VALUATION

Valuation involves putting a price on a piece of property, whether it be real estate, intellectual property (patents, copyrights, trademarks, and other intangibles), personal property, or a business. In the context of a business valuation the appraiser considers many factors, including financial attributes (such as sales and profitability trends, noncash expenses, capital expenditures, tangible and intangible assets, the implications of long-term contracts, nonrecurring profit and loss statement items, related party transactions, and contingent liabilities), marketing attributes (including location, competition, barriers to entry, distributor relationships) and macroeconomic attributes (regulatory constraints, labor relations, interest rates, general economic conditions, the state of the art for the company's products, and others). A thorough understanding of the subject company's background and circumstances is critical to the appraiser's ability to assess the reasonableness of various assumptions that will underlie the valuation.

VALUATION APPROACHES

There are many different valuation methodologies, some more suited to certain types of property than others. The main approaches include liquidation, asset value, market comparable, and discounted cash flow.

LIQUIDATION APPROACH.

This method assumes a company will cease operations and that the value will simply be the sum of the individual assets that can be sold; no goodwill for the company's name, location, customer base, or other accumulated experience is captured. This level is further divided into forced liquidations (as in a bankruptcy) and orderly liquidations, with values generally placed higher in the latter.

ASSET VALUE APPROACH.

This approach starts with the company's book values per its balance sheet (at historical cost), and makes adjustments thereto to bring them in line with market values. For example, real estate acquired long ago is frequently worth more than its historical cost. Alternatively, some intangible assets may have no continuing value in certain situations, or may be worth much more than book value in others. This method is most often used in companies where much of the assets are commodity like.

MARKET COMPARABLE APPROACH.

This approach looks to comparable companies—in terms of industry, size, growth rates, capitalization, and other factors—for which a market value is known or observable (e.g., publicly held companies) to establish a gauge. Then, a ratio of value is calculated for the comparable(s)—such as market to book, market to earnings, and market to cash flow —which is applied to the target company's parameters. In some cases a comparable private company may have recently changed hands under similar terms and circumstances. Here, the particular transaction may be useful as an indicator of value.

DISCOUNTED CASH FLOW (DCF) APPROACH.

This method uses projections of future cash flows from operating the business or using the asset, and requires detailed assumptions about future operations, including volumes, pricing, costs, and other factors. DCF usually starts with forecast income, adding back noncash expenses, deducting capital expenditures, and adjusting for working capital changes to arrive at expected cash flows. The appropriate discount rate must be determined and used to bring the future cash flows back to their present value at the as-of date of the valuation. DCF in its single-period form is known as capitalization of earnings, which usually involves normalizing a recent measure of income or cash flow to reflect a steady-state or going forward amount that can be capitalized at the appropriate multiple.

VALUATION ISSUES AND STANDARDS

It is important to recognize and deal properly with certain subtleties and standards in the field of valuation. Issues and standards to be aware of include:

• Treatment of debt: if the methodology applied uses a pre-debt-service income measure, then debt must usually be subtracted from the resulting figure.
• Control premiums: if the methodology is based on price/earnings ratios of comparable public companies and the interest being valued is the entirety of a company, a control premium may be applicable. Conversely, if the starting point is from a controlling perspective and the interest being valued is 'minority," then a discount for lack of control may be indicated.
• Discount for lack of marketability: also known as the liquidity discount, this involves whether or not the property can be readily sold. For example, publicly traded companies are highly marketable, and their shares can be quickly turned into cash. Closely held corporations, on the other hand, are more difficult (and in some cases by agreement, impossible) to sell. Depending on the reference point of the valuation, it may be necessary to subtract a discount for lack of marketability, or add a premium for the presence of marketability.
• The standard of value must be clearly defined. That is, whether the valuation is based on book value, fair market value, fair value, liquidating versus going concern value, investment value, or some other defined perspective of value. The distinction is important because of adjustments that are necessary under some, but not all, of these standards (e.g., control premiums, discounts for illiquidity).
• The as-of date must be specified and maintained. Values of property vary over time, and it is critical to state the date reference for any valuation. Further, the information used by the appraiser should be limited to that which would have been available at the as-of date; that is, subsequent information is generally excluded from the equation when doing valuations.
• The form of organization is important. Different legal forms of entity—corporations, S corporations, and partnerships —are subject to different tax rules, which affect the value of the enterprise.
• The focus of the valuation must be clearly identified. The portion of the enterprise being acquired, the type(s) of securities involved, whether the transaction is a stock purchase or an asset purchase deal, and how the transaction may affect existing relationships, such as related party transfers, can all affect the value.