Overview of the Valuation Process
Business valuation is a specialized discipline that incorporates a range of economic, financial, and general business concepts. To arrive at a reasonable estimate of value for a closely held company, the business appraiser must possess a deep understanding of public market dynamics, and engage in a rigorous analytical process consistent with generally accepted valuation theory and practice.
While it is up to the valuation expert to perform the necessary analysis, a general understanding of how value is determined can be of great benefit to the private company owner-manager, whose primary objective, after all, is to create value for shareholders. The owner-manager will almost inevitably be involved, at some point and in some capacity, in estimating firm value, whether to complete an M&A transaction, evaluate a new growth opportunity, or for some other purpose. A familiarity with the mechanics of business valuation can help ensure a meaningful contribution to the endeavor.
The following is a concise elucidation of the process of valuing a closely held business. It is by no means intended to be a comprehensive tutorial on valuation theory and practice. Rather, our objective is to acquaint owner-managers, as well as outside advisors such as attorneys and accountants, with certain fundamental concepts, methodologies, and procedures likely to be encountered in the valuation process.
Standards of Value
Prior to beginning the process of valuing a privately held business, the analyst determines which standards of value are most appropriate for the particular purpose of the valuation. Standards of value include:
- Fair Market Value (FMV): Fair market value is defined as the price that a hypothetical investor would be willing to pay to purchase a business in an arm's length transaction and in an open and unrestricted market. FMV assumes that both buyer and seller have reasonable knowledge of the relevant facts, and that neither is acting under compulsion.
- Investment Value: Investment value is the maximum price that a particular strategic investor – an investor who contributes synergies and other value enhancing factors – is willing to pay for a business. Investment value is the sum of the fair market value of the standalone entity in its present form and the value created by the strategic buyer through synergies and other means.
- Fair Value: Fair value is a term that is generally used in a particular statutory context. While it is often used interchangeably with fair market value, its meaning varies by jurisdiction or circumstance.
- Intrinsic Value: Intrinsic value is a term used in the context of valuing publicly traded securities. It is defined as the true value of a security, as opposed to current market value, which may or may not reflect the true underlying fundamentals of the business. Securities analysts routinely search for situations in which intrinsic value differs from current market price, with the objective of profiting from such market inefficiencies.
Fair market value is the standard most commonly used when appraising privately held businesses for strategic planning, legal disputes, tax and estate planning, and other purposes. In M&A transactions, fair market value of the standalone entity is used as the starting point of the analysis, while investment value, which varies by potential acquirer, is considered as the maximum price that can be paid in a proposed transaction.
Approaches to Valuing a Business
There are three primary approaches to estimating the value of a privately held business, and various methods within each approach:
- Income Approach: Under the income approach, future economic benefit streams, namely net cash flows, are projected and converted into value by applying a rate of return reflecting the uncertainty, or risk, associated with the projections. In other words, the income approach calculates the present value of all estimated future net cash flows, taking into account the risk that those cash flows may not materialize as anticipated.
- Market Approach: Under the market approach, multiples of various financial performance metrics observed for comparable publicly traded companies – price/earnings, enterprise value/revenue, enterprise value/EBITDA – are applied to a private company to arrive at an estimate of value.
- Asset Approach: Under the asset approach, value is estimated by subtracting the current market value of liabilities from the current market value of assets. The asset approach assumes that the entity's value is equal to the hypothetical net cost, as of the valuation date, of assembling from scratch the company's specific collection of assets and liabilities.
When valuing a privately held business for M&A, strategic planning, legal disputes, tax and estate planning, and most other purposes, the income approach is generally most useful, from a practical as well as a conceptual perspective. A business with ongoing operations is worth, by definition, the present value of all future net cash flows available to capital providers (investors). Only under the income approach are net cash flows and the required rate of return to investors explicitly estimated. And in M&A-related analyses, only the income approach explicitly identifies and quantifies the value that can be created through synergies resulting from the combination.
The market approach is generally most useful when employed in combination with the income approach. Comparable company multiples observed in the public markets implicitly reflect the magnitude of anticipated future benefits, as well as the risk associated with those benefits. However, since any multiple is based on a benefit stream from a single period, the analyst must apply careful judgment to identify and quantify various factors – expected growth rates, risk profiles, variability of income streams, accounting policies – that cause multiples to differ across companies. In addition, when examining a multiple paid in a comparable M&A transaction, the analyst must take into account the value of the unique set of synergies embedded in that multiple. As a general rule, the market approach is most useful as a sanity check after the analyst has arrived at an estimate of value using the income approach. While market multiples are commonly cited as industry standards, particularly in M&A negotiations, a rigorous analysis of cash flow generating potential and required rate of return within the income approach framework typically produces the most meaningful estimate of value.
The asset approach, meanwhile, is most often used in cases of liquidation, and is generally not appropriate for valuing a going concern. In a going concern, the particular combination of operating assets in use – factories, equipment, technologies, brand equity, customer lists, managerial talent – is valuable precisely because of the cash flows it is expected to produce. That value is captured through those cash flows, and as a result, the standalone value of each individual asset is not particularly relevant to the valuation calculation.
Within the income approach, there are two primary methods of converting expected cash flows into value:
- The single-period capitalization method assumes that the net cash flow of one particular period, usually the coming year, is representative of the company’s future cash flow generating capacity, and that the growth rate will be steady for the foreseeable future. The representative cash flow figure is divided by a capitalization rate (or cap rate), a percentage figure incorporating required rate of return and growth assumptions, to arrive at an estimate of firm value. The single-period capitalization method is identical to the method used to estimate the value of commercial real estate properties.
- The multi-period discounting method explicitly forecasts individual cash flows for a specific projection period – typically 3-10 years – and converts them into present value through the required rate of return. The process is commonly referred to as the discounted cash flow (DCF) methodology. Cash flows beyond the projection period are incorporated into terminal value, which is typically estimated using the single-period capitalization method or by applying a multiple to a return for the year following the projection period.
The single-period capitalization method is appropriate in real estate valuation, because real estate returns tend to be stable. Returns produced by operating companies, by contrast, tend to exhibit significant variability. As a result, the multi-period discounting method is generally the most effective means of estimating the value of a business under the income approach.
Projecting Economic Benefits to Investors
When valuing a company under the income approach, the relevant benefit stream is net cash flow. Often referred to as free cash flow, net cash flow is the cash generated from operations during a particular period, less any investment required to maintain ongoing operations or pursue growth initiatives; it is the actual cash generated that is available to investors, after all necessary investments have been made.
There are two measures of net cash flow:
- Net cash flow to equity is the amount available to pay out to stockholders in the form of dividends. It is calculated as net income plus non-cash charges (depreciation & amortization), minus additions to working capital, minus capital expenditures, plus/minus changes in debt principal. Net cash flow to equity is the most relevant benefit stream for calculating the value of a specific equity stake.
- Net cash flow to invested capital is the amount available to pay out to all investors (stockholders and lenders) in the form of dividends, principal repayment, and interest. It is calculated as earnings before interest and taxes (EBIT), minus taxes on EBIT, plus non-cash charges, minus additions to working capital, minus capital expenditures. Invested capital net cash flow is the relevant benefit stream when calculating the value of an entire business, independent of how it is financed (capital structure). Since each acquirer will apply its own capital structure, valuing net cash flow to invested capital is most meaningful for M&A and many other purposes, as it removes the distortions caused by differing capital structures.
In contrast to net cash flow (which is commonly referred to as an economic benefit stream), an accounting benefit stream – net income, EBIT, EBITDA, revenue – is not generally considered to be a precise measure of actual return to investors. Under accounting convention, revenues and expenses are most often recorded on an accrual, rather than cash, basis. As a result, accounting measures do not reflect the exact point in time at which a customer settles an invoice or a payment is made to a vendor. Moreover, comparing accounting profits between companies is made difficult by differences in accounting methodologies. Examples of such differences include LIFO vs. FIFO and straight-line vs. accelerated deprecation.
When valuing a business for purposes of an M&A transaction, the business appraiser projects net cash flows from two distinct sources: those expected from the standalone entity in its present form, and those generated through expected synergies resulting from the proposed combination. The analyst values each set of net cash flows separately, thereby explicitly differentiating between the fair market value (FMV) of the independent entity and any additional value that be created as a result of the combination.
Converting Projected Cash Flows into Value
The value of a going concern is, by definition, equal to the present value of all future net cash flows available to capital providers. Once future net cash flows have been projected, therefore, the business appraiser must determine what those future net cash flows, collectively, are worth today. Future net cash flows are converted into present value through the application of a discount rate, which is equal to the rate of return that investors require as compensation for: (a.) foregoing immediate consumption; (b.) the effect of inflation; and (c.) the uncertainty, or risk, surrounding whether projected cash flows will materialize as expected.
A commonly used framework for estimating the required rate of return is the Capital Asset Pricing Model (CAPM). The CAPM posits that:
Re = Rf + β x (ERP)
CAPM has long served as a useful framework for estimating the value of publicly traded stocks, and is commonly used in the private company valuation process as well. Certain critical limitations come into play when estimating the required rate of return for closely held businesses, however. In particular, CAPM assumes that company-specific (or unsystematic) risk can be eliminated by assembling a diversified portfolio of equity stakes, and as a result does not account for such risk. While it is reasonable to assume that a prudent investor can and will own a diverse collection of publicly traded stocks, it is generally not feasible for the owner of a significant stake in a private company to achieve a significant degree of diversification. Company-specific risk, therefore, must be considered when valuing a closely held business.
To account for the non-diversifiable risk associated with ownership of a closely held business, a modified version of the CAPM framework is applied, represented by the following formula:
Re = Rf + β x (ERP) + α
The business appraiser begins the process of estimating a closely held company’s required rate of return by identifying publicly traded companies that are similar in terms of products and services offered, markets addressed, risk profile, and other factors. The analyst then examines market-derived beta figures for those comparable companies, making various adjustments to account for dissimilarities with the subject private company. The risk factors unique to the private company being considered – market position, cost structure, distribution capability, managerial talent, to name a few – are then carefully assessed in order to estimate company-specific risk, or alpha. Only after performing a rigorous analysis of market-derived required rates of return of comparable companies, and assessing the risks unique to the subject private company (alpha), can the business appraiser arrive at an estimated required rate of return, using the modified CAPM framework.
A Word about Capital Structure and Valuation
Each business has a unique capital structure – the amount of equity financing relative to debt financing. The cost of capital for debt is lower than for equity, of course, since the lender assumes less risk than the equity investor. If the effect of taxes is ignored, the overall cost of capital – the weighted average cost of capital (WACC) – remains constant, regardless of the proportion of debt versus equity. As lower cost debt is added, the cost of equity capital rises to compensate for the additional volatility of equity cash flows (risk) produced by the increased leverage. In a tax-free environment, the rise in the cost of equity capital is just enough to offset the effect of adding lower cost debt financing, and therefore the WACC remains constant, regardless of capital structure.
In the real world, however, returns to debt holders (in the form of interest payments) are tax deductible for the company, while equity returns (whether distributed as dividends or reinvested in the operations of the company) may not be. As a result, as the proportion of debt in the capital structure rises, the amount of tax savings (the tax shield) also increases. That tax shield represents value for the enterprise, and that value accrues to equity holders.
While increasing the proportion of debt financing can have a positive effect on equity value, thanks to the tax shield, there are also costs associated with adding debt to the capital structure. The higher the proportion of debt, the greater the likelihood of bankruptcy and related costs. Also, high debt levels may cause customers, suppliers, employees, and other parties critical to the company’s operations to offer less favorable terms. An optimal capital structure is achieved by increasing leverage to the point where any additional tax benefits to be realized from further debt financing are outweighed by increased associated costs.
The optimal capital structure, which reflects risk profile, access to financing, effective tax rate, and other factors, varies by owner. In order to eliminate distortions caused by differing capital structures, the business appraiser considers the economic returns, or net cash flows, available to all capital providers: lenders and equity investors. As explained previously, interest payments are not deducted when calculating net cash flows to invested capital. The effect of a specific capital structure can instead be incorporated into the discount rate (the WACC) applied to those economic returns.
Discounts for Lack of Marketability and Lack of Control
After arriving at an initial estimate of value through processes such as those outlined above, the business appraiser must determine whether to apply valuation discounts to account for two factors that commonly affect ownership stakes in closely held companies: lack of marketability and lack of control.
Marketability is defined as the ease with which an asset, such as an equity stake in a privately held business, can be transferred or sold. Unlike shares that are actively traded in public markets, ownership stakes in closely held businesses typically cannot be easily or quickly monetized through transfer or sale to another party. As a result, all other factors being equal, a stake in a privately held entity is worth less than shares in a comparable publicly traded corporation. The valuation expert accounts for that reduction in value through the application of a discount for lack of marketability (DLOM).
A control premium accounts for the value of benefits associated with decision making power in an organization, usually as determined by voting rights. A controlling shareholder has the ability to determine corporate strategy, pursue acquisitions, pay dividends, and market the entity to acquirers, for example. The valuation expert accounts for the absence of benefits associated with control through the application of a discount for lack of control (DLOC).
For explanations of commonly used business valuation terms, as well as certain economic, finance, and accounting terms as they pertain to business valuation, please consult our Business Valuation Glossary.