Methods of Company Valuation

Whether you use a professional business appraiser or attempt a self-evaluation, it is helpful to understand the basic methods of valuation that may be used to determine a value for your company–or a company you are thinking of acquiring. A professional business appraiser typically applies several different methods of valuation that fit into these categories and uses the knowledge gained to pick one or two methods that make the most sense to arrive at a range of values for a company. The three most widely-accepted approaches to valuation are the Comparable Worth method, the Asset Valuation method, and the Financial Performance method.

The Comparable Worth Method

The notion of comparable worth reflects the performance and potential selling prices of publicly and privately held companies compared to yours, in order to arrive at a value. The appraiser examines publicly held companies that operate in the same or similar industry, providing the same or similar products and/or services. The justification for this method is that potential buyers will not pay more for the target company than what they would spend for a similar company that trades publicly. The appraiser must carefully choose the publicly held companies with which to compare. Obviously, the companies should be as similar to the target as possible, particularly with regard to geographical location(s) and the relationship to suppliers.

Because it is not possible to find companies that are the same as the target company in all respects, it is important for the appraiser to use the available data as “creatively” as possible. For example, because of differences in the businesses’ sales volumes, it is more useful to compare the ratio of sales to costs, rather than absolute amounts of sales to each other. Comparisons of this type will provide a clearer picture of the strengths and weaknesses of the target company relative to those of others in its industry.

Once the appraiser arrives at a preliminary range of values using this method, it is necessary to adjust the prices for situations particular to the target company. If, for example, the target company has profits that are consistently above industry averages, thanks to an unusually low cost structure, then its value must be adjusted upward to account for that competitive advantage. As with all methods of valuation, all prices and subsequent adjustments must be backed up. Buyers or investors must be able to see and understand the justification for a valuation higher than that of apparent comparables, or they will not be willing to pay the premium.

If the target business is a closely held company, this method can present some difficulties. The goals of financial reporting for a publicly held company can be quite different from those for a closely held company. A publicly held company’s management strives to show high earnings on its financial reports, in order to attract people to buy its stock and therefore to improve its price-to-earnings ratio. A closely held company’s management may be a solo entrepreneur or small group wishing to minimize the earnings shown on its financial reports, in order to minimize its tax burden. Both goals are legitimate, but clearly some confusion would arise if an appraiser tried to compare the key financial ratios of a closely held company with those of similar but publicly traded companies in the industry.

The Asset Valuation Method

If a company has a large portion of its value wrapped up in fixed assets, an appraiser may lean towards some type of asset valuation when attempting to price it. The justification for asset valuation is that the buyer will pay no more for the target company than it would cost to obtain a comparable set of substitute assets. Within these guidelines, the appraiser can choose how to value the substitute assets—calculating the “Cost of Reproduction,” that is, of constructing a substitute asset using the same materials as the original but at current prices, or the “Cost of Replacement,” that is, of obtaining the same asset at current prices while adhering to modern standards and using modern materials. The appraiser also considers the time that would be required until replacement or new assets could be put in place and made usable.

The asset valuation method involves examining every asset held by the company, both tangible and intangible. A great degree of detail is required in order to arrive at a fair valuation. The appraiser must assess all machinery and equipment, real estate, vehicles, office furniture and fixtures, land and inventory. The value of intangibles like patents and customer lists should also be included. These intangibles often are referred to as the company’s goodwill, the difference in value between the company’s hard assets and its true value. It is more difficult to convince buyers of the value of intangibles, since they usually want to be able to see and verify the assets in order to feel comfortable with the price.

Generally it is in the seller’s best interest to supply the business appraiser with as much concrete detail as possible about the company’s intangibles. The greater the value of goodwill that can be attributed to specific, well-defined intangibles, the higher the company’s valuation is likely to be set. For example, rather than lumping patents that the company holds under the intangible goodwill category, list the patents as separate assets and include specifics pertaining to each one, such as date of expiration and effect on the company’s operations.

Financial Performance Methods

Perhaps the most commonly-used set of valuation methods in the context of small-to-medium company acquisitions, financial performance methods attempt to measure historical performance as well as predict future performance in determining the value of the seller’s business to the buyer on a post-closing basis. These methods include Net Present Value (NPV), Internal Rate of Return (IRR) and Return on Investment (ROI).

Net Present Value is probably the most common financial-performance calculation used by appraisers in a pre-acquisition valuation. It is a capital-budgeting model that compares the present value of the proposed transaction’s benefits and costs. The difference between benefits and costs is the net present value of the proposed deal. A positive NPV means that the proposed transaction’s benefits exceed its costs, and the decision to undertake the deal increases the value of the buyer and its shareholder wealth. A negative NPV means that the proposed transaction’s costs exceed benefits, and the decision to undertake it would decrease the value and shareholder wealth of the buyer. Zero NPV means that the proposed transaction’s benefits are equal to costs, and the decision to make the deal does not change the value of the buyer or the wealth of its shareholders.

Internal Rate of Return is a capital-budgeting model represented by the discount rate that equates the price with the anticipated profits from the proposed transaction. Computing the IRR is tantamount to answering the following question: If the proposed transaction were similar to a bank account, what interest rate would the bank have to offer in order to produce the same benefits as the proposed deal? To evaluate the seller’s business using the IRR, the appraiser takes two steps: calculating the IRR and comparing the IRR to the required rate of return. Acceptable proposed transactions are those with an IRR greater than the required return. Proposed transactions should be rejected if the IRR is lower than the required rate of return. Shareholders are indifferent when the IRR is equal to the required rate of return.

Return on Investment Ratio may be used in certain cases to decide whether to acquire a target company. Taken as an average of the recent years’ earnings compared to equity and long-term debt, the ROI can be useful in providing an important benchmark for the buyer. It is important to remember, however, that such decisions must be based on the interaction of numerous factors; and the whole picture, not just fragments, must be studied in order to make a sound decision. Evaluating a company’s financial health and future growth prospects is a very involved process through which the professional business appraiser is trained to lead the potential buyer.

It’s Not So Simple

The professional appraiser (or whoever is conducting the analysis) should not use any one valuation method without considering other methods or other factors. One method may overlook key aspects of the business that will be uncovered only after further investigation required for another method is completed. For example, if the appraiser utilizes several methods and consistently arrives at a range of $2.2 million to $2.6 million, then an asset valuation that yields a result of only $1.5 million can be eliminated if the appraiser finds that the value of the company’s assets is not a fair approximation of its entire value when intangibles or other market or competitive trackers are added in. And if the asset valuation method were the only one used, then the company would be dramatically underpriced.

Proper valuation of a company is never simple. A method that appears to be too simple probably is. For purposes other than merger-and-acquisition transactions, simple methods are commonly used, and are actually prescribed by law in some cases. However, it is wiser to invest a bit more time and effort initially than to experience remorse over an inappropriate initial valuation after the deal has been concluded.

One term commonly heard in the business world as a simple way of calculating ca company’s value is “industry multipliers” or “multiples.” Multipliers are set by unknown entities based on unknown factors that most likely were valid at one time in a particular market, but may no longer hold true. For example, it may be said that in Industry X, the price to pay for a business is five times the company’s annual earnings or amount of goodwill. However, it would be difficult to convince a well-informed potential buyer to purchase a company for a price defined only by such a formula. From the seller’s perspective, there is no guarantee that the company is not worth more than the amount arrived at by using a simple formula without basis. In fairness to both parties, the appraiser should not be taking the easy way out of this task.

Evaluating the Final Report

At the end of the analysis, the appraiser produces a final report detailing the range of values for the business. Paradoxically, just when the formal valuation process seems to have ended, the acquisition team must evaluate the impact the report will have on the actual price and structure of the transaction.

If the acquiring company perceives that it will benefit from the economies of scale that will be created by an acquisition, it may be willing to pay more than would otherwise be expected, known as the “acquisition premium,” an added cost to the buyer’s shareholders and a windfall to the seller’s shareholders. But if the buyer is really just looking to acquire only certain assets or views the acquisition as a short-term tactic, then the price it is willing to pay may not even approach the price given by the appraiser. From the seller’s point of view, if the founders or owners are really not very eager to give up the business just yet, the negotiated price may be driven higher. However, if the seller is motivated to sell quickly, the negotiated price could plummet.

It is an essential aspect of the valuation process that while detailed methods of valuation can provide a solid starting point, that often remains all they provide. The final negotiated price can vary widely and depend on diverse factors, including market conditions, timing of the negotiations and of the valuation date, internal motivation and goals of both buyer and seller, operating synergies that will result from the transaction, the structure of the transaction and other factors that may not even be explicitly defined.

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