The Art of Valuations

by Carole Belmar, CPA

Despite "Not for Sale" signs on the doors of many private companies, most owners have considered the question: "How much is my company worth?" Of course, value is a subjective concept.

At its best, valuation is an art. It is influenced by institutional, macroeconomic and personal factors. What may be valuable to one person may actually be considered detrimental to another. For example, an in-house design department may be considered by one owner to be a significant attribute because it can provide proprietary designs quickly and efficiently, while another owner may perceive it as a detriment because of its high fixed costs and limited flexibility.

Given the subjective nature of calculating an accurate valuation range, it is tempting to simply avoid the exercise. Nonetheless, if you are thinking about selling your business, raising new capital or settling estate matters, this type of analysis may be critical to protecting your personal interests.

The financial community relies on several quantitative techniques to arrive at an estimation of fair market value for operating businesses, and subsequently refines the estimate to take qualitative factors into account. These qualitative factors constitute the art of valuation.

Valuation Basics

There are three valuation approaches used: the market approach, the income approach and the cost approach. All valuation techniques follow one of these approaches. While no one technique should be relied upon exclusively, a realistic range of fair market value can be determined by employing several methodologies. The four most common valuation techniques are: 1) comparable company analysis or market multiple technique (a market approach); 2) comparable transaction analysis or transaction multiple technique (a market approach); 3) discounted cash flow (an income approach); and 4) liquidation analysis (a cost approach).

Comparable Company Analysis or Market Multiple Technique - An attempt to measure value by employing the market values of public companies possessing attributes similar to your business as benchmarks.

This technique hinges upon the efficient market theory which indicates that the price of exchanged securities reflects all readily available information, as well as the supply and demand effects of educated and rational buyers and sellers. In other words, the market is continuously evaluating each company and expressing that valuation in bids and offers for its stock. Therefore, in a perfect world, the market has already done most of the work for you. When using this approach, all publicly-traded companies are reviewed in order to identify a peer group similar to the subject company. Once the peer group and proper multiples are determined, the premium paid over the calculated market must be decided based on the variety of factors. Unfortunately, several problems arise and limitations become apparent when this technique is employed.

Comparable Transaction Analysis or Transaction Multiple Technique - Similar to the previous technique, except companies used as models are recently acquired companies.

With the transaction multiple approach, similar acquisitions or divestitures are identified, and the multiples implied by their purchase prices are used to assess the subject company's value. This technique is similar to the market multiple technique; however, the following should be noted. The greatest impediment in finding truly comparable transactions is the absence of available information on private transactions. In addition to the lack of information on the sales of private companies, the available information in public transactions may be outdated. There is no rule of thumb for the appropriate age of a comparable transaction, although one should be aware of the competitive market at the time of the transaction and factor any changes in the marketplace environment into the analysis. The more recent the transaction, the better this technique, with all other things being equal.

Discounted Cash Flow/DCF - Based on one simple premise (although an extremely complex calculation); the worth of a company is based on the total amount of after-tax cash it can generate for the benefit of its shareholders.

This valuation approach, the most frequently used valuation technique, provides a "going concern" value, which is the value indicated by a company's future economic capabilities. Using this technique, value is calculated by the summation of the present value of projected cash flows for a determined period, plus the present value of the residual or terminal value at the end of the projection period. When using the DCF technique, the following four key areas must be assessed for accuracy and appropriateness:
- The assumptions underlying the projection of cash flow;
- The length of the projection period;
- The residual or terminal value at the end of the projection period; and
- The discount rate.
It is valuable to compute the DCF value using different assumptions of growth, profitability, investment in capital expenditures and working capital, residual values and discounts rates. A range of values under the best, worst and expected-case scenarios is typically developed.

Liquidation Analysis - Valuing a company by determining what proceeds can be derived from selling off assets, less the cost of satisfying liabilities.

Normally, there are at least two liquidation values: one based on a forced sale of the assets or operations, and the other based on an orderly disposition of the company's assets and liabilities. This valuation methodology is appropriate when the assets of the company are worth more dissolved than as a part of a continuing operation. A company's lowest liquidation value is the amount its tangible and identified intangible assets will bring in a forced sale net of any liabilities. An orderly liquidation value is the amount the tangible and intangible assets will generate if disposed of in the normal course of business net of any liabilities. The liquidation valuation technique may be used for specific assets or divisions targeted for disposal, while other methods are used to value the operating assets.

Other Value Influencers

Many qualitative factors are not captured in rigid quantitative methods despite their obvious impact on value. Some of these factors may influence value in the eyes of many, while others may be important only to a few. This is where matching the right company to the right buyer can make all the difference in obtaining the greatest value for your business.

The significance placed on qualitative characteristics cannot be discounted and must not be overlooked. Below is a sample of factors that can impact value but which are not directly taken into account with traditional quantitative approaches:

Dominant market share
Company size and critical mass
Union-management relations
Strength of competition
Technological capability and expertise
Size of backlog
Location of operations
Strength of customer-vendor relationships
Competence of management
Tax considerations
Intangible assets (e.g., mailing lists and key supply contracts)

The Market Matters

The impact of the current merger and acquisition environment must also be taken into account when assessing fair market value. If your company is in a hot industry segment in terms of merger and acquisition activity, a significant premium may be offered by potential buyers. On the other hand, a profitable business in an industry not subject to much activity may actually carry a fair market value lower than that of an unprofitable company in a highly popular market.

Other market factors that can influence fair value include:

Availability of financing
Interest by foreign companies
General economic conditions
Positioning of company in a sale process

Why Be In the Dark?

Even if you are not currently interested in selling your company, going through the exercise of determining its fair market value has many advantages. It can identify: 1) competitive weaknesses in your operations; 2) misallocation of resources; and 3) new opportunities for growth or other value-enhancing ideas. In addition, determining that the value of the company is greater to you than to someone else is confirmation to forge ahead under your current structure. However, if it happens that the market is valuing your business at a level you find surprising, it may be time to cash out, in whole, or in part.

Know as You Go

While valuing a company is not an exact science, it is also not a total mystery. Valuation is an art practiced by experienced financial professionals. Given the complexities of analyzing all the direct and indirect factors influencing a company's value, it is often a good practice to meet with a financial adviser as early as possible. Such an adviser can be just as valuable to you in quantifying a realistic range of fair market value as he or she can be in preparing your company for sale. Additionally, as the dynamics of the market change, a trusted, informed adviser can quickly reevaluate your company's worth, thereby enhancing your chances of selling at the best possible time.

About the Author

This article was compiled by Carole Belmar, CPA, from various articles and publications of PricewaterhouseCoopers LLP. The Tennessee Society of Certified Public Accountants is the state professional organization for more than 8,000 CPAs in government, education, industry, business and public practice. For more information on small business issues, visit the Tennessee Society of CPAs' Small Business Resource Center on the Web at www.tscpa.com.