Valuation Law and Legal Definition
Valuation is the process of putting a price on a piece of property. The value of businesses, personal property, intellectual property (such as patents, trademarks, and copyrights), and real estate are all commonly determined through the practice of valuation. Businesses are valued for many tax, legal, and business reasons but selling the business is the usual motive. Determining the value of a business is simple yet complex. The value is what a knowledgeable buyer is willing to pay for it. And what price should a buyer be willing to pay? Here things become complicated. More than one valuation method exists but each one must take future earnings into account if continued operations are planned.
Theory recognizes three approaches to business valuation: the income-based approach, asset-based approach, and the market approach. The income approach is the most commonly used and is based on an entity's estimated future income stream. The asset-based approach is based on a straight forward determination of the collective value of an entity's assets. The market approach is a hybrid form of the earlier two. Using the market approach usually involves utilizing some market multiple of assets and income.
Putting a value on a small company is much more difficult than establishing the value of a large, publicly traded company. Publicly traded companies have a known value on any given day—the value of their outstanding stock. The value of small companies is much harder to establish, especially family-owned or closely held companies, companies that are unique in the marketplace, or companies built by creative entrepreneurs who will not be running the companies in the future. The valuation of a small company is usually best accomplished by using more than one method and melding the results of various assessments in a way that best reflects the individual business.
APPROACHES TO VALUATION
Of the many methods used in determining the value of a business, some are better suited to certain business types than others. Finance companies tend to value a business at what the assets will bring at a liquidation auction. Investment bankers and venture capitalists, on the other hand, tend to be interested in rapid appreciation and high return on investment and, thus value a business on a discounted future cash flow basis. Statisticians tend to use complex deviation curves based on historical performance to project future earnings when doing a business valuation. Corporate America looks to the prevailing profit-to-earnings (P/E) ratios, unless the market is depressed, in which case they use book value.
Rules of Thumb
Because the cost of having a formal appraisal performed may be prohibitive for small businesses, owners will frequently turn to their accountants for assistance with a business valuation. Accountants faced with this task often revert to what are known as business valuation rules of thumb to try and determine a range of values for their clients.
Rules of thumb are standards established for businesses in the same industry. Brokers and financial intermediaries involved in mergers and acquisitions observe how certain types of businesses are valued and sold and over time patterns emerge. Based upon these empirical data they derive and publish rules of thumb to guide the valuation of businesses by industry and type. Examples of such rules of thumb are: dry cleaning businesses sell from 75 percent to 90 percent of gross revenues; property and casualty insurance businesses sell for 1.2 to 1.6 times book value, dental practices sell for 50 percent to 60 percent of gross revenues, optometrist practices sell for the value of their net fixed assets plus the most recent year's net income, etc. Many books and professional journals provide information about these rules of thumb. One of the largest collections of such rules is available in the book Handbook of Small Business Valuation Formulas and Rules of Thumb, by authors Glenn Desmond and John A. Marcell. Trade associations are another source of information about industry-specific, business valuation rules of thumb.
Income Statement Methods of Valuation
The two related valuation methods listed below are by far the most frequently used means of assessing the value of a small business.
- Historical Cash Flow Approach—This is the most commonly used of all valuation methods. Many buyers view this method as the most relevant of all valuation approaches for it tells them what the business has historically provided to its owners in terms of cash. Lawrence Tuller noted in The Small Business Valuation Book, "the value of assets might be interesting to know, but hardly anyone buys a business only for its balance sheet assets. The whole purpose is to make money, and most buyers feel that they should be able to generate at least as much cash in the future as the business yielded in the past." This method typically takes financial data from the company's previous three years in drawing its conclusions.
- Discounted Future Cash Flow (DCF) Approach—This method uses projections of future cash flows from operating the business to determine what a company is worth today. The DCF approach requires detailed assumptions about future operations, including volumes, pricing, costs, and other factors. DCF usually starts with forecast income, adding back non-cash expenses, deducting capital expenditures, and adjusting for working capital changes to arrive at expected cash flows. The future cash flow method also is notable for its recognition of industry reputation, popularity with customers, and other "goodwill" factors in its assessment of company value. Once the value of the business's assets has been settled upon, the appropriate discount rate must be determined and used to bring the future cash flows back to their present day value. DCF in its single-period form is known as capitalization of earnings, which usually involves "normalizing" a recent measure of income or cash flow to reflect a steady-state or going-forward amount that can be capitalized at the appropriate multiple.
Balance Sheet Methods of Valuation
These methods of valuation are most often employed when the business under examination generates most of its earnings from its assets rather than from the contributions of its employees. These methods are also used, wrote John A. Johansen in How to Buy or Sell a Business, "when the cost of starting a business and getting revenues past the break-even point doesn't greatly exceed the value of the business's assets."
- Liquidation Approach—This method assesses the value of a business by gauging its value if it were to cease operations and sell its individual assets. Under this approach, the business owner would receive no compensation for business "goodwill"—nontangible assets such as the company's name, location, customer base, or accumulated experience. This method is further divided into forced liquidations (as in bankruptcies) and orderly liquidations. Values are typically figured higher in the latter instances. Asset-based lenders and banks tend to favor this method, because they view the liquidation value of a company's tangible assets to be the only valuable collateral to the loan. But it is unpopular with most business owners because of the lack of consideration given to goodwill and other intangible assets.
- Asset Value Approach—This approach begins by examining the company's book value. Under this method, items listed on a business's balance sheet (at historical cost levels) are adjusted to bring them in line with current market values. In essence, this method calls for the adjustment of an asset's book value to equal the cost of replacing that asset in its current condition. This method is most often used to determine the value of companies which feature a large percentage of commodity-type assets. The net asset value method, also referred to as net worth or owner's equity, is one of the more commonly employed of all valuation approaches. While flawed in some respects, the net asset value method is popular because this approach can be easily figured from existing financial records.
Valuing Personal Service Businesses
The valuation of a personal service business, like a medical practice, is often approached somewhat differently. While equipment, pplies, real estate and other assets that are typically included in assessing the value of companies are also included in assessing personal service business values, they are often of little consequence to potential buyers of the business in question. After all, a buyer may have an entirely new location in mind for the business, and costs associated with leases, utilities, and taxes often change dramatically with relocation. Instead, wrote Tuller, the most important consideration in valuing any personal service business "is how much gross billings can be generated from the customer/client base, not what profits have been recorded or how much cash [the owner has] taken out…. A key consideration to keep in mind if you are selling a professional practice is that the goodwill you have built up over the years is really what you are selling. Sometimes, it is called customer or client lists, or client files, but it is really just goodwill."
VALUATION ISSUES AND STANDARDS
It is important to recognize and deal properly with certain subtleties and standards in the field of valuation. Issues and standards to keep in mind include:
Treatment of Debt
If the method used to determine company value uses a pre-debt-service income measure, then debt must usually be subtracted from the resulting figure.
If the valuation methodology used is based on price-earnings ratios of comparable public companies and the interest being valued is the entirety of a company, a control premium may be imposed.
Discount for Lack of Marketability
This discount, also known as the liquidity discount, comes into play in situations where the business owner's ability to readily sell his or her business is questionable. For example, publicly traded companies are highly marketable, and their shares can be quickly turned into cash. Closely held companies, however, are sometimes far more difficult to sell. Depending on the valuation, it may be necessary to subtract a discount for lack of marketability, or add a premium for the presence of marketability.
Standard of Value
When determining valuation of a company, the standard of value must be clearly defined. That is, it must be clear whether the valuation is based on book value, fair market value, liquidating versus going-concern value, investment value, or some other definition of value. Defining the standard of value is important because of adjustments that are necessary under some, but not all, of these standards.
Valuation methods determine the value of a company at a given point in time. Thus, businesses that undergo a valuation process are said to be worth X dollars "as of" a certain date. Values of businesses inevitably change over time, so it is critical to state the date for any valuation. In addition, the information used by the appraiser should be limited to that which would have been available at the as-of date.
Form of Organization
The legal definition of the organization under examination is an important factor in any valuation. Different legal forms of entity—corporations, S corporations, partnerships, and sole proprietorships—are all subject to different tax rules, rules which impact the value of the enterprise being appraised.
Focus of Valuation
The focus of the valuation must be clearly identified. The portion of the business enterprise being acquired, the type(s) of securities involved, the nature of the purchase (asset purchase or stock purchase), and possible impact of the transaction on existing relationships (such as related party transfers) can all affect the value of the entity under examination.
Going through a business valuation exercise is useful for any business owner. He or she will learn a lot about the business by applying any one or several of the valuation methods discussed here. In the end, however, the true value of a business is, much like beauty, in the eye of the beholder. Or, in the case of a business owner who wishes to sell, it is the price another is willing to pay for the business.
SEE ALSO Discounted Cash Flow; Mergers and Acquisitions; Selling a Business
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Hillstrom, Northern Lights
updated by Magee, ECDI