Understanding the basic business valuation methods. Control Engineering, 24.
Hall, S. C. (2004). Applying Income Approach Business Valuation Methods to Professional Practices.
Society of Financial Service Professionals, 90-102.
Hitchner, J. R. (2017). Financial Valuation-Applications and Models. Hoboken: John Wiley & Sons.
Saari, S. (2016). How a Company is Valued. Retrieved from
https://leaglobal.com/thought_leadership/How%20a%20Company%20is%20Valued%20-%20An
%20Overview%20of%20Valuation%20Methods%20and%20Their%20Application.pdf
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