M. Ferrara & Sons - News

As business valuation practitioners we are constantly being asked, “How much is my business worth?” Our initial response to this question is “What is the purpose of the business valuation?” Some of the common reasons for a business valuation include:

• Selling the business
• Structuring a buy/sell agreement
• Estate planning
• Gifting
• Marital dissolution proceedings
• Shareholder dispute

Each of the above implies a “standard of value.” Among standard of value are the following:

Fair Market Value - defined as “the amount at which property would change hands between a willing buyer and a willing seller where neither is acting under compulsion and when both have reasonable knowledge of the relevant facts.” This standard of value is used in the estate and gift tax arena and is required by the IRS.

Investment Value – defined as “the specific value of an investment to a particular investor or class of investors”…In many instances investment value is equal to strategic value and is used in valuing acquisitions and mergers.

Fair Value - is the standard of value used in shareholder oppression and dissenting shareholder litigation. It is largely defined in case law.

The implication then, for a chosen standard of value, is the nature and type of financial statement adjustments a valuation analyst would consider.

FUNDAMENTAL CONCEPT OF BUSINESS APPRAISAL

The value of any business, other than in a liquidation scenario, is dependent upon the present value of the expected benefits to be derived by the ownership interest. It is important to note that the future benefits received can be in the form of dividends, salary, draw and benefits. As in any forecast involving future benefits, different investors may have different views about the future benefit stream to be received. In addition, investors may have different required rates of return, which will further influence any valuation indication.

APPROACHES TO VALUING A BUSINESS

Having established the preliminary considerations for a business valuation, we will now explore the ways of determining value. Under the assumption of “going concern”, there are basically three approaches to valuation: Market Comparison, Cost or Asset Based, and Income. Each of these approaches are described below:

Market Comparison

Perhaps the most direct way of valuing a company, this approach encompasses 3 basic methods of valuation.

A)Comparable Sales Method

The valuation analyst searches and identifies similar companies that have been bought or sold, and compares the indicated pricing and terms to the subject company.

B) Public Comparables Method

In this case the valuation analyst searches for comparable, publicly-traded companies and develops valuation ratios or indications based upon market pricing.

C) Industry Methods (Rules of Thumb)

Valuation formulas, rule of thumb multiples and similar industry specific indicators of value are useful. It must be stressed however, that the use of these methods can be disastrous and result in over or under stated values.

Asset Based

Often referred to as the cost approach, this valuation approach identifies each component of a business, both assets and liabilities, and determines their value under the appropriate standard of value. The values are totaled, liabilities are subtracted, and the result is equity value. This approach is not as useful in valuing businesses that have intangible assets.

Income

Generally speaking, the income approach determines value by analyzing the future expected economic benefits (cash flow, dividends, salary, etc.) to be derived from the subject business and discounting or capitalizing the identified benefit stream by a market derived rate of return. Among the methods used are: Capitalization of Earnings, Discounted Cash Flow and Excess Earnings Methods.

This article has addressed the initial considerations in performing a business valuation. Future articles in this series will address the application of various valuation methods to a fictional client – Razor Manufacturing Co., Inc.