Given the many purposes for valuing a business interest and the various entity structures and standards of value involved, it can often be a daunting task for a business appraiser to develop a proper valuation conclusion. However, most business valuations, regardless of the type of entity, valuation purpose, or ownership characteristics, include one or more of three primary approaches. Surprisingly the logic and methodology behind these three valuation approaches can also be used to value many other forms of assets including, as we will see, even the farm cow…
First, business valuations generally fit into one of the following three general categories:
Litigation | Marital Dissolutions, Partnership and Corporate Dissolutions, Bankruptcy, Breach of Contract, Dissenting Shareholder and Minority Oppression Cases, Economic Damages, etc.
Taxes | Gift and Estate Taxes, Estate Planning, Family Limited Partnerships, Ad Valorem Taxation, etc.
Transactions | Acquisitions, Mergers, Leveraged Buy-Outs, Initial Public Offerings, ESOPs, Buy-Sell Agreements, etc.
Standard of Value
To determine the correct valuation approach to consider one must first determine the “standard of value”, which defines the “value to whom?” Different standards of value apply to different valuation purposes. A few examples: Fair Market Value – (e.g. Taxes, Divorce), Investment Value – “Strategic Value” (e.g. M&A), Intrinsic or Fundamental Value, Fair Value under State Statutes – (e.g. dissenting SH, minority oppression), Fair Value for Financial Reporting – (required by GAAP and SEC). Now let’s consider how to value the cow…
How to Value the Cow
You own a cow. Now how do you value it? The old expression, “Never look a gift horse in the mouth”, meaning you don’t want to question the value of a free gift, came from an actual method used to determine the value or overall health of the horse by looking in its mouth. Unlike horses, you cannot value the cow by looking in its mouth any more than you can value a business by walking through the front door. It may help, but it should not be a determining factor. To determine the value of the cow (or business interest), consider the following three attributes:
How much milk will the cow produce in the future and how much is all the future milk worth today? Stated in business valuation language, what are the entity’s expected future benefits (e.g. cash flows, dividends) and what is the present value of those benefits? In business valuation, the “milk” analysis is known as the Income Approach. The income approach attempts to evaluate a business from an investor’s perspective, weighing expected returns against inherent risk. The business risk associated with the realization of the stream of expected cash flows may be captured through the use of an appropriate discount rate or capitalization rate. Such a rate should reflect a rate of return on investment that is commensurate with the risk associated with the assets under consideration. The income approach is typically utilized for valuing operating companies.
How much are similar cows selling for currently? The question is the same in business valuation: How much is my business worth based on the current sales prices of other similar businesses? This “whole cow” analysis is known as the Market Approach. The market approach values a business by comparing the subject entity to guideline firms in similar lines of business that either: (1) have stocks that are publicly traded (“Guideline Public Companies Method”) or (2) were part of a transaction (“Guideline Transaction Method”). Valuation pricing multiples (e.g., price to earnings) are calculated and applied to the subject company to arrive at an indication of value. A determination of similarity with the subject company to guideline companies is based upon many factors, including those outlined in Revenue Ruling 59-60.
Parts of the Cow
How much is the cow worth if each part of the cow were sold separately? In business valuation, this is known as the Asset Approach (or Cost Approach). The asset approach values an entity based on the market value of its underlying assets less its liabilities. This approach is based on the principle of substitution, meaning that the economic value determined is also viewed as the anticipated cost to acquire an equally desirable substitute of the subject asset. This valuation method uses the premise that no party involved in an arm’s-length transaction would be willing to pay more to use the property than the cost to replace the property. Accordingly, all assets and all liabilities, including off-balance sheet assets and liabilities, must be identified and adjusted to reflect their fair market value.