Valuation is the process of putting a price on a piece of property. The value of businesses, personal property, intellectual property (such as patents, trademarks, and copyrights), and real estate are all commonly determined through the practice of valuation. In the context of a business valuation, the appraiser considers many factors, including the following:
Several different valuation approaches can be used to determine the value of a business. Some are better suited to certain business types than others, and as Lawrence Tuller noted in Getting Out: A Step-by-Step Guide to Selling a Business or Professional Practice, "everyone has his own theory about the most equitable and accurate method [of valuation]." Tuller noted that each business interest naturally tends to favor the valuation method that best suits his own self-interests: "Finance companies value a business at what the assets will bring at liquidation auction. Investment bankers and venture capitalists, interested in rapid appreciation and high returns on their investment, value a business at discounted future cash flow. Statisticians have devised complex deviation curves based on historical performance to project future earnings. Corporate America looks to the prevailing P/E ratios, unless the market is depressed, in which case they use book value."
BALANCE SHEET METHODS OF VALUATION These methods of valuation are most often employed when the business under examination generates most of its earnings from its assets (rather than the contributions of its employees). It is also used, wrote John A. Johansen in How to Buy or Sell a Business , "when the cost of starting a business and getting revenues past the break-even point doesn't greatly exceed the value of the business's assets."
INCOME STATEMENT METHODS OF VALUATION These valuation methods are perhaps the most frequently used of the myriad valuation approaches that exist.
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 traded companies) to establish a value for the company under examination. This approach, contended Johansen, is inherently flawed since "rarely if ever are two businesses truly comparable. However, businesses in the same industry do have some characteristics in common, and a careful contrasting may allow a conclusion to be drawn about a range of value."
Different valuation methods and emphases are required when assessing the value of a personal service business such as a medical practice. While equipment, supplies, real estate and other assets that are typically included in assessing the value of companies are also included in assessing personal service business values, they are often of little consequence to potential buyers of the business in question. After all, a buyer may have an entirely new location in mind for the business, and costs associated with leases, utilities, and taxes often change dramatically with relocation. Instead, wrote Tuller, the most important consideration in valuing any personal service business "is how much gross billings can be generated from the customer/client base, not what profits have been recorded or how much cash [the owner has] taken out. …A key consideration to keep in mind if you are selling a professional practice is that the goodwill you have built up over the years is really what you are selling. Sometimes, it is called customer or client lists, or client files, but it is really just goodwill."
It is important to recognize and deal properly with certain subtleties and standards in the field of valuation. Issues and standards to keep in mind include:
TREATMENT OF DEBT If the method used to determine company value uses a pre-debt-service income measure, then debt must usually be subtracted from the resulting figure.
CONTROL PREMIUMS If the valuation methodology used 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 imposed.
DISCOUNT FOR LACK OF MARKETABILITY This discount, also known as the liquidity discount, comes into play in situations where the business owner's ability to readily sell his or her business is questionable. For example, publicly traded companies are highly marketable, and their shares can be quickly turned into cash. Closely held companies, however, are sometimes far more difficult to sell. Depending on the valuation, it may be necessary to subtract a discount for lack of marketability, or add a premium for the presence of marketability.
STANDARD OF VALUE When determining valuation of a company, the standard of value must be clearly defined. That is, it must be clear whether the valuation is based on book value, fair market value, liquidating versus going concern value, investment value, or some other definition of value. Defining the standard of value is important because of adjustments that are necessary under some, but not all, of these standards.
"AS-OF" DATES Valuation methods determine the value of a company at a given point in time. Thus, businesses that undergo a valuation process are said to be worth X dollars "as of" a certain date. Values of businesses inevitably change over time, so it is critical to state the date for any valuation. In addition, the information used by the appraiser should be limited to that which would have been available at the as-of date.
FORM OF ORGANIZATION The legal definition of the organization under examination is an important factor in any valuation. Different legal forms of entity—corporations, S corporations, partnerships, and sole proprietorships—are all subject to different tax rules which impact the value of the enterprise being appraised.
FOCUS OF VALUATION The focus of the valuation must be clearly identified. The portion of the business enterprise being acquired, the type(s) of securities involved, the nature of the purchase (asset purchase or stock purchase), and the possible impact of the transaction on existing relationships (such as related party transfers) can all affect the value of the entity under examination.
Buchanan, Doug. "Business Valuators Must 'Dig Behind the Hype.' " Washington Business Journal. September 15, 2000.
Johansen, John A. How to Buy or Sell a Business. Small Business Administration, n.a.
Medaglia, Arthur. "Corporate Valuation: Is There Room for Improvement?" Fordham Business Review. January 1999.
Semanik, Michael K., and John H. Wade. The Complete Guide to Selling a Business. AMACOM, 1994.
Slee, Robert. "How Much is Your Small Business Worth to a Roll-Up?" Triangle Business Journal. August 20, 1999.
Tuller, Lawrence W. Getting Out: A Step-by-Step Guide to Selling a Business or Professional Practice. Liberty Hall, 1990.
"Twelve Ways to Multiply the Value of Your Business." The Business Owner. May-June 1994.
Yegge, Wilbur M. A Basic Guide to Buying and Selling a Company. Wiley, 1996.
SEE ALSO: Selling a Business