Assets have value if they will give rise to future economic benefits. For businesses, these future economic benefits take the form of either the expected net income stream or the amount that could be realised in the short term through either a sale of the business as a going concern or its liquidation.
At its root, valuing businesses is similar in many ways to valuing real estate, artwork or most other assets. Just as real estate and artwork appraisers look to the prices paid recently for similar real estate or artwork, the business valuer looks to evidence of values for other income streams comparable to that expected from the subject business.
Three of the key issues a valuer needs to consider are:
- How to obtain information about the value investors place on comparable income streams;
- How to use values for comparable income streams to derive a value for the subject business; and
- Whether other adjustments to the business valuation might be required.
Where to Obtain Information on Values
In some cases, business valuers will make statements along the lines of “in my experience, companies like this are valued at between three and five times their net profit.” Increasingly however, clients are demanding more robust valuations that are supported with evidence of the values placed on businesses in actual transactions or active markets.
Courts and tribunals are also more inclined to rely on the testimony of an expert who can cite independent support for his or her valuation and the multiples, discount rates and/or adjustments on which it is based.
Some information on which valuers might rely, such as public company share prices, is publicly available. However, many databases of M&A transaction details and other information that can be essential in arriving at a valuation based on independent support require subscriptions.
Professionals specialising in valuations will usually subscribe to a number of dedicated information sources and know where to look for the most relevant data. In the event that usual sources fail to yield useful or reliable indicators of value, the experienced valuer will likely be able to cast a wider net and make use of data for less obviously comparable businesses.
How to Use the Information
Many valuations are based on a multiple of earnings (for example, three times net profit) or a discounted cash flow model (in which projections of future years’ earnings are discounted to a present value).
Experienced valuers generally agree that where possible, it is preferable to perform a valuation using two or more methods and to reach a conclusion after investigating and understanding the reasons for any differences between the methods’ results. Such differences often arise due to the differing assumptions implicit in the models used and a thorough grasp of the underlying economic and valuation theory is essential in resolving them.
Occasionally, the valuer will need to adopt alternative established valuation methods in order to value a business. Financial institutions for example, have often been valued using what may be referred to as an excess earnings approach. The more methodologies a valuer is able to successfully consider and potentially employ, the greater the likelihood that they will arrive at a robust and defensible valuation of unusual subject companies.
It is very rare that the comparable income streams or businesses used in a valuation will be identical to those being valued. There are likely to be many differences including size of the business or cash flow, the country or countries from which income is derived and the concentration or diversification of customers.
If the valuation is to be reliable, the more significant differences should be considered and appropriate adjustments made if necessary. As with the fundamental inputs for the valuation, the output will be more credible if the valuer can point to independent evidence in support of the need for an adjustment and its magnitude.
The journals of the leading valuation professional bodies often include papers on these adjustments, how they should be calculated and applied and the arguments for and against their use. Awareness of developments in the field enable a valuer to exploit current best practice and to understand the limitations of the adjustments made by other valuers.
Not All Valuations are Created Equal
Business valuation is a developing field. Courts and tribunals are increasingly familiar with the mechanics of the valuation process and there is a growing expectation that valuers should be able to point to independent evidence in support of both the methodology and the variables used.
Specialist valuation professionals will maintain accreditation with a reputable professional body, will stay abreast of leading valuation and economic theory and will have access to the data, analysis and information required to develop, explain and support robust valuations.
The views expressed in this article are the authors and not necessarily those of MDD or its member offices. The article highlights some of the key issues that commonly arise in business valuations and does not address all circumstances.