Business Valuation Methodologies

VALUATION METHODOLOGIES

There are two fundamental bases on which a company may be valued:

1. As a going concern, and
2. As if in liquidation.
The value of a company is deemed to be the higher of the two values determined under a going concern or a liquidation premise.

The economic value of a company is viewed as to be the greater of the two values determined under either a going concern or a liquidation assumption. This approach is concordant with the appraisal concept of highest and best use, which compels an appraiser to look at the best use of the assets being appraised under current market conditions. If a business will command a higher price as a going concern then it should be valued as such. Conversely, if a business enterprise will command a higher monetary value if it is liquidated, then it should be valued as if in orderly liquidation.

Going Concern Valuation Summary

Going concern value takes for granted that the company will remain in business, and anticipates the enterprise’s earnings ability and cash generation capacities for indicants of its fair market value. There are a lot of accepted techniques used in business enterprise valuation today. The cornerstone for business valuation originates from what has been used in valuing real estate for many years. The three basic approaches that must be weighed by the appraiser are:

1. The Income Approach,
2. The Asset Based Approach, and
3. The Market Approach.

Within each of these approaches there are a lot of accepted valuation techniques usable for use by the appraiser. Appraisal standards indicate that an appraiser could look at as many methods as may be relevant to the facts and conditions of the holding being appraised. It is then up to the appraiser’s educated judgment as to how these values will be reconciled in inferring a final appraisal of value.

The Income Approach

The income approach, occasionally referred to as the investment value approach, is an income orientated approach instead of an asset or market oriented approach. This approach presumes that an investor could invest in a property with like investment characteristics, although not of necessity the identical business enterprise.

The calculations, applying the income approach determine that the value of the business is equal to the present value of the future benefit flow to the owners. This is achieved by either capitalizing a single historical period income stream or by discounting a series of income streams supported with a multi-period forecast.

Because calculating the future income of a business is considered to be speculative, historical information is normally used as a beginning point in numerous of the accepted methods under the premise that history will repeat itself. The future can’t be dismissed, however, since valuation is a prognostication of the future.

The Asset Based Approach

The asset based approach, occasionally named to as the cost approach, is an asset oriented approach instead of a market oriented approach. Each component part of a business enterprise is valued individually, and added together to derive the full value of the enterprise.

The appraiser estimates value, employing this approach, by approximating the cost of replicating or replacing the individual components of the business enterprise property being appraised, detail by detail, asset by asset.

The physical assets of the business are appraised using this approach; although it can’t be employed alone as many businesses have intangible asset value as well, to which this method cannot easily be utilized.

The Market Approach

The market approach is central to valuation as fair market value is ascertained by the market. Under this approach, the appraiser endeavors to determine guideline companies traded on a public securities market, in a equivalent or like industry because the appraisal subject that provides the appraiser with the ability to make a comparison between the pricing multiples that the public company trades at and the multiple that is viewed as pertinent for the appraisal subject.

A different basic variation of this approach is to locate entire companies that have been purchased and sold in the market, publicly traded or closely-held, that allows for the appraiser the ability to ascertain the multiples that resulted from the transaction. These multiples can then be employed to the appraisal subject, with or without modification, depending on the circumstances.

Liquidation Value

Liquidation value assumes that a business enterprise has higher value if its individual assets are sold to the highest bidder and the company discontinues operating as a going concern.

Shannon Pratt, a well known authority in business appraisal states:

Liquidation value is, in essence, the antithesis of going-concern value. Liquidation value means the net amount the owner can realize if the business is terminated and the assets sold off in piecemeal.2

He adds,

…it is essential to recognize all costs associated with the enterprises liquidation. These costs normally include commissions, the administrative cost of keeping the company alive until the liquidation is completed, taxes and legal and accounting costs. Also, in computing the present value of a business on a liquidation basis, it is necessary to discount the estimated net proceeds at a rate reflecting the risk involved, from the time the net proceeds are expected to be received, back to the valuation date.3

Pratt concludes by stating:

For these reasons, the liquidation value of the business as a whole normally is less than the sum of the liquidation proceeds of the underlying assets.4

2 Shannon Pratt, Valuing a Business: The Analysis and Appraisal of Closely Held Companies, 2nd edition (Illinois: Dow Jones-lrwin, 1989): 29.
3 Ibid.
4Ibid.

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