An Introduction to the Process of Valuing a Business - Part 1
One of the most difficult aspects of business appraisals is “How did you arrive at your opinion?” I have been in the valuation business since 1995, and have performed hundreds of valuations – from simple analyses to complex modeling – across a variety of industries, real estate/investment holding entities to manufacturing, service and private equity funds, among others. Prior to my career in valuation, I have been involved in the due diligence of an acquisition of a large multinational. What struck me to be the most interesting aspect of that work was that our opinion was that it was a third of the value opined by the investment bankers, which soon peaked my interest and led me down the path of performing business valuations for the next 20 years.
After having performed these valuations, you soon realize the perplexed look on faces of our clients, who have never been through the process of a valuation. What’s more is that you also soon realize in some instances, they too have an opinion of value simply for having worked in the business and have put their blood sweat and tears building their businesses; and some times they just don’t match our opinions. You honestly cannot blame them -- with the various standards of value, the various approaches to value, and within each approach, the different methodologies. To make matters worse, within each methodology, there are often assumptions and judgments.
You can slowly begin to appreciate that there are a multitude of ways to arrive at any given conclusion of value, and the difficult responsibility appraisers have shoulder to decide on a single point of value. At best, we as appraisers have to simply:
understand the assignment,
determine the appropriate standard,
explain our approach or approaches adopted,
determine the appropriate methodology or methodologies if more than one is applied, and
disclose all our assumptions we applied to arrive at our conclusion.
The more approaches adopted, and the more methodologies are reconciled with one another, the better is the support for the appraiser’s opinion of value. However, from past experience, the number of approaches adopted and the methodology selected will often depend upon the availability of information, both from the client and in the public domain that will help point or guide the direction of the value one seeks. This is part one of a three-part introduction to a simplified process of how appraisers seek to determine a value conclusion.
As part of the process of opining on value, it is most important to identify the standard of value. There are a various standards – fair value, investment value, synergistic value – but the most common standard used is “fair market value”. These standards will guide appraisers to make the appropriate choices when arriving at their conclusions.
Once you have determined the standard of value, you then have to determine the approach or approaches you intend to adopt. It is important to first always consider all of the approaches to value. Being able to explain which approaches make the most sense and which approaches are not meaningful is part of the valuation process. As a starting point, there are basically three approaches to value are the market, income, and cost.
The income approach typically analyzes the value of a business based on prospective information of the business, i.e., forecasts or projections. Projections of earnings, cash flow, or other proxy measures are considered when trying to assess the value of the business. Discounting these projected benefits to the present using the concept of discount rates will often lead to an indicative value or values of the business at a given point in time. This discount rate is typically based on expected rates of return available from alternative investments.
The market approach analyzes the value of the business based on benchmarking it to publicly traded companies or comparable transactions of similar businesses, using various financial performance indicators, such as revenue, gross profit, net income or other earnings proxies. These value indications are then adjusted to reflect the unique characteristics of the subject business to arrive at a fair market value.
The cost approach uses the concept of reproducing or replacing the business with another like asset or group of assets, i.e., assets having the same utility, establishing the highest and best value that investors are willing to pay.
Once the decision is made as to the appropriate approaches to adopt, choosing a methodology or methodologies within the different approaches is the next step in this process – to be continued.
Core Valuation LLC
312.801.0100 | email@example.com
1245 S Michigan Ave, Suite 190, Chicago, IL 60605
Core Valuation LLC is a full-service business valuation and valuation consulting firm that provides end-to-end business services for a range of purposes, including estate and tax planning, financial reporting, litigation, arbitration and transaction advisory, among others.