Business valuation is as much an art as it is a science. The Science is a series of prescribed processes and analyses you need to perform on the path to reaching credible results, which most accountants (myself included) learn a classroom. The Art comes from the doing: there is significant professional judgement that must be applied to reach credible results.
This is part of an ongoing series to explore some of the complexities and nuances of business valuation in the context of complex litigation. In it, we refer to The Science and The Art of business valuation, generally referring to difference between the theoretical, prescriptive practice of business valuation and the more nuanced realities, respectively.
Ways to Value a Business
Before we can discuss some of the nuances of The Art, it is important to have a basic, working vocabulary for business valuation. The following are the basic methods appraisers use in their practice. This is intended to be a high-level summary, and is by no means exhaustive. There are books that are hundreds of pages long dedicated to business valuation; it is a complicated subject.
Income Approach: The theory behind the Income Approach is that a subject company is worth, today, all earnings the subject company in the future. It requires a calculation to translate future dollars into today’s dollars in a way that incorporates (i) the timing of those earnings and (ii) the risk associated with those future earnings. The term for this math is encapsulated in the “discount rate” or “capitalization rate”, depending on the specifics.
The Income Approach is a well regarded valuation approach. There are certain appraisers that simply can not and will not do a valuation without including the Income Approach (though it is certainly not required by any standard). The Income Approach is conceptually sound, though it does require some more esoteric calculations that will readily be familiar to any appraiser.
Market Approach: The Market Approach values a company based on how the market actually values similar companies. This can either be based on (i) similar publicly-traded companies or (ii) acquisitions of 100% of similar, closely-held companies. The most important part in selecting guideline companies is the element of comparability. The Market Approach is similarly well-regarded because it incorporates how the marketplace actually values a subject company.
Prior Transactions: Technically, this is a variation of the market approach, though it rarely gets used for lack of information. As the name suggests, this method uses prior transactions involving the company’s stock to provide a current value. This also includes buy-sell agreements. Did the company recently issue or repurchase stock for $3 per share? Then the Prior Transactions Approach would indicate the price is $3 per share.
The relative strengths of the Prior Transaction Approach are the same as the Market Approach, only even more pointed. The Prior Transactions Approach uses the subject company to value the subject company; it is hard to argue that the subject company cannot be compared to itself.
Cost Approach: This approach attempts to value a company by the cost required were a buyer to purchase assets comparable to those of the company. The cost approach is generally only applicable to asset-heavy businesses (e.g., manufacturing). The proper value of a company that includes significant intangible assets (or does not include significant assets) would not be properly captured by looking at the assets. Consider a consulting business (like Nolte Analytics). The assets of a consulting firm are generally limited limited to cash, trade receivables and some fixed assets (like computers, phones and copiers). That would underestimate the value of a consulting company because it does not drive earnings from its assets.
Another application of the cost approach is to provide a valuation floor, or the minimum valuation the company could achieve. Phrased another way, if one could buy all of the assets of a company for the specified price, presumably that means the company’s assets could be sold for the same. This usually is significantly less than the value a credible valuation would provide. Nevertheless, it cannot be ignored entirely
Where to go from here?
Absurd rhetorical device notwithstanding, business valuation is both a science and an art. The Science may tell you what to do, The Art is in knowing how to do it. The good news is there are any number of competent appraisers who can help you do just that.