Executive Summary
Business valuation is basically a process and a set of procedures that are used to determine the economic value of an owner’s interest in a business. A company’s value is usually different for different buyers. It may also be different for the buyer and seller and these differences arise due to a number of reasons. This paper starts with explaining the concept of fair market value and then examines three approaches to business valuation: the income approach, asset-based approach, and the market approach. It defines these approaches and the methods they use to derive the value of the business. It also explores the strengths and shortfalls of each of these approaches as neither is perfect for all situations. The general conclusion is that aside from some instances mentioned in the text, the methods which take into consideration the future earnings capacity of the company provide the most reliable and accurate value for a business. All the same, there are a number of assumptions these approaches use and some market variables which are not considered by either of these methods. Hence, the professional discretion of the evaluator also plays a role in the process. A lot of times, it might be advisable to apply several different methods of valuation and then use the knowledge gained to pick one or two methods that make the most sense to arrive at a range of values for a company. This paper nevertheless aims to provide useful insight into the methods of business valuation as well as their relative merits and demerits, and the situations which might favor the use of one over the other.
Introduction
For anyone involved in the field of corporate finance, knowing the mechanics of company valuation is a highly important prerequisite. Not only is it important in acquisitions and mergers, but also because if they know about the process of valuing the company and business units, they will be able to better identify sources of economic value creation and destruction within the company. There are a number of uses for business valuation, some examples being while estimating the selling price of a business, resolving disputes related to estate and gift taxation, divorce litigation, allocating business purchase price among the business assets, and in many other business and legal disputes.
Generally, a company’s value varies for different buyers and it may also be different for the buyer and seller. It must be noted here that value and price are two different concepts, as the latter refers to the quantity agreed between the seller and the buyer in the sale of a company. This difference in a specific company’s value may be due to a variety of reasons. For example, a large and technologically highly advanced foreign company might want to buy a famous national company so that it can gain entry into the local market, leveraging the reputation of the local brand. In this scenario, the foreign buyer will only value the brand but not the plant, machinery, etc. as it has owned more advanced assets itself. However, the seller will value its own material resources very highly, as they are able to continue producing. Both seller and buyer have different viewpoints: the buyer aims to determine the maximum value it should be prepared to pay for what the company it wishes to buy is able to contribute. While the seller wants to ascertain what should be the minimum value at which it should accept the operation. Hence, when both sit down at the negotiation table, they bring different figures to the table, and the agreed-upon price usually lies between the two values. Also, a company may have different values for different buyers owing to economies of scale, economies of scope, or different perceptions about the industry and the company (Brigham & Gapenski, 1997).
Fair Market Value
Assets can also be valued at their fair market value. “Fair market value” is accounting and law terminology which means “the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.” There are certain assumptions that are incorporated in the fair market value standard. For example, it assumes that the hypothetical purchaser is reasonably prudent and rational but is not motivated by any synergistic or strategic influences. It also assumes that the business will continue as a going concern and not be liquidated, that the hypothetical transaction will be conducted in cash or equivalents; and that the parties are willing and able to consummate the transaction. There is a lot of scope for error and inaccuracy here as these assumptions might not, and usually do not, reflect the true conditions of the market in which this business might be sold. But it is necessary to make these assumptions because they result in a uniform standard of value, after applying generally accepted valuation techniques, which consequently makes possible a meaningful comparison between businesses that are similarly situated (“Fair Market Value”).
Approaches to Business Valuation
Business valuation uses three different approaches: the income approach, the asset-based approach, and the market approach. Each of these approaches uses different techniques for determining the fair market value of a business. The income approaches generally reach the value by first calculating the net present value (the sum of the discounted net cash flows) of the benefit stream generated by the business; the asset-based approaches determine value by adding the sum of the parts of the business; and the market approaches determine value via comparison of the subject company to other companies in the same industry, of the same size, and/or within the same region. Obviously, each technique has its own strengths and weaknesses and it is up to the professional who is valuing the company to exercise discretion and consider these factors when choosing a technique. Sometimes valuators use more than one technique and reconcile them with each other to determine the value of the company. The approaches are as follows:
Income Approaches
Methods based on the income statement seek to determine the company’s value through the size of its earnings, sales, or other indicators. Thus, for example, it is a common practice to perform quick valuations of cement companies by multiplying their annual production capacity (or sales) in metric tons by a ratio (multiple) such as the price/earnings ratio, price/sales ratio, or other multiples.
Other methods within this approach determine the fair market value by multiplying the benefit stream generated by the subject company with a discount or capitalization rate. The function of the discount or capitalization rate is to convert the stream of benefits into present value. The discount or capitalization rate is defined as the yield necessary in order to attract investors to a particular investment, given the risks associated with that investment. The difference between the two rates is that while the discount rate is applied only to discounted cash flow (DCF) valuations (based on projected business data over multiple periods of time), a capitalization rate is applied in methods of business valuation that employ historical business data for a single period of time.
Several different methods can be used to arrive at a suitable discount rate the rate itself comprising two elements: (a) the risk-free rate: the return that an investor would hope to get from a secure, virtually risk-free investment, such as a government bond; plus (b) a risk premium that compensates an investor for the relative level of risk associated with a particular investment, which is more than the risk-free rate. One of these methods is called the build-up method, called so as it is the sum of risks associated with various classes of assets. It uses the risk-free rate as well as the equity risk premium. These two elements coupled with the size premium are known as the “systematic risk”. Aside from this, the discount rate must also include “unsystematic risks” which can be categorized into industry risk premium and specific risk premium. The latter is determined by the valuation professional and is derived from specific characteristics of the business as well as the discretion of the professional (Brigham & Gapenski, 1997).
Another method for determining the discount rate in business valuation based on the income approach is by use of the Capital Asset Pricing Model, which adds a risk premium to the risk-free rate to arrive at the discount rate. The distinguishing factor however is that the risk premium is derived by multiplying the equity risk premium with “beta”, which denotes stock price volatility. Various sources give a measurement of beta for specific industries and companies and it is used to refer to the systematic risks of an investment. This method within the income approach is often criticized because beta is derived from the price volatility exhibited by publicly traded companies that have markedly different capital structures, product and market structures, size, and management strength, and credit availability among other factors. Hence, if private companies can be shown to be similar to public companies, the CAP-M model would be suitable; otherwise, it may not give accurate results (Brigham & Gapenski, 1997).
The third method of determining the discount rate is the weighted average cost of capital, which calculates the company’s actual cost of capital by calculating the weighted average of the company’s cost of debt and cost of equity. Critics of this approach believe that its objectivity suffers because the valuator would calculate the WACC according to the company’s existing capital structure, the average industry capital structure, or the optimal capital structure (Brigham & Gapenski, 1997).
Within this approach, there are a number of methods used such as capitalization of earnings or cash flows, discounted future cash flows (‘DCF’), and the excess earnings method (a combination of asset and income approaches). Except for the DCF method, most income approaches use the subject company’s historical income statements and financial data while the DCF method also makes use of projected financial data. Also, most approaches require the company’s adjusted historical financial data for only a single period while the DCF method needs data for multiple future periods. It is important to match the discount or capitalization rate to the type of benefit stream to which it is applied. The calculation results in the fair market value of a controlling, marketable stake in the subject company, as the entire benefit stream of the company, is mostly values and the discount rate is derived from statistics of public companies.
Even though it is said that the most suitable method for valuing a company is to discount the expected future cash flows, as the value of a company’s equity -assuming it continues to operate- arises from the company’s capacity to generate cash (flows) for the equity’s owners, this method has a number of weaknesses which generally arise from an inaccurate calculation of the discount rate. Sometimes an unsuitable beta value or market risk premium is used or the WACC is calculated incorrectly or a small-cap or specific premium is included when it is not appropriate. Hence, there is a lot of scope for error and areas where professional discretion is exercised, which ultimately leads to a subjective valuation (Brigham & Gapenski, 1997).
One of the weaknesses of the discounted cash flow method is that it can not be used in scenarios where the company has negative cash flows and earnings, or if a firm has unutilized or underutilized assets as the value of these assets will not be reflected in the value determined by discounting future cash flows (Fernandez, 2007).
Buyers may use the same valuation methods in this approach and arrive at different results as each buyer will likely have a different perception of the risk involved, and hence differing capitalization and discount rates. Also, they might envision different plans for the business, which will affect how they project the income stream. Thus, even if they use the same valuation methods the resulting value conclusions may be quite different. This means that the two buyers or investors measure the business’s worth by what it is worth to them. Their measurement of the business value is derived from their unique ownership or investment objectives. Hence, this is both a strength and weakness of the income valuation approach as on one hand, it offers the valuator great flexibility in measuring the business worth but at the same time, brings in a substantial subjective element into the measurement (Fernandez, 2007).
Asset-Based Approaches
The basic premise of the asset-based approach to business valuation is that a business is equal to the sum of its parts. The underlying principle is that of substitution as it assumes that no rational investor will pay for business assets in excess of the costs of acquiring assets of similar economic usefulness. While the income-based approaches require relatively subjective discretion to be used when determining discount or capitalization rates, the adjusted net book value method is comparatively more objective (Brigham & Gapenski, 1997).
Keeping with the accounting conventions, most assets are reported in the financial statements of the company at their acquisition value, adjusted for depreciation where applicable. Whenever possible to do so, these values must be adjusted to their fair market value, explained earlier in this paper. For intangible assets such as goodwill or trademarks can not be determined aside from the company’s overall enterprise value. This is the reason why the asset-based approach is not considered the most probative method of determining the value of going business concerns. This is because in these cases, this approach results in a value that is generally lesser than the fair market value of the business. This value suffers from the shortcoming of its own definition criterion: accounting criteria are subject to a certain degree of subjectivity and differ from market criteria, with the result that the book value almost never matches the market value and this is a major weakness of this method (Fernandez, 2007).
Hotel values in Asia went through a metamorphosis, according to Karp (2000) when owners realized that their assets were overvalued on their books as they were recorded at original cost and decided to change this valuation to one that is income-based. They did this after the Asian crisis when their overvalued assets resulted in financial insolvency and threatened to weaken their credit ratings.
While using this method of business valuation, it is necessary that the evaluator considers whether the shareholder whose interest is being valued is a controlling or non-controlling shareholder, that is, does he have the authority to access the value of the assets directly or not. Hence, if he can not avail that value himself, the value of the corporation’s assets would not be the most relevant indicator of value for him. Also, Claessens (2002) studied ownership and valuation structures of firms in Asia and found firm value to be lower when controlling management group’s control rights exceed cash flow rights. Also, large non-management control rights block holdings were positively related to firm value.
If liquidation is either expected or in process, the most appropriate and relevant method to use would be that of adjusted net book value. This would also be apt where company earnings or cash flow are negligible, negative, or of lesser worth than its assets, or even in a situation where this method is the industry standard. Also, the netbook value can be used in comparison with the income and market approaches as it usually provides a relatively more objective valuation, which is also its major strength (Fernandez, 2007).
Market Approaches
The underlying principle in this approach is that of competition: it relies on a free market where demand-supply forces will cause the price of business assets to achieve equilibrium. The price of a comparable business enterprise would serve as the point of evaluation, more than which the buyers will not pay for the business and less than which the sellers will not accept. Real estate appraisal often makes use of a similar method known as the comparable sales method. In the case of public companies, the market price of stocks of other listed companies in the same or similar businesses/industries can be used as an indicator of value, but only when the stock transactions and other factors are similar enough to allow this comparison. This is a drawback of this method, as identifying public companies which are sufficiently comparable to the subject company is often a hurdle (Brigham & Gapenski, 1997).
Another drawback of comparison can be inferred from the following example of the banking industry of East Asia: a study found that announcement of bank closure, preceding liquidation and resulting in a complete loss of ties with the main creditor, leads to discounts in the market value of related firm while the announcement of a foreign sale is associated with initial value discounts, but longer-term market premiums as investors revise their expectations of the effect of foreign capital and expertise (Djankov, 2000). Hence, this shows how market trends generally follow a pattern and are subject to rapid changes and fluctuations.
Conclusion
Some methods are based solely on the balance sheet, while some are based entirely on the income statement. Some make use of nothing except for historic data while others consider projected future statements. Two companies might have identical balance sheets and income statements but different future prospects: one can be expected to have high sales, earnings, and profit potential, while the other could face stable growth in a highly competitive industry. In spite of their equal balance sheets and income statements, a higher value would be given to the former company and this is why it is said that the most suitable method for valuing a company is to discount the expected future cash flows based on the fact that the value of the company’s equity would be determined by its capacity to generate future cash flows for its owners. However, even that method has some weaknesses which have been discussed in the text earlier.
There were three approaches outlined in this paper regarding the valuation of a business: income, asset-based, and market, and a number of methods that can be used within these approaches. The methods used should depend on the nature of the company. Holding companies are generally valued at their liquidation value, while for utility companies it is more suitable to project their operating statements and discount the cash flows, as they usually have stable growth. Hence, there is no one best method that can be applied across the board for all types of companies, situations, and buyers. Business valuation has today taken on renewed importance owing to the adoption of several accounting standards and it is imperative that accountants and auditors of financial statements understand the mechanics of fair value determinations and their implementation when assessing and attesting to values reflected in financial statements.
Bibliography
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Claessens, Stijn et al. “Disentangling the Incentive and Entrenchment Effects of Large Shareholdings.” Journal of Finance 57 (2002): 2741-2771.
Djankov, Simeon, et al. Resolution of Bank Insolvency and Borrower Valuation in East Asia, In The Changing Financial Industry Structure and Regulation: Bridging States, Countries, and Industries, Federal Reserve Bank of Chicago (2000).
“Fair Market Value.” Wikipedia, the free encyclopedia. Web.
Fernandez, Pablo. “Company Valuation Methods: The Most Common Errors in Valuation.” IESE Working Paper No 449, 2007.
Karp, Tony. “What Is That Hotel Worth? – Asian hotel valuation.” Business Week. 2000.