February 9, 2016 | Valuations
Valuing a private business is a complex process, but most closely held business owners want to know the value of their investments, especially if they are going to sell or gift shares to family members or charities. It is vital to hire a valuation professional who understands the current marketplace and the relevant value drivers for your business.
Valuators use three general approaches to appraise private businesses and business interests. Each approach can be summarized as follows:
Asset-Based (or Cost) Approach
This approach is commonly used for asset-holding companies or other businesses that rely heavily on tangible assets. It may also serve as the “floor” for the value of an operating business, in case the other approaches indicate a value below its adjusted net worth.
The balance sheet serves as a starting point for this approach, and the value is calculated by subtracting the market values of the company’s liabilities from the market values of its assets. However, some assets may be understated on the books (such as equipment subject to accelerated depreciation methods) or missing (such as internally-generated intangible assets), so the book value of equity doesn’t necessarily equate with the fair market value of equity. Off-balance sheet liabilities (such as pending litigation or environmental liabilities) also must be considered when adjusting the balance sheet to market values.
When appraisers use the market approach, they compare the subject company to similar businesses or business interests that have been sold. Here are two common methods that fall under the market approach:
- Guideline Public Company Method. The valuator identifies publicly traded companies that are similar to the subject company and develops pricing multiples (for example, price-to-earnings or price-to-revenues). Nearly 30,000 companies trade stock on public exchanges, creating a wealth of transaction data. However, many closely-held companies are too small and specialized to compare to large, diversified public stocks.
- Merger and Acquisition Method. This method examines sales of similar companies, and these deals may involve privately held or publicly traded companies. There are a number of proprietary databases available to business valuators that provide the details of these transactions. As with the guideline public company method (above), the valuator computes pricing multiples (such as price-to-earnings) and applies them to the subject company’s financial metrics to determine value.
Valuators use specific selection criteria to obtain a relevant sample of transactions when searching transaction databases for comparable companies. Examples of selection criteria include:
- Markets and customers served
- Projected growth in sales and earnings
- Methods of operations
- Accounting Methods
This approach assumes that the value of a business is equal to the sum of the current values of expected future benefits. In other words, value is based on the subject company’s ability to generate income in the future. The two most common methods within this approach are:
- Capitalization of Earnings Method. This method is better suited for companies with established, stable cash flows, because the value of a business is based on a single estimate of what the future income of the business is likely to be. In turn, the single representative period is divided by a capitalization rate that’s based on the company’s required rate of return and its long-term sustainable growth rate.
- Discounted Cash Flow Method. Under this method, cash flows are projected over a finite period and then they’re assumed to stabilize. Once earnings are presumed to be stable, a “terminal value” is calculated, typically using the capitalization of earnings or merger and acquisition method. Discounting is a multi-period method of valuation, so the value of a business equals the net present value of its expected future cash flows or income. The cash flow or income stream is discounted by the company’s required rate of return.
What’s the Preferred Valuation Technique?
No technique works best for all cases, and there are many factors that go into determining the value of a business. Valuators consider all three of these approaches when valuing a private business but they may use only one or two methods when valuing a specific company. A valuation expert is trained in the art and science of applying these approaches to value your business. Be sure to contact an expert to understand what your business is currently worth.