Business valuation

Business valuation is a process and a set of procedures used to estimate the economic value of an owners interest in a business. Valuation is used by financial market participants to determine the price they are willing to pay or receive to effect a sale of a business. In addition to estimating the selling price of a business, the same valuation tools are often used by business appraisers to resolve disputes related to estate and gift taxation, divorce litigation, allocate business purchase price among business assets, establish a formula for estimating the value of partners' ownership interest for buy sell agreements, and many other business and legal purposes such as in shareholders deadlock, divorce litigation and estate contest. In some cases, the court would appoint a forensic accountant as the !oint expert doing the business valuation. Before the value of a business can be measured, the valuation assignment must specify the reason for and circumstances surrounding the business valuation. "hese are formally known as the business value standard and premise of value. "he standard of value is the hypothetical conditions under which the business will be valued. "he premise of value relates to the assumptions, such as assuming that the business will continue forever in its current form #going concern$, or that the value of the business lies in the proceeds from the sale of all of its assets minus the related debt #sum of the parts or assemblage of business assets$. There are two premises of Value

%oing &oncern Value as an ongoing operating business enterprise.'() *i+uidation , Value when business is terminated.

-remise of value for fair value &alculation

In use , If the asset would provide maximum value to the market participants principally through its use in combination with other assets as a group. In .xchange , If the asset would provide maximum value to the market participants principally on a stand alone basis.

Business valuation results can vary considerably depending upon the choice of both the standard and premise of value. In an actual business sale, it would be expected that the buyer and seller, each with an incentive to achieve an optimal outcome, would determine the fair market value of a business asset that would compete in the market for such an ac+uisition. If the synergies are specific to the company being valued, they may not be considered. /air value also does not incorporate discounts for lack of control or marketability. 0ote, however, that it is possible to achieve the fair market value for a business asset that is being li+uidated in its secondary market. "his underscores the difference between the standard and premise of value. "hese assumptions might not, and probably do not, reflect the actual conditions of the market in which the sub!ect business might be sold. 1owever, these conditions are assumed because they yield a uniform standard of value, after applying generally accepted valuation techni+ues, which allows meaningful comparison between businesses which are similarly situated. Elements of business valuation[edit] 2 business valuation report generally begins with a description of national, regional and local economic conditions existing as of the valuation date, as well as the conditions of the industry in which the sub!ect business operates. 2 common source of economic information for the first section of the business valuation report is the /ederal 3eserve BoardsBeige Book, published eight times a year by the /ederal 3eserve Bank. 4tate governments and industry associations also publish useful statistics describing regional and industry conditions. Financial analysis "he financial statement analysis generally involves common si5e analysis, ratio analysis #li+uidity, turnover, profitability, etc.$, trend analysis and industry comparative analysis. "his permits the valuation analyst to compare the sub!ect company to other businesses in the same or similar industry, and to discover trends affecting the company and6or the industry over time. By comparing a companys financial statements in different time periods, the valuation expert can view growth or decline in revenues or expenses,

changes in capital structure, or other financial trends. 1ow the sub!ect company compares to the industry will help with the risk assessment and ultimately help determine the discount rate and the selection of market multiples. It is to mention that among the financial statements, the important statement to show the li+uidity of the company is cash flow. &ash flow shows the company's cash in and out flow. Normalization of financial statements "he most common normali5ation ad!ustments fall into the following four categories7

&omparability 2d!ustments. "he valuer may ad!ust the sub!ect companys financial statements to facilitate a comparison between the sub!ect company and other businesses in the same industry or geographic location. "hese ad!ustments are intended to eliminate differences between the way that published industry data is presented and the way that the sub!ect companys data is presented in its financial statements. 0on operating 2d!ustments. It is reasonable to assume that if a business were sold in a hypothetical sales transaction #which is the underlying premise of the fair market valuestandard$, the seller would retain any assets which were not related to the production of earnings or price those non operating assets separately. /or this reason, non operating assets #such as excess cash$ are usually eliminated from the balance sheet. 0on recurring 2d!ustments. "he sub!ect companys financial statements may be affected by events that are not expected to recur, such as the purchase or sale of assets, a lawsuit, or an unusually large revenue or expense. "hese non recurring items are ad!usted so that the financial statements will better reflect the managements expectations of future performance. 8iscretionary 2d!ustments. "he owners of private companies may be paid at variance from the market level of compensation that similar executives in the industry might command. In order to determine fair

market value, the owners compensation, benefits, per+uisites and distributions must be ad!usted to industry standards. 4imilarly, the rent paid by the sub!ect business for the use of property owned by the companys owners individually may be scrutini5ed. Income, asset and mar et approaches "hree different approaches are commonly used in business valuation7 the income approach, the asset based approach, and the market approach. '9) ':) ;ithin each of these approaches, there are various techni+ues for determining the value of a business using the definition of value appropriate for the appraisal assignment. %enerally, the income approaches determine value by calculating the net present value of the benefit stream generated by the business #discounted cash flow$< the asset based approaches determine value by adding the sum of the parts of the business #net asset value$< and the market approaches determine value by comparing the sub!ect company to other companies in the same industry, of the same si5e, and6or within the same region. 2 number of business valuation models can be constructed that utili5e various methods under the three business valuation approaches. Venture &apitalists and -rivate .+uity professionals have long used the /irst chicago method which essentially combines the income approach with the market approach. In certain cases e+uity may also be valued by applying the techni+ues and frameworks developed for financial options, via a real options framework, as discussed below. In determining which of these approaches to use, the valuation professional must exercise discretion. .ach techni+ue has advantages and drawbacks, which must be considered when applying those techni+ues to a particular sub!ect company. =ost treatises and court decisions encourage the valuator to consider more than one techni+ue, which must be reconciled with each other to arrive at a value conclusion. 2 measure of common sense and a good grasp of mathematics is helpful. Income approaches "he income approaches determine fair market value by dividing the benefit stream generated by the sub!ect or target company times a discount or

capitali5ation rate. "he discount or capitali5ation rate converts the stream of benefits into present value. "here are several different income approaches, including capitali5ation of earnings or cash flows, discounted future cash flows #>8&/>$, and the excess earnings method #which is a hybrid of asset and income apprope of benefit stream to which it is applied$. "he result of a value calculation under the income approach is generally the fair market value of a controlling, marketable interest in the sub!ect company, since the entire benefit stream of the sub!ect company is most often valued, and the capitali5ation and discount rates are derived from statistics concerning public companies. I34 3evenue 3uling :? @A states that earnings are preeminent for the valuation of closely held operating companies. !iscount or capitalization rates 2 discount rate or capitali5ation rate is used to determine the present value of the expected returns of a business. "he discount rate and capitali5ation rate are closely related to each other, but distinguishable. %enerally speaking, the discount rate or capitali5ation rate may be defined as the yield necessary to attract investors to a particular investment, given the risks associated with that investment.

In 8&/ valuations, the discount rate, often an estimate of the cost of capital for the business is used to calculate the net present value of a series of pro!ected cash flows. Bn the other hand, a capitali5ation rate is applied in methods of business valuation that are based on business data for a single period of time. /or example, in real estate valuations for properties that generate cash flows, a capitali5ation rate may be applied to the net operating income #0BI$ #i.e., income before depreciation and interest expenses$ of the property for the trailing twelve months.

"here are several different methods of determining the appropriate discount rates. "he discount rate is composed of two elements7 #C$ the risk free rate, which is the return that an investor would expect from a secure, practically risk free investment, such as a high +uality government bond< plus #D$ a risk premium that compensates an investor for the relative level of risk associated with a particular investment in excess of the risk free rate. =ost

importantly, the selected discount or capitali5ation rate must be consistent with stream of benefits to which it is to be applied. "apital #sset $ricin% &odel '"#$&( "he &apital 2sset -ricing =odel #&2-=$ is one method of determining the appropriate discount rate in business valuations. "he &2-= method originated from the 0obel -ri5e winning studies of 1arry =arkowit5, Eames "obin and ;illiam 4harpe. "he &2-= method derives the discount rate by adding a risk premium to the risk free rate. In this instance, however, the risk premium is derived by multiplying the e+uity risk premium times >beta,> which is a measure of stock price volatility. Beta is published by various sources for particular industries and companies. Beta is associated with the systematic risks of an investment. Bne of the criticisms of the &2-= =ethod is that beta is derived from the volatility of prices of publicly traded companies, which differ from private companies in their li+uidity, marketability, capital structures and control. Bther aspects such as access to credit markets, si5e, management depth, and many other respects are often different also. "he rate build up method also re+uires an assessment of the sub!ect company's risk, which is a valuation of itself. ;here private companies can be shown to be sufficiently similar to public companies, however, the &2-= method may be appropriate. &odified "apital #sset $ricin% &odel "he &ost of .+uity #Fe$ is computed by using the =odified &apital 2sset -ricing =odel #=od. &2-=$ =od. &2-= =odel ke G 3f H B # 3m 3f$ H 4&3- H &43- ;here7 3f G 3isk free rate of return #%enerally taken as CA year %overnment Bond Iield$ B G Beta Value #4ensitivity of the stock returns to market returns$ Fe G &ost of .+uity 3mG =arket 3ate of 3eturn 4&3- G 4mall &ompany 3isk -remium, &43-G &ompany specific 3isk premium )ei%hted avera%e cost of capital '*)#""*( "he weighted average cost of capital is an approach to determining a discount rate. "he ;2&& method determines the sub!ect companys actual cost of capital by calculating the weighted average of the

companys cost of debt and cost of e+uity. "he ;2&& must be applied to the sub!ect companys net cash flow to total invested capital. Bne of the problems with this method is that the valuator may elect to calculate ;2&& according to the sub!ect companys existing capital structure, the average industry capital structure, or the optimal capital structure. 4uch discretion detracts from the ob!ectivity of this approach, in the minds of some critics. Indeed, since the ;2&& captures the risk of the sub!ect business itself, the existing or contemplated capital structures, rather than industry averages, are the appropriate choices for business valuation. Bnce the capitali5ation rate or discount rate is determined, it must be applied to an appropriate economic income stream7 pretax cash flow, aftertax cash flow, pretax net income, after tax net income, excess earnings, pro!ected cash flow, etc. "he result of this formula is the indicated value before discounts. Before moving on to calculate discounts, however, the valuation professional must consider the indicated value under the asset and market approaches. &areful matching of the discount rate to the appropriate measure of economic income is critical to the accuracy of the business valuation results. 0et cash flow is a fre+uent choice in professionally conducted business appraisals. "he rationale behind this choice is that this earnings basis corresponds to the e+uity discount rate derived from the Build Jp or&2-= models7 the returns obtained from investments in publicly traded companies can easily be represented in terms of net cash flows. 2t the same time, the discount rates are generally also derived from the public capital markets data.