The Art (and Science) of Valuation

A widely accepted cliché in the appraisal community is that valuation is as much art as it is science. Although teaching the art of valuation in a brief article is impossible, here are the basics behind its science.

8 Important Factors - A good starting point for any valuation assignment is the IRS’s Revenue Ruling 59-60. Even if the valuation isn’t being prepared for tax purposes, the ruling has had widespread influence within the appraisal discipline. In fact, many civil and family judges cite this landmark when writing case opinions.

Although best known for its concise definition of fair market value, Revenue Ruling 59-60 also details the fundamental factors valuators should consider when valuing a privately held business. The list isn’t intended to be all-inclusive, but it does provide a preliminary checklist for your expert’s work. You may rightfully question your valuation expert’s diligence and request an explanation if his or her report doesn’t address each of these eight elements:

1. The business’s nature and history - The valuator should take steps to truly understand how the company operates, including but not limited to its products and services, capital structure, plant facilities, sales records, and management. The valuator should review the company’s history to assess its stability, growth, diversity and risk.

2. The economic and industry outlook - A valuator should take the time to uncover current and prospective macroeconomic trends affecting the business. He or she should also understand the company’s market position relative to its competitors.

3. The company’s book value and financial condition - Using current and historic balance sheets, the valuator needs to consider the company’s liquidity, gross and net book value of fixed assets, working capital, long-term debt, capital structure, net worth, and no-operating assets. He or she should also review any shareholder agreements to assess shareholder rights and whether the business has different classes of stock.

4. The company’s earning capacity - Current and historic income statements offer an expert another valuable information source. He or she should analyze the company’s expenses — such as officers’ salaries, cost of sales, insurance, interest and depreciation — to assess their reasonableness. The valuator should further evaluate the profitability of each line of business to uncover whether the business should discontinue any particular line.

5. The business’s dividend-paying capacity - Related to earning capacity, a company’s ongoing ability to compensate shareholders for investing in it is a key value indicator. Additionally, the valuator needs to consider whether the business reinvests funds in its operations to maintain competitiveness.

6. Goodwill and other intangible value - If the company earns an above-market return on its net tangible assets, it possesses intangible value. Goodwill and other intangible value can result from several factors, such as location, brand name and reputation.

7. Past stock sales and size of the block - Previous sales of a company’s stock can give insight into the company’s current value — especially if the transactions are recent and at arm’s length. If a transaction is forced or involves a small block of stock, though, it may not represent fair market value.

8. The market price of guideline companies - A valuation expert should look at the prices paid for a company’s competitors, either on public stock exchanges or in private transactions. When selecting a guideline business, the appraiser should also consider other selection criteria, such as its classes of stock, capital structure and financial performance.

Choosing a Method - Even though there are dozens of valuation methods to choose from, a valuator typically picks just one or two methods to value a particular business. Not every method makes sense for every company. The choice of valuation method depends on several factors, such as the availability of information and the type of company being valued. Here are pros and cons of some common valuation methods:

Adjusted book value method. Under this method, the valuator converts each asset and liability to fair market value. The company’s value is the sum of the fair market values of its tangible assets and liabilities. This method works best for asset-holding companies, such as family limited partnerships (FLPs) holding real estate or marketable securities. It is also useful in valuing distressed companies, such as those facing bankruptcy. But this technique is more difficult to apply to going-concern entities with intangible value or synergies among the assets. Because it tends to undervalue going-concern entities, some valuators use this method to estimate a “floor” for the company’s value.

Public guideline company method. A subset of the market approach, the public guideline company method uses the prices paid for shares of similar publicly traded companies to estimate a business’s value. Although the courts favor this method for its perceived objectivity, a public company’s typically larger size and the public market’s limited number of pure players are two factors that often prevent appraisers from applying this method.

Private transaction method. Similar to the public guideline company approach, the private transaction formula uses sales of entire comparable companies to estimate the business’s value. Although the courts also appreciate this method’s perceived objectivity, it is often difficult to apply because many industries lack a sufficient number of meaningful comparables. Further, many criticize this method because private company transaction databases seldom contain enough information to truly understand the comparables’ operations or the deals’ terms.

Income capitalization. When the valuator uses the income capitalization method, he or she projects an annual income stream and divides it by a capitalization rate. This method is useful if future income can be reliably predicted and if the company expects to grow at a stable rate. But because capitalization rates and income streams depend on your expert’s judgment, many courts perceive this method to be biased.

Discounted cash flow. Arguably the most complex and subjective technique, the discounted cash flow method is used to estimate a company’s value through computation of the net present value of the company’s future income stream. Despite its drawbacks, most experts feel it is the most technically sound method, and it is frequently used by investors in real-life decision-making and transactions. And it is usually the best choice in high-growth industries or for startup companies.

Excess earnings method. This method combines elements of the asset-based and income approaches. The valuator uses the adjusted book value approach to estimate net tangible value. Then he or she calculates the company’s intangible value by capitalizing above-market earnings. This option is a popular choice for small professional practices. Although many courts recognize this technique, some don’t like it because no empirical evidence supports the capitalization rates used on excess earnings. In fact, Revenue Ruling 68-909 states that valuators should choose this method “only if no better method is available.”

Making the Difference - Clearly, whether we consider valuation an art or a science, skill, expertise and experience can make all the difference in sorting through these complex factors to determine the most accurate value. Please call with your valuation questions. We would be glad to advise you.