A business valuation requires a working knowledge of a variety of factors, and professional judgment and experience. This includes recognizing the purpose of the valuation, the value drivers impacting the subject company, and an understanding of industry, competitive and economic factors, as well as the selection and application of the appropriate valuation approach(es) and method(s). Some of the more important considerations are discussed below.
What is the purpose of the valuation?
Identifying the purpose of the business valuation is a critical first step in the process as it dictates the “basis of value” or “standard of value” to be applied, which, in turn, impacts the selection of approaches, inputs and assumptions considered in the valuation. The purpose of a valuation could be for acquisition or sale, litigation, taxation, insolvency, or financial reporting, to name just a few. Once the purpose is identified, the appropriate standard of value can be applied. For example, a tax valuation for U.S. tax reporting generally requires fair market value, defined by U.S. tax regulations and further interpreted by case law while financial reporting requires fair value as defined by U.S. and IFRS accounting standards as a basis of value. While all valuations, regardless of purpose, share certain common attributes, there are differences that need to be reflected in the analysis pursuant to the basis of value. These differences can have a significant impact on the outcome of the business valuation.
What basis of value should apply?
The basis of value (or simply put, value to whom?) describes the type of value being measured and considers the perspectives of the parties to the assumed transaction. For example, the basis of value may be defined as the value between a willing buyer and a willing seller or as the investment value to the current owner. Thus, the basis of value may have a significant impact on the selection of valuation approach(es), method(s), inputs and assumptions. It is often specified by a statute, regulation, standard, contract or other document, pursuant to which the valuation is performed. Therefore, the purpose of the valuation and the applicable basis of value are linked.
What premise of value should be used?
The valuation approach(es), inputs and assumptions applied are highly dependent on the selected premise of value. The premise of value is driven by the purpose of the valuation and basis of value used, and generally falls into the following categories:
- A going concern premise is the most common premise of value; it presumes the continued use of the assets, and that the company would continue to operate as a business.
- An orderly or forced liquidation premise incorporates an in-exchange assumption (i.e., the assets are operated or sold individually or as a group, not as part of the existing business).
What is the subject of the valuation?
The subject of the valuation is of vital importance to the valuation process, the selection of inputs and approach(es) and method(s). Valuing the invested capital or common equity of a business, options, hybrid securities, or some other form of financial interests in a business each require the application of specific valuation methods (a.k.a. techniques, all falling under three main valuation approaches), that are tailored to reflect their specific attributes and terms. Additional complexities arise when one valuation may be required as an input to perform another. For instance, a business valuation may serve as an input or a distinct step in the valuation of stock options, preferred stock, or debt. A business interest (ownership interest in a business), on the other hand, may be characterized by various rights and preferences such as voting rights, liquidation preferences, redemption provisions, and restrictions on transfer, each having an impact on the value measurement.
How has the business performed historically?
Regardless of the business valuation approach applied, an understanding of the company’s history and evolution, management and ownership structure, and financial measures of historical performance, is imperative. Financial ratio, margin and growth analysis - the nature of which may vary across industry sectors - provide requisite insight into historical performance. Industry benchmarks offer a frame of reference to evaluate the subject company’s performance relative to its peer group. For example:
- The ratio of enterprise value to the historic amount of invested capital provides an indication of the market’s perception of the ability of the guideline companies to create value.
- Measures such as return on invested capital (ROIC) and an evaluation of competitive advantages, including unique or innovative products, offer insight into how value is being created in the industry, and present benchmarks to assess the performance of the subject company.
Analyses of historical performance also require careful consideration of additional items and factors, such as non-operating assets and non-recurring events. Businesses are generally valued by first estimating the value of the operations and then adding any non-operating assets. Therefore, isolating and valuing the non-operating assets is important, especially when they are material. Non-recurring events should be removed from historical performance in order to get a more representative measure of the indicated future value of operations.
What is the future outlook for the business?
While the historical analyses described above are a key consideration, so are a company’s future prospects. After all, a business derives its value primarily through its ability to create value in the future. In simple terms, value is created when management invests available capital in a manner that provides returns in excess of the cost of that capital. When investment returns equal the cost of capital, no value is created, and when returns fall below the cost of capital, value is eroded.
An assessment of a company’s future outlook comprises understanding the company’s continued strategy in managing its current operations and the expected performance of its future investments. This may include the evaluation of detailed forecasts, revenue, volume and market share data, operating expenses, taxes, capital requirements, cost of capital, etc., and various scenarios thereof. Industry and guideline company analyses also provide insight into a company’s expected performance and future value creation, on a more macro level.
Understanding management’s expectations for the ongoing value creation process; whether it would be built upon continuing successes of the past or through new strategic directions; and whether it is to be generated organically or through acquisitions, is critical in evaluating the future outlook of the business. Business expectations that deviate significantly from prior performance should trigger an incremental level of scrutiny in the analysis due to the lack of historical reference points.
Which valuation approaches should be utilized?
With all this foundational information and the assumptions in place, the analysis turns to the selection of valuation approach(es). The income, market and cost approaches are the three generally accepted valuation approaches. The selection of valuation approach(es) depends on the facts and circumstances of the subject company. A brief summary of each approach follows.
Income Approach: The income approach converts future cash flows into a single present (discounted) amount, while reflecting current expectations about such future cash flows.
The discounted cash flow (“DCF”) is the most recognized method under the income approach. In very broad terms, the DCF method captures the operating value of a business in two primary components: (1) the present value of projected cash flows over the discrete projection period, and (2) the present value of the cash flows beyond the discrete projection period, reflected in a residual (terminal, or continuing) value calculation. A DCF may be applied to estimate enterprise value through the present value of cash flows available to all investors (e.g. debt-free cash flows), or to directly measure the value of equity by discounting equity-level cash flows.
A number of additional issues come into play when applying the DCF method, including understanding the underlying nature of the cash flow projections (e.g. a single most likely case vs. a weighted average of various scenarios, or expected cash flows); assessment of the continuing value beyond the discrete projection horizon; and selection of a discount rate (cost of capital) consistent with the nature and risk of the projections.
In addition to the DCF method, there are other methods or techniques categorized as methods under the income approach such as Monte Carlo simulation, contingent claims analysis, discounted economic profit, and real options analysis, which are applied when appropriate.
Market Approach: The market approach uses prices and other relevant information generated by market transactions involving identical or comparable (similar) companies or assets to benchmark the value of the subject business or business interest.
Two market approach methods commonly utilized in a business valuation are the Guideline Company method and the Guideline Transaction method, both of which provide indications of the value of a business by applying various ratios of value (e.g., enterprise value, equity value, price per share) to financial metrics (e.g. earnings before interest expense, depreciation and amortization “EBITDA”, after-tax earnings, revenue) or nonfinancial parameters (e.g. number of subscribers) derived from publicly traded companies or market transactions.
Comparability between the subject company and the guideline companies or transactions is paramount when applying the market approach, as is the selection of the appropriate type of multiple(s), the selection of the appropriate range of observed multiples, and the manner in which they are applied to the subject company. Furthermore, a valuation would consider potential adjustments to the multiples, including adjustments for non-operating assets, unfunded pension liabilities, and operating leases, as well as growth (e.g. price/earnings growth ratios, or PEG). Identifying guideline companies or transactions, adjusting the financial statements of the peer group, and deriving relevant multiples requires an understanding of the history and outlook of both the guideline companies and the subject company.
Additionally, analyzing prior transactions or offers for shares of the subject company, if any, is another form of the application of the market approach.
Cost Approach: The cost approach reflects the amount that would be required currently to replace the service capacity of an asset.
Thus, many associate the cost approach with the replacement cost method which is more appropriate to apply to an individual asset rather than a business. However, a cost approach may be of use for early stage or start-up companies where comparisons to guideline companies are unreliable, or projections are so subjective that they cannot be reliably estimated. Also, entrepreneurs often think of the value of their business in terms of the investment that would be required to replace the assets they have assembled.
The adjusted net assets method (also known by other names) can also be applied to value a business under certain circumstances. This method derives the value of the overall business by estimating the value of the underlying assets and liabilities comprising the business (tangible and intangible assets, whether recorded on the balance sheet or not), whereby each of the component assets and liabilities would be valued under the cost, market or income approach(es), as appropriate.
In a valuation analysis, the valuation approach(es) and method(s) most appropriate in the circumstances would be applied, considering the availability of relevant data.
How do you arrive at a conclusion of value?
The resulting value indications from the approaches and methods applied would be evaluated and weighted, on a qualitative basis, as appropriate. In many cases, a greater weight may be ascribed to a particular approach. For example, when the guideline companies are not truly comparable to the subject company, a greater weight may likely be placed on the indication of the income approach. However, this should not preclude consideration of the market approach altogether, as it can still serve as a reasonableness check of the valuation conclusion.
If the valuation is for a business interest (for example, a minority, or non-controlling ownership interest in the business), additional adjustments for lack of control and/or lack of liquidity or restrictions on marketability may be required, depending on the facts and circumstances, and the specific rights of the holders of the class of equity interest.
As you can see, the valuation of a business or a business interest is often a complex process involving a number of considerations, ranging from defining the purpose of the valuation, the basis and premise of value used, the historical performance and future outlook for the subject of the valuation. While standard valuation approaches exist, the challenges lie in selecting the appropriate approach(es), developing the inputs, appropriately weighting the value conclusions, and making any adjustments, using judgement. While valuation appears to be entirely quantitative, the reality is that significant consideration is also given to all relevant qualitative factors, and that professional judgment is critical.
Duff & Phelps is a recognized thought leader on calculating cost of capital, and publishes a number of books and related materials on the topic.