What is a Business Valuation?

Provided by James R. Martin, Ph.D., CMA
Professor Emeritus, University of South Florida

Mergers and Acquisitions Main Page | Value/Valuation Main Page

Business valuation services have been provided by public accounting firms and others since the early 1900s.¹ Business valuation services are needed in many circumstances including: mergers and acquisitions, shareholder disputes, buy-sell agreements, gift and estate purposes, employee stock option plans, divorce, and litigation. The literature on business valuation is extensive and confusing. The purpose of this note is to provide a summary of business valuation methods based on several related articles.

Although the first article is not very comprehensive, I chose it because it is fairly recent and includes some terminology emphasized in the AICPA guidelines for a valuation engagement.

1. Smith (2012) ² defines business valuation as "the process of determining the estimated value of a business entity". A business valuation performed in accordance with the AICPA guidelines requires an understanding and analysis of the business and the relevant industry, as well as related economic conditions. The goal is to provide a valuation that represents the price a willing buyer and seller would agree on where both have knowledge of the relevant facts. (This is the fair market value concept mentioned below in the discussion of article 3).

The AICPA terminology associated with business valuation makes a distinction between a "conclusion of value" and a "calculation of value". A "conclusion of value" requires that the valuator consider all valuation approaches and methods to determine which methods are most appropriate. A "calculation of value" is based on specific valuation methods agreed to by the valuator and client, rather than a consideration of all approaches and methods.

According to Smith there are three main approaches to business valuation as indicated in the table below. The most appropriate approach and method depends on the facts and circumstances involved. The asset approach is used for holding companies and companies with little or no income, and is based on the value of the company's assets net of liabilities. As indicated in the table there are a couple of variations based on market values. The income approach is applicable for closely held companies where there are no market values available. The methods associated with the income approach are based on discounted income or discounted net cash flow. Whether accounting income or net cash flow is more appropriate is controversial. The market approach is applicable to public companies where public documents from the SEC or from mergers and acquisitions are available to be used as a basis for establishing a business valuation.

Smith also mentions the AICPA's Statement on Standards for Valuation Services SSVS 1. This document provides guidance for determining when an engagement is considered a valuation engagement and whether an estimate of value is a "conclusion of value" or a "calculation of value".

Smith also list four professional certifications related to business valuation. These include:

The CVA or Certified Valuation Analyst granted by the National Association of Certified Valuators and Analysts. A valid CPA license is required,

The ABV or Accredited in Business Valuation by the AICPA. A valid CPA license is required,

The CBA or Certified Business Appraiser is granted by the Institute of Business Appraisers, and

The ASA or Accredited Senior Appraiser is granted by the American Society of Appraisers.

2. Harrison (2003) ³ refers to a four step cash-simulation method of business valuation. He emphasizes cash flow rather than earnings and contends that this method simplifies business valuation. The steps include:

1) Adjusting the prior period cash flows, e.g., some prior expenses such as the owner's salary may be a bit too high or too low.

2) Projecting a range of future cash flows considering factors such as customer retention after a change of ownership.

3) Determining discount rates and projection periods considering the industry and level of risk. The stability of the industry is important in determining the projection period. This step also includes estimating the cash value of assets at the end of the projection period, usually five to ten years.

4) Discounting the cash flows to find the net present value using the range of potential cash flows.

After conducting the four steps above, the valuator should talk to industry analysts, customers, and competitors to see if the numbers seem reasonable. If the new owner is going to work in the business, then there are two things to consider. The owner's salary, and the owner's return on investment. Harrison's approach is deceptively simple and tends to ignore many problems mentioned by Strischek in the following article.

3. Strischek (1983) ⁴ provides a more comprehensive coverage of business valuation. He begins by pointing out that the term value has many different meanings. Some value concepts include: assessed value, condemnation value, book value, reproduction value, going-concern value, liquidation value, collateral value, sale value, market value, fair market value, intrinsic value, and investment value. The relevant concept of value depends on the circumstances in which it is to be used. For example, the county tax agent is interested in assessed value. A government agent is interested in condemnation value in cases where the right of eminent domain is applied to buy private property for highway construction. Accountants emphasize book value and reproduction value, while entrepreneurs are interested in going-concern value. Bankers want to know the liquidation value and collateral value of assets pledged to secure loans. Business valuation for purposes of mergers and acquisitions considers many different concepts of value. Strischek separates these business valuation concepts into objective methods and subjective methods.

Objective Valuation Methods

Objective valuation methods are based on the assets of the business to be valued. Methods include a wider range than those mentioned by authors in the previous two articles. These include book value, original cost value, market value, fair market value, reproduction value, and liquidation value.

Book Value : When book value is considered, various adjustments include deducting preferred stock, goodwill, patents, bond discounts, organization expense, and deferred charges. However, there are two serious weaknesses of book value. Accounting policies of different companies are not comparable, and book value fails to provide any indication of the earnings potential of the assets involved.

Original Cost : Original cost might be considered a minimum value to the seller, but it is a sunk cost and irrelevant to future decisions and to the future performance of the firm.

Market Value : If available, the market value of the company's stock would set a floor since it tends to be based on the price/earnings ratio and the reciprocal, earnings/price ratio provides an implicit capitalization. Unfortunately, only a relatively few large firms' stocks are traded on a regular basis.

Fair Market Value : Fair market value is the theoretical concept mentioned above, i.e., the price a willing buyer and seller would agree on where both have knowledge of the relevant facts. This concept seems to support a more subjective method such as capitalizing earnings.

Reproduction Value : Reproduction value or replacement costs provides a ceiling in situations where the physical assets can easily be replaced and are the firm's only major things of value. Price-level adjusted cost might be considered, but selecting a price index is a controversial subjective decision. A weakness of the replacement cost approach is that management experience, and the firm's reputation or goodwill are not considered.

Liquidation Value : Liquidation value provides a floor for firms with low or non-existent earnings.

The main weakness of the asset-based approaches is that asset values are sunk costs and provide little or no relevant information about the firm's ability to produce income.

Subjective Valuation Methods

Subjective valuation methods generally apply a discounting technique to flows of earnings, dividends, or cash.

Capitalized Earnings : Earnings capitalization is based on the assumption that the value of the firm depends on future income. Earnings projections begin with prior years' financial statements. A variety of statistical techniques can be used such as the simple average, weighted average, or regression analysis of prior period results. A weakness of these approaches is the underlying assumption that the past can be used to predict the future. Another problem is that there is no precise way to determine the capitalization rate. The rate should be set sufficiently high to offset the risk of an uncertain future. One might start with alternatives such as the current interest rates on money market funds and savings accounts. Other useful rates can be identified from the price/earnings ratios of similar companies if available, the so-called riskless rate on U.S. Treasury bills, and the firm's average cost of debt and equity. Note the lower the rate, the higher the valuation.

Discounted Cash Flow or Dividends : Discounting operating cash flow or dividends provide other subjective valuation methods. An advantage of using cash flow or dividends is the avoidance of distortions that arise from the various alternatives available for calculating net income. The problems associated with establishing the appropriate discount rate also apply to these methods.

The main advantages of the subjective valuation methods are that

1. they focus on the firm's earnings potential, not the sunk cost associated with asset values, and

2. the buyer's preferences for risks and time adjusted rate of return are represented in the capitalization or discount rate.

Present Value Formulas : Note that the capitalization or discount rate is the time-adjusted rate of return that makes the estimated earnings or operating cash flows equal to the business valuation. For a continuous stream of earnings in perpetuity the present value formula is as follows:

PV = R_t ÷ r

where PV = present value, R_t = Net earnings in year t, and r = discount rate.

For example, if net earnings per year are expected to be $50,000 and the discount rate is 6%, the capitalization is $50,000/.06 = $833,333. This means that if the buyer pays $833,333 for the business, the buyer's time-adjusted rate of return with be 6% if the earnings projections are precisely accurate.

The following formula is not mentioned in Strischek's article, but a buyer might find the previous calculation a bit too optimistic and unacceptable. In such cases a calculation based on a shorter period would be more acceptable to the buyer. For short periods, the present value of $1 received at the end of each period becomes part of the calculation.

PV_n = 1/r[ 1-1/(1+r)ⁿ]

where n is the number of periods.

The capitalization value is determined by multiplying the earnings per period by this amount. Adding earnings to the formula we have

PV = (R_t)(1/r[ 1-1/(1+r)ⁿ])

The formula assumes that net earnings are equal for each period and received at the end of each period. For example, for a 6% discount rate and a ten year period, the present value of $1 received at the end of each year is 1/.06[1-1/1+.06)¹⁰] = 7.36. If net earnings per year are $50,000, then the capitalization is ($50,000)(7.36) = $368,000. Note that this business valuation is very different from the $833,333 calculated assuming a continuous stream of earnings in perpetuity. For longer periods, the valuation increases along with the risk to the buyer. The calculations become somewhat more involved where earnings are expected to be very different for each period and average earnings are not acceptable.

Strischek Suggest Using a Bracketing or Valuation Range Approach

The purpose of the valuation range approach is to establish a range of values that can be used by buyer and seller to negotiate a final price. Most of the discussion above implies that the valuator determines the value of the business, but establishing a business valuation is not that simple. The buyer and seller must agree on a value. Tangible book value, liquidation value, or market value tend to set a floor or minimum for the buyer. On the other hand, the buyer would probably not be willing to pay more than the reproduction or replacement value. In terms of capitalization values, the buyer would probably be willing to pay an amount equal to the average earnings capitalized at the target rate (particularly for shorter periods of 5 to 10 years), but no more than the weighted average cash flow capitalized at a riskless rate. The seller will probably be reluctant to sell below original cost or book value even though these values represent sunk costs and have little if anything to do with future earnings. Calculating the various objective and subjective values helps frame the issue in a rational way. The final price agree to by buyer and seller is ultimately a compromise.

4. According to Moskowitz (1988) ⁵, "A corporation's value may be estimated by shareholder value analysis (SVA), a variation of discounted cash flow (DCF) analysis. Two broad measurements of value are used in SVA: expected cash flow and the cost of capital or discount rate reflecting minimum returns expected by shareholders. The benefits of SVA include: providing a consistent basis for capital allocation decisions; avoiding accounting measures never intended for future investment decisions; minimizing corporate game-playing over budgeting and planning; and providing a standard investor communications vehicle. Management can anticipate probable market reaction to its plans with SVA and evaluate business units more effectively." More emphasis is placed on the cost of capital in this paper than in the articles discussed above, and it shows how capital investment decisions and business valuation decisions are similar.

5. Kuttner (1989) ⁶ discusses another business valuation model based on Demond and Marcelo's 1993 Handbook of Small Business Valuation Formulas. The Handbook contains formulas for 20 common types of businesses. There are four categories of industry formulas: The gross sales multiplier, the monthly or annual profit (cash flow) multiplier, unit multipliers, and summation formulas that combine the other three approaches and include an appraisal value of the tangible assets. Kuttner also mentions balance sheet and income statement methods, the comparable sales method, and the comparable company pricing method. The paper includes an illustration of a valuation formula for an accounting firm. The formula is based on a multiple (50% to 200%) of the previous 12 months net revenue. The net equity value (net current assets restated at market value less liabilities) is added to the value indicated by the multiplier. The transferability of the client base also needs to be considered. It is interesting that this author does not mention the discounted earnings or cash flow methods. The paper is based on the AICPA MAS Small Business Consulting Practice Aid No. 8, Valuation of a Closely Held Business.

6. LeClair (1990) ⁷ compares an adjusted book value approach to the earnings capitalization approach discussed above. The purpose of the paper is to test the validity of the two approaches. The adjusted book value approach separates earnings into two components and applies different capitalization rates to each.

V = EAIA/r_i + EATA/r_a

where V = value of the firm,

EAIA = earnings attributable to intangible assets, r_i = capitalization rate for intangible assets,

EATA = earnings attributable to tangible assets, r_a = capitalization rate for tangible assets.

The earnings capitalization formula is as indicated in article 3 above, i.e.,

PV = R_t÷ r

where PV = present value,

R_t = Net earnings in year t, and r = discount rate.

The test compares the results of the two valuation methods for a sample of publicly-traded firms to the values actually established in the open market. The results indicate that the capitalization of earnings is superior to the adjusted book value method. The author did not test the validity of the capitalization of net cash flows method and indicates that this approach might provide estimates of value that are superior to capitalized earnings.

7. Textbooks on business valuation provide a great deal more depth. For example, Palepu, Healy and Bernard (2000, 2004, 2007) ⁸ provide fifteen chapters in a case book format. Chapter 11 covers valuation theory and concepts, and Chapter 12 covers valuation implementation. The authors also discuss valuation applications in Chapters 13, 14, and 15. All of this is well beyond the scope of my summary, but it does emphasize the scope of this topic. In addition to discounted earnings, discounted abnormal earnings, discounted dividends, and discounted cash flow analysis, they include valuations based on multiples. These include applying the price/earnings ratio to a forecast of earnings for the coming year, using multiples of the price to book ratio, price to sales ratio, and other measures. Valuation using multiples includes the following steps:

1. Select a measure of value or performance (e.g., earnings, sales, cash flows, book equity, book assets) as a basis for analysis.

2. Estimate price multiples for comparable firms using the measure chosen.

3. Apply the comparable firm multiple to the value or performance measure of the firm being analyzed.

An advantage of using the multiples approach is that it does not require multiyear forecasts of earning or cash flows. A disadvantage is that identifying comparable firms is often quite difficult.

8. Finally, there are a number of practice oriented books available on business valuation. For example, Bethel, S. K. 2009. Business Valuation Rules of Thumb and Formula Resource Guide: An Invaluable Guide for Valuing Hundreds of Different Businesses. Mattatall Press. A search on Amazon or Google will reveal many others.

See the Value/Valuation Bibliography for many more books and articles.

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References:

¹ For some early articles see:

Shorrock, E. G. 1905. The accountant and appraisals. Journal of Accountancy (December): 146-147.

Journal of Accountancy. 1912. How property is valued. Journal of Accountancy (February): 153-154.

James, C. C. 1915. Valuation of public utilities for rate-making purposes. Journal of Accountancy (September): 173-178.

McKenna, J. A. 1916. Ascertainment of value and profits from books of account. Journal of Accountancy (March): 192-205.

Wade, E. B. 1917. Accounting features of public utility valuations. Journal of Accountancy (September): 193-200.

Hawkins, L. G. 1920. Appraisals and their relation to accounts. Journal of Accountancy (March): 206-209.

Freeman, H. C. 1921. Some considerations involved in the valuation of goodwill. Journal of Accountancy (October): 247-264.

Harvard Business Review. 1923. Summaries of business research: Going value as an element in the valuation of public utility properties. Harvard Business Review (April): 359-367.

Harvard Business Review. 1927. Legal developments significant in business: Is there but one kind of value? Harvard Business Review (January): 236-244. (Is there one "real value", or are there different values for different purposes? For example: exchange value, utility or use value, cost, book value, market value, and assessed value).

Littleton, A. C. 1929. Value and price in accounting. The Accounting Review (September): 147-154.

Paton, W. A. including comments by S. J. Broad. 1936. Valuation of the business enterprise. The Accounting Review (March): 26-35.

² Smith, E. P. 2012. The basics of business valuation, fraud and forensic accounting, and dispute resolution services. The CPA Journal (June): 6, 8-11.

³ Harrison, D. S. 2003. Business valuation made simple: It's all about cash. Strategic Finance (February): 44-48.

⁴ Strischek, D. 1983. How to determine the value of a firm. Management Accounting (January): 42-49.

⁵ Moskowitz, J. I. 1988. What's your business worth? Management Accounting (March): 30-34.

⁶ Kuttner, M. 1989. Business valuation: An important management advisory service. Journal of Accountancy (November): 143-148.

⁷ LeClair, M. S. 1990. Valuing the closely-held corporation: The validity and performance of established valuation procedures. Accounting Horizons (September): 31-42.

⁸ Palepu, K. G. and P. M. Healy. 2007. Business Analysis and Valuation: Using Financial Statements, Text and Cases. South-Western College Pub.

Palepu, K. G., P. M. Healy and V. L. Bernard. 2000. Business Analysis and Valuation: Using Financial Statements: Text and Cases, 2e. South-Western Educational Publishing.

Palepu, K. G., P. M. Healy and V. L. Bernard. 2004. Business Analysis and Valuation: Using Financial Statements: Text and Cases, 3e. South-Western Educational Publishing.

Related summaries:

Grojer, J. 2001. Intangibles and accounting classifications: In search of a classification strategy. Accounting, Organizations and Society 26(7-8): 695-713. (Summary).

Jeacle, I. 2022. The gendered nature of valuation: Valuing life in the Titanic compensation claims process. Accounting, Organizations and Society (99): 101309. (Summary).

Lev, B. 2004. Sharpening the intangibles edge. Harvard Business Review (June): 109-116. (Summary).

Porter, M. E. 1980. Competitive Strategy: Techniques for Analyzing Industries and Competitors. Chapter 16: Entry into New Businesses. The Free Press. (Summary).