As a business valuation professional, I regularly appraise the value of privately-held companies. Difficult economic conditions require that we carefully study the unique facts and circumstances of the subject-company. Not every business can be “painted with the same brush”.
This article is an abbreviated summary of the techniques used to value privately-held businesses with special attention to the impact of a recently-depressed public stock market and strain on financial institutions.
Most people are familiar with the definition of fair market value. The Internal Revenue Service defines fair market value as the price at which the property would change hands between a willing buyer and a willing seller when the buyer is not under any compulsion to buy and the seller is not under any compulsion to sell, with both parties having reasonable knowledge of the relevant facts.
How We Estimate Value
What would this hypothetical buyer be willing to pay? The answer to this questions lies, at least in part, on the following:
- The nature of the business and the history of the enterprise from its inception.
- The economic outlook in general and the condition and outlook of the specific industry in particular
- The financial condition of the business.
- The earning capacity of the company.
- The dividend-paying capacity.
- Whether or not the enterprise has goodwill or other intangible value.
- The market price of publicly-traded corporations engaged in the same or a similar line of business.
The American Society of Appraisers Business Valuation Standards recognizes three principal approaches in estimating the fair market value of a business:
- The Asset Based (Cost) Approach
- The Income Approach
- The Market Approach
All comparative valuation approaches relate some market value observation to some unit of measure that is indicative of a property’s ability to produce income given the condition of its assets.
The Asset Based Approach is based on the principal of substitution that a prudent buyer will pay no more for a property than it would cost to acquire a substitute property with the same usefulness as of the valuation date. The Cost Approach estimates the value of a business by estimating the fair market value of each discrete asset both tangible and intangible. It is often avoided because it usually fails to identify otherwise unrecorded tangible and intangible assets (i.e. goodwill).
The Income Approach values a company by estimating the future benefits that will accrue to it. The value of the future economic benefits is discounted back to a present value using a discount rate that provides the investor with an acceptable return on their investment given the level of risk associated with the subject company. These future cash flows are estimated for a number of individual years until the company enters a period of steady long-term growth in perpetuity (the terminal year growth rate). The sum of the present values of the forecasted individual cash flows plus the present value of the terminal value (the value of the business in perpetuity, starting at the end of the individual year forecast period) represents the value of the company.
The Market Approach values a company by comparing the subject company to the value of other companies in the same or similar line of business using The Guideline Company Method and the Merger and Acquisition Method.
The Guideline Company Method values a company based on prices at which shares of stock of companies in the same or similar line of business (guideline companies) are trading in a public market. A set of value measures (multiples) are calculated by dividing the guideline company’s stock price as of the valuation date by relevant data in the guideline company’s financial statements. The value multiples are adjusted (usually downward) to reflect differences in risk and growth rates of public versus private companies. Then the selected adjusted value multiples are applied to the financial information of the subject company to estimate its value.
The Merger and Acquisition Method values a company based on prices at which the entire company or substantially all of its assets was sold. Certain private databases compile information about the financial attributes of these sales. Value multiples are calculated by dividing the purchase price by data in the acquired company’s financial statements. These value multiples are then applied to the financial information of the subject company to estimate its value.
The Impact of Difficult Economic Times
The use of Market Approaches requires that we apply observed market valuation multiples to the earnings of the subject-company. The most commonly used earnings to which the multiples are applied are the last twelve months as of the valuation date. In difficult economic times these multiples are often applied to one of the lowest levels of earnings in the subject-company’s recent history. In addition, the multiples themselves often decline when the economy is depressed. The obvious result is a low value.
When a buyer purchases a company they are entitled to the earnings produced from the acquisition date forward. They get what’s coming, not what’s been. If the future outlook calls for improved earnings, valuing the subject-company based on historical earnings undervalues the company. An overvaluation would result if future earnings were expected to decline.
Application of an income approach solves this problem by valuing the subject-company based on a consideration of the future outlook for the subject company. Management interviews are conducted and the appraiser attempts to confirm their opinion by independently studying the market in which the subject-company operates. Historical results are also studied and used as a “benchmark” to assess the quality of the projection.
We have seen companies doing very well and others doing very poorly in the current recessionary environment. This makes it important that valuation principles consider the unique facts and circumstances of each company being valued. We don’t “paint every business with the same brush”.