Factors to be Considered in a Business Valuation

Whatever the technique, the analyst should consider a variety of factors about the business and its industry. Among the factors to be considered are the following:This listing is drawn from American Institute of Certified Public Accountants (2003).

• What is the stage of the company’s development? Is it new, established and growing, mature, or declining?
• What is the current and prospective state of the industry in which the company operates, and of the economy in which it competes? How attractive is the industry to capital suppliers?
• What is the experience and competence of the members of top management and the company’s Board of Directors?
• What is the company’s position in the marketplace—for example, its market share—and what major competitors does it have?
• Are there barriers to entry in the company’s marketplace?
• What are the competitive forces in the company’s industry (recall Porter’s five competitive forces, discussed in an earlier chapter)?
• Does the company have proprietary technology, products, or services, and what is the nature of the protection, such as patent rights or exclusive licensing?
• What is the nature and quality of the company’s work force, including employer–employee relations, pay and benefits, labor supply, and the like?
• What is the nature and quality of the company’s suppliers and of the company’s customers? Is the company dependent on a small number of customers or vendors, or does it have a broad base? Are the customers and suppliers financially solid?
• Are there strategic relationships with suppliers, customers, and sources of financing? The existence of such relationships may be a positive or a negative factor when valuing the company.
• What is the company’s cost structure (operating leverage, fixed-variable mix) and its financial strength indicated by debt capacity, free cash flow, and the like?
• What risk factors does the company face?

The consideration of risk factors is an especially important part of business valuation. Uncertainties or concerns in any of the above areas may signify risks to be considered.

Two simple approaches to business valuation are (a) determining the value of the company’s net assets (assets minus liabilities) and (b) identifying the fair market value of a similar business. We discuss them briefly in the following sections, although they often prove unsatisfactory.

Asset-Based Methods

One approach to business valuation involves direct estimation of the value of the net assets to be acquired (=assets to be acquired by the buyer minus any liabilities to be assumed by the buyer). An asset-based approach typically begins by examining the firm’s balance sheet. However, there are several reasons why book (recorded) values are typically unsatisfactory indicators of business value:

• Book values reflect the accumulated effects of applying Generally Accepted Accounting Principles to the past transactions of the firm and have no necessary connection to current economic value.
• Book values may not reflect the impact of changing prices (inflation) or technological change.
• Balance sheets may not include all the relevant assets of the business, especially unrecorded intangible assets.

Given these deficiencies, the analyst attempts to adjust book values to arrive at an overall business valuation. The analyst examines and values each asset and liability to estimate its fair market value, using techniques such as the determination of market values for comparable assets, expert appraisals, and price index-based inflation adjustments. It is important to identify and value unrecorded intangible assets, including goodwill, and unrecorded liabilities, such as environmental liabilities, operating leases, and other off-balance-sheet and contingent obligations.

Direct Comparison Approach

The logic of a direct comparison approach lies in the idea that similar assets should sell for similar prices, a principle well established in other markets.See Cornell (1993). In real estate, for example, the market value of a house could be estimated by finding recent selling prices for substantially similar houses in comparable neighborhoods. Finding sales of comparable businesses, however, is difficult. Transactions are few, and comprehensive data sources do not exist. Thus, a true direct comparison approach cannot generally be used in business valuation.

However, a form of direct comparison exists when some measure or ratio serves as the link between the business valuation in question and other businesses. For example, professional practices like Certified Public Accountant (CPA) firms often sell for a multiple of billings, perhaps two to three times annual billings. For example, the average price–earnings (P/E) ratio of similar public firms in the industry might be used. If such firms sell for 12 times earnings, we can apply that same measure to a business being valued. The capitalized earnings approach discussed later is a version of this technique. As with the discounted future returns approach discussed later, one needs to select a particular cash flow or income measure, such as gross revenues. One also needs to select the “other variable”—number of years’ billings, P/E ratio, and the like—that will link the business being valued to other businesses.

Direct comparison techniques serve as a quick way of estimating business value, with little need for extensive estimation. However, because the comparison typically reflects an average of other businesses, this technique does not do a good job of incorporating distinctive features of the business being valued.

Payback Method

The payback for an investment is the number of periods management must wait before the accumulated positive cash flows from the investment exceed the initial cost of the investment project plus any negative operating cash flows. Investments are considered acceptable when the payback period is less than some predetermined time period, for example 3 years. Here is the computation:

In this example, the payback occurs at about 3 years and 1 month. Many people do not consider payback to be a discounted cash flow technique because it does not take into account the time value of money. This is not entirely true. A short payback period, say, for example, 2 years, reflects the importance of dollars received in the short term and thus the time value of money.The payback approach is related to the hyperbolic discounting phenomena. There appears to be psychological as well as economic reasons behind the fact that people prefers a reward today rather than wait for a substantial reward. Studies have found that people sometimes use average annual discount rates of over 300% over the course of 1 month and over 100% over a 1-year horizon. They ask people whether they prefer $100 today rather than $200 next month. See Noor (2009). The payback approach does not take into account cash flows that are outside of the payback threshold and they do not take into account the magnitude of the cash flows. Amazon is now a viable business but early investors did not consider the payback to be an important tool for deciding whether to invest in Amazon. This is a normal situation for many start-ups where positive cash flows do not occur until many years in the future. Discounted cash flow approaches incorporate the importance of distant cash flows and the magnitude of the cash flows.

Discounted Future Returns

Perhaps the most common, and conceptually best, technique for business valuation is calculation of the present value of expected future returns from the business. Although present-value computations are easy, determining the relevant inputs is not. Choices need to be made for:

• the type of future return to be measured (income or cash flow);
• estimates of the future amounts;
• an appropriate discount rate;
• the time period for the analysis; and
• the estimation of a terminal value.

We consider each of these areas.

Capitalizing Excess Earnings

A widely used variation of the capitalized earnings method is called the capitalization of excess earnings. This hybrid method reflects the concept that earnings are derived from both the tangible assets and intangible assets of the business. Earnings from tangible assets are assumed to be relatively constant from one firm in an industry to another, whereas earnings from intangible assets may vary widely. The method proceeds as follows:

• Estimate the value of net tangible assets
• Estimate the earnings attributable to the tangible assets, perhaps by multiplying the value of the tangible assets by the average industry return
• Subtract this amount from total reported earnings; the difference is excess earnings, the amount above what is explained by the company’s tangible assets
• Capitalize the excess earnings.

The value placed on the business has two components:

Business value = Net tangible assets + Capitalized value of excess earnings

Because we tend to consider earnings attributable to intangibles to be more risky than earnings attributable to tangible assets, we tend to use high capitalization rates (low multiples).

When we calculate negative excess earnings, the business is still presumed to be worth the value of its net tangible assets and we make no reduction for apparent negative intangibles.

For example, suppose a company reports earnings of $50,000 and net tangible assets of $350,000. Average industry earnings are 10% of net tangible assets, and we decide to capitalize excess earnings at 25%. The value estimate for the business is $410,000, as shown in Table 3 “Capitalization of Excess Earnings ($)”.

The excess earnings method, like much of business valuation, has its foundation in materials promulgated by the Internal Revenue Service. Revenue Ruling 68–609 sets forth a so-called formula method, as follows:

The question presented is whether the “formula” approach, the capitalization of earnings in excess of a fair rate of return on net tangible assets, may be used to determine the fair market value of the intangible assets of a business. The “formula” approach may be stated as follows:
A percentage return on the average annual value of the tangible assets used in a business is determined, using a period of years (preferably not less than five) immediately prior to the valuation date. The amount of the percentage return on tangible assets, thus determined, is deducted from the average earnings of the business for such period and the remainder, if any, is considered to be the amount of the average annual earnings from the intangible assets of the business for the period. This amount (considered as the average annual earnings from intangibles), capitalized at a percentage of, say 15 to 20 percent, is the value of the intangible assets determined under the “formula” approach.
The percentage of return on the average annual value of the tangible assets used should be the percentage prevailing in the industry involved at the date of valuation, or (when the industry percentage is not available) a percentage of 8 to 10 percent may be used.
The 8 percent rate of return and the 15 percent rate of capitalization are applied to tangibles and intangibles, respectively, of businesses with a small risk factor and stable and regular earnings; the 10 percent rate of return and 20 percent rate of capitalization are applied to businesses in which the hazards of business are relatively high.
The above rates are used as examples and are not appropriate in all cases.…
The past earnings to which the formula is applied should fairly reflect the probable future earnings. Ordinarily, the period should not be less than five years, and abnormal years, whether above or below the average, should be eliminated. If the business is a sole proprietorship or partnership, there should be deducted from the earnings of the business a reasonable amount for services performed by the owner or partners engaged in the business.…
The “formula” approach should not be used if there is better evidence available from which the value of intangibles can be determined.…

Because of the extensive guidance given in Revenue Ruling 68–609, many business valuation analysts follow it closely, even though it contains many cautions and qualifications, especially in performing valuations for tax purposes. This approach has come to be known as the Treasury Method.See Pratt et al. (1993) for an expanded discussion of the excess earnings method.

Valuation Premiums and Discounts

After initially estimating the value of a business, that estimate may be adjusted upward (premium) or downward (discount) to reflect other factors related to the ownership interest in question. For example, a controlling interest in a business is worth more on a per-share basis than a minority interest, as the holder of a controlling interest has authority over business decisions, whereas the minority interest holder does not. This section briefly examines some common premiums and discounts.For an extended discussion of premiums and discounts, see Pratt (2001).

Business valuations typically begin with a base value, using techniques applicable to a broad range of businesses. A premium or discount is an upward or downward adjustment to this base value, to reflect some different characteristics of the particular business being considered. These characteristics are reflected in various ways. If one uses a discounted cash flow approach to valuation, a higher or lower discount rate could reflect the special characteristics. Alternatively, the analyst could adjust the initial valuation estimate upward or downward for specific features of the business. Knowing how to identify and quantify premiums and discounts is one of the specific skills of a business valuation expert. The following situations can increase or decrease the discount premium:

• Control premium: The buyer acquires a controlling interest—usually defined as more than 50% of the voting power—in the acquired company. Because of all the powers a controlling owner has, a controlling ownership interest is clearly worth more than a noncontrolling interest. These premiums can be in the 30–50% range.
• Minority interest discount: A minority interest discount, also known as a discount for lack of control, is the logical opposite of a control premium. If the ability to exercise control commands a premium, the lack of that ability is worth less.
• Strategic acquisition premium: Sometimes the acquisition of a business may be important from a strategic perspective. For example, an acquisition may complement the existing product line, broadening the geographic market, ensure a source of supply, or eliminate a key competitor, for a specific buyer.
• Lack-of-marketability discount: Publicly traded equity shares have a high degree of liquidity—they can be readily converted into cash at close to prevailing prices. Because investors value liquidity, a negative factor exists when the investor lacks the ability to sell on short notice at a market price. Studies report that thinly traded stocks realized a 30–50% price decline when the brokerage firm that was their sole market-maker went out of business.Pratt (2001), p. 79. Studies of restricted stock of public companies that itself cannot be publicly traded find discounts for the lack of marketability ranging from about 20% to 70%.Pratt (2001), chapters 5–9. Ownership interests in nonpublic companies almost always are discounted for the lack of marketability.
• Key person discount: Some acquisitions include an arrangement for the key person(s) to join the new company for a period of time. In other cases, the key persons do not accompany the acquisition, perhaps due to death or retirement. When the key person does not continue with the business, attributes such as the loyalty of customers, suppliers, or employees may be lost, as well as the key person’s particular business skills. Research studies and court cases find the key person discount to typically be in the range of 5–10% in public companies, and 10–25% in private companies.

Discounts may be applied to base business valuations for factors other than those described earlier. One possibility is a discount for contingent liabilities, reflecting potential future claims resulting from past business activities that will become the responsibility of a buyer. Such contingent liabilities involve potential litigation such as product liability, potential environmental claims, or potential tax adjustments for prior years. Because these liabilities are situation-specific, the valuation analyst must look sharply for them!

The above discussion indicates that discounts are more frequent than premiums. After achieving a base valuation, the analyst considers adjustments for the various factors discussed above. Note that the impact of these factors can be incorporated into the base analysis—for example, by adjusting the estimates of future income or cash flows—or can be reflected as an adjustment to the base value calculation. However incorporated into the business valuation analysis, discounts can have a large effect on the ultimate value.

Approaches to Valuing a Start-Up

Because a new business has little to no history, and because it may be pursuing innovative products, services, or other business features, uncertainty about its future prospects is especially high. A capitalized earnings approach cannot be used, as new companies frequently report losses in the early years, and their present earnings (losses) may not be indicative of expected earnings. A discounted earnings or discounted cash flow approach is typically most appropriate. Many analysts favor using cash flows rather than earnings, because of the importance of cash management in start-up firms. Many start-ups fail because they quickly run out of cash. During the “dot.com” era, analysts often focused on the rate at which a start-up consumed cash, a phenomenon colorfully known as its burn rateThe rate at which a start-up consumed cash..

When performing a discounted cash flow approach to valuing a new business, the analyst must decide on the estimate of cash flows to use. The entrepreneur’s forecasts are likely to be highly optimistic, reflecting his or her vision of a successful future. When using an entrepreneur’s forecasts, the analyst typically tries to neutralize the entrepreneur’s optimism with a high discount rate. A high rate reflects both the degree of risk involved and the expectations of capital providers for high returns to compensate for the risk. VCs might seek rates of return of 50% or more during the seed capital stage and 30–50% at later stages.

VCs are not long-term investors. They seek to cash out after 3–5 years. Their investments often take the form of specialized equity, such as a preferred stock issue with a high dividend rate and mandatory redemption at a specified future time, either at a high cash price or at a generous conversion into common shares. The latter option is appealing when the VCs anticipate an initial public offering of the start-up’s shares.

Venture capital investing is high risk. First-time start-ups have a 21% chance of succeeding. Even previously successful venture-capital-backed enterprises still only have a 30% chance of succeeding in the next venture.Gompers, Kovner, Lerner, and Scharfstein (2010).

Multiscenario Approaches

In addition to using high discount rates for start-up companies, valuation analysts may use a multiscenario approach. One multiscenario approach begins by constructing alternative outcomes under different degrees of optimism about the future of the company. The approach next estimates a discounted cash flow value for each outcome, called a conditional value, and then weights each outcome according to a probability estimate of its likelihood of occurring. Often referred to as the First Chicago Approach.,Abrams (2001), pp. 410–413. this methodology frequently creates a table such as the one shown below, using the success percentages cited above: