Business Valuation Theory and Practice – Part One: Valuation Approaches
By Dan Browning, founder and President of DB Consulting, Inc.
This article is for educational purposes only. Nothing contained herein can be used against me in a litigation or other adversarial setting. Examples have been changed to protect the innocent (and not so innocent).
How do appraisers determine the value of a business? There are three value approaches that can be used, and each approach has various methods within it. The three approaches are:
- The Cost or Asset Approach
- The Market Approach
- The Income Approach
For most small, privately owned businesses, business appraisers typically do not use the Cost Approach. This approach is more applicable when a business is a very asset-intensive operation, such as a manufacturing company. Occasionally an Asset Approach could be called for, but the other two approaches are usually more indicative of value.
The Market Approach develops a value based on the amount at which other similar companies have been sold. The theoretical underpinning for the Market Approach is the principle of substitution, in that a hypothetical, disinterested, financially motivated willing buyer can evaluate many possible targets for acquisition and will not pay more for one particular business than for another comparable, similarly situated business.
For larger companies, appraisers sometimes use a Guideline Public Company Method, wherein the subject business is compared to publicly traded companies in the same or similar industries. Given the vast size differentials, most appraisers typically do not use this Method for smaller, privately owned businesses.
More suitable for smaller private companies is the Direct Market Data Method, wherein the appraiser will research private databases containing reported transactions of other smaller, privately owned companies. These transactions are often reported by business brokers. Some of the most common transaction databases include DealStats (formerly Pratt’s Stats), BizComps, and ValuSource Market Comps (formerly Institute of Business Appraisers database).
After researching and finding comparable transactions, the appraiser analyzes the data by looking at various ratios derived from the transactions (among other things). Some of the most common are the Price to Gross Revenues and Price to Earnings ratios. However, one must BE CAREFUL when using these transaction databases, because different databases have different measures and definitions of “earnings.” Sometimes the earnings include add-backs such as owners’ compensation, interest, and income tax expenses (as is the case with the ValuSource database), while others may add back depreciation, amortization, and interest expenses. The short answer is that you can’t simply use the “Price to Earnings” ratios from all databases combined into one calculation.
One approach to selecting which ratio(s) to utilize is to analyze the data sets to find which set of value indications is the most internally consistent (statistically speaking). This could be done by calculating the data set’s Coefficient of Variation (which is the standard deviation divided by the mean), or by using a regression analysis.
The Income Approach develops a value that includes all tangible and intangible assets of the company. In theory, whatever operating assets are required to generate the earnings are included in the value developed from applying the appropriate capitalization or discount rate. One of the keys to developing a reliable, reasonable value for the business lies in choosing the correct earnings base.
There are two essential steps to address when selecting a reasonable estimate of earnings – selecting the level of earnings, and forecasting the most reasonable estimate of stable earnings into the future. The earnings base is capitalized to develop a value for the ongoing business.
Two common methods under the Income Approach are the Single Period Capitalization method and the Discounted Cash Flow/Discounted Future Earnings method. If the earnings of the business are relatively stable, one can utilize the Single Period Capitalization method by building up a capitalization (“cap”) rate and applying it to a representative level of earnings. If, however, the earnings are not stable, the Discounted Future Earnings method is more appropriate, because this method allows one to forecast several years of revenues and discount the various revenue streams (including a reversionary value) back to present value.
That’s a basic overview of valuation approaches in business appraisal. Our next article will focus on common adjustments to reported revenues and earnings figures.
Dan Browning, a GABB Affiliate, has 20 years of experience as a business appraisal professional and holds the Master Analyst in Financial Forensics (MAFF) and Accredited in Business Appraisal Review (ABAR) designations from the National Association of Certified Valuators and Analysts (NACVA).