Preface: The value of a business is often associated with the future value the business will add to its customers or clients, in its geographic marketplace. That value is a reflection of cash flows, net income, and asset values. A business valuation applies a fair market value assessment of that value contribution to the marketplace from a valuation model approach, i.e. the science; and adds the art of deal.
The Science and Art of Business Valuation
Credit: Donald J. Sauder, CPA
“Price is what you pay, value is what you get,” a famous Warren Buffett quote, is certainly most applicable to business valuation. Purposes of a business valuation, from setting value for buy/sell agreements, to obtaining bank financing for an acquisition, alternative financing, or exit planning in a transition, a look at what a business valuation process encompasses should be helpful for entrepreneurs.
Business valuation is both an art and science. With the science of the process and set of procedures applied to a valuation approach 1) Asset approach; 2) Market approach; 3) Income approach; and an art applied to the normalization of company activity, say with a controlling interest. There are as many specific values for a business as there are valuation experts, because business value means different things to different people. For investors, the value is based upon cash flows; for a strategic bidder, e.g. a vertical integration purchase, a business value is determined from consolidation metrics, or market share advantages. The circumstances surrounding the valuation report is part of the art, e.g. exit planning for retirement, relocation, or partners joining.
Albert Einstein is quoted as say, “Try not be a man of success, but rather try to be a man of value. This is true for business valuations too. A business valuation is not a success because the business value is the highest stretch, the valuation is a success because it is objective, independent and a fair market value; and a value achievable in a public marketplace bid. Business value, while both an art and science, is not saying that valuations reports should have substantial ranges in value; while each is unique and different, good valuations should be similar. Price expectations for a professional report usually include a value appraised for a fair market,
- i.e. fair market value: the price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts. {NOTE: In Canada, the term “price” should be replaced with the term “highest price.”} as define in Statement on Standards for Valuation Service No. 1.
The approaches to valuation are the methods for determining a business value. The Income approach include a profit multiplier or capitalization of earnings based upon normalized earnings of business. This approach is often used when a business has stable cash flows from year to year, and earnings or cash flows can be weighted for a number of historic year financial performance. The cash flows or net income can be multiplied or capitalized at either a pre-tax or after-tax performance metric. For an investor, it is important that your valuation use an after-tax approach. Why? You are purchasing the business for profit generation, and those profits will be taxed. Therefore, you must account the after-tax cash flows either for ROI (return on investment), ROE (return on equity), or credit financing repayments.
Another income approach is the discounted future cash flows. This method is often used for companies with variable earnings or variable cash flows, and requires the preparation of financial projections for discounted earnings of financial performance for a determined value, i.e. what is the value today of $1,000,000 of future cash flows in the next 10 years? The excess earnings method is a third income approach that applied an intangible and tangible rate of return on business assets, with multiple calculation metrics.
The asset approach is not based upon income or cash flows, but the net value of the business. This would be most applicable to real estate partnerships say, where the asset is most the business value.
The market approach to valuation, applies comparisons of other marketplace transactions to guide values. This approach required the valuator to access comparable market transactions, i.e. a BIZCOMPS or IBA Market Data, and compare similar size business transactions. The market method is subjection to differences to location, and management performance that influence appraised value. For instance, 10 business transactions with a value determined with the capitalization of income approach would result in 10 data points for the market approach BIZCOMPS sale price data. The subjective factors in those values would ultimately influence the market approach of a discretionary earnings multiple or multiple of revenues.
NACVA Standards have two types of value. A calculation of value and a conclusion of value. A calculation of value simply calculates and documents a calculation of a business value and is often a report between 18 to 34 pages. A conclusion of value requires economic and industry analysis and additional steps of documentation for the appraisal conclusion. A conclusion of value is often a report more than 50 pages required to appropriately document the business appraised value. Conclusions of value are required for litigation and compliance-oriented engagements, i.e. tax matters, e.g. gift tax compliance or estates.
“The value of an idea lies in the using of it.” Thomas Edison’s words could be rephrased for business valuations to say, the value of a business valuation lies in its marketplace relevance. The value can be modified annually from shifts in economic circumstances or transactional circumstances. The valuation report documents why that value is defensible, fair, and accurate.
In summary, the value of business is often associated with the future value the business will add to its customers or clients, in its geographic marketplace. That value is a reflection of cash flows, net income, and asset values. In a competitive market, there are few competitive advantages, and therefore, the businesses are somewhat comparable, e.g. the method or model consistently applied accurately determines appraisal value of the business. A professional business valuation applies a fair market value assessment of that value contribution to the marketplace from a valuation model approach, i.e. the science, and adds the art of deal.