If you take a look at the highly efficient capital markets such as the NYSE or NASDAQ exchanges, the prices per share of public company stock are actually the minority share prices. What this means is that the buyers and sellers typically trade a small number of shares. Each block of shares sold does not represent control of the entire company.
If, on the other hand, someone wants to buy a controlling share of the company, they would need to pay a premium over the current share market price. This is usually done in the form of a tender offer.
Controlling ownership interest is valuable
Why is a controlling block of shares more expensive? First, because the acquirer needs to induce many small shareholders to sell their stock. Second, because the acquirer gets to control the company, including making such momentous decisions as hiring and firing executives, distributing dividends, raising capital, merging with other companies, or selling the business.
In the public market, there is plenty of data on such tender offers. The premium paid over the market price is reported in regulatory disclosures. As a rule, the control premium typically falls somewhere in the 30% – 40% range. Put another way, to buy the entire company you would need to pay up to 40% more per share than if you just bought a single share of stock in the firm.
From control premium to minority discount
The opposite side of this is the minority discount. This discount usually arises in the context of valuing private companies. The reason is that private businesses do not sell their stock to the public, so their valuation is typically done on the business enterprise basis. The value of the whole company is determined. If you want to know what a partner’s ownership interest is worth, you first figure out the value of the pro rata share, then apply the minority discount.
Why is this discount important? Since there is no public market for ownership of private companies, there is no way to observe the price per share for a privately owned business. Think about it – how valuable would a 10% ownership of a small company be to an outside investor? You cannot make any decisions in a business controlled by the owners of the remaining 90%.
All you can hope for is an occasional dividend payout by the board. If the board is controlled by the same 90% owners, you should be lucky to see any money. More often than not, the controlling owners pay themselves in salaries and generous perks, and minimize the taxable income. If you object to the board, you are out of luck.
Adjusting for DLOM
If you use guideline public company comparables to figure out the value of a private firm, you would need to make the adjustments for lack of marketability (DLOM) first. Assuming your comparable companies are close enough to the target firm financially and operationally, you can work out the valuation multiples and determine the value of the private company on a per share basis. But remember that this guideline public company approach prices in the minority discount! In other words, your private company value could actually be 30% – 40% higher than this calculation shows.
On the other hand, you can use a set of valuation methods directly to value the entire private company. The business enterprise value you come up with is on a controlling ownership basis. If you want to figure out the value of minority ownership interests, you can apply the minority discount to the per share price you calculated.
Systematic risk is unavoidable, you cannot diversify away from it as it affects the entire market. Unsystematic risk, on the other hand, is something the investors should handle by diversification. In other words, you should not expect additional returns just because you put all your eggs in one basket.
Yet this is precisely what many small business owners do. Their company is the major source of their investment and commands their undivided attention to run successfully. Even if the public capital markets are silent about the company specific risk, it is quite real.
In the eyes of a financial expert, company specific risk premium or CSRP for short, cannot be observed. That’s because public company investors do in fact diversify from risks inherent in any particular company or asset. But if your company is more or less risky than the market as a whole, you are incurring the additional risks every day.
So a realistic approach when valuing a private firm that is expected to continue in private ownership is to account for this additional risk element. The typical factors that contribute to make a company more or less risky are these:
Earnings growth expectations: is the firm likely to be more or less profitable than its industry peers?
Financial leverage: can the company service its debt without financial failure?
Operational risk: can the operations be successfully scaled to meet the market demand and sustain growth?
Profitability: will the firm be able to generate profits in line with investor expectations?
Customer concentration: does the company depend on just a few customers for most of its sales?
Competitive position: does the firm operate in a well defended market niche or can it be easily replaced by competitors?
Management and key staff: what is the quality of the management team when compared to the industry peers?
Successful private companies with smooth, predictable earnings operating in a market niche they can defend skillfully tend to be less risky. On the other hand, a firm that is likely to experience competitive headwinds from well funded, large companies without a strategy of defending its turf is likely to be far more risky. The way to assess this level of risk is to analyze the company specific risk factors and adjust your discount and capitalization rates accordingly.
The debate about how to assess company risk and calculate the discount and cap rates rages on. While the CAPM and Build Up cost of capital models remain widely accepted, the devil, as usual, is in the details.
None as obvious as when using the risk premia for building up the equity discount rates for valuation. There seems no argument among the industry mavens that the risk free rate of return and so-called equity risk premium, or ERP for short, are the gold standard.
Company size premium – does size matter?
With this pretty much settled, the lively debate ensues as soon as you venture into the murky world of company size risk premia. The idea behind this additional element of discount rates is that smaller, less capitalized companies are inherently more risky than the larger, more established competitors.
Big business advantages and size effect on company’s value
Other things being equal, a large competitor is likely to enjoy better access to capital investment, greater acceptance of their products and services by customers, more flexibility in dealing with regulatory compliance (yes, the lobbying does pay off quite often), handsome war chests for fending off legal challenges, and much more.
Market acceptance of established companies is well known. Consider the power of a brand from a major competitor and compare it to a functionally equivalent product from a less known, smaller company. Study after study shows that customers prefer to go with the better known brands from larger companies.
In the business to business space, customers may hesitate to commit to purchases from a new vendor for fear of the company failing and leaving them high and dry without a critical supply. Often the procurement managers would demand to see the start-up’s balance sheet just to make sure they are not going belly up any time soon. The old adage of ‘show me the money’ plays right into the hands of larger, established deep pockets competitors.
Bigger companies also tend to enjoy the economies of scale, unavailable to their smaller industry peers. Ever wonder how come a large software company can come up with a working prototype by lunch time, while a smaller company has to invest ‘all-nighters’ to show similar progress?
That’s because the big company has plenty of talent on board with many pre-existing solutions lying around ready for reuse. They don’t need to reinvent the proverbial wheel, plenty of spare parts ready to be plugged into a new solution.
Smaller companies – trail blazers often fly under the radar screen
As a result, smaller companies often thrive in the netherworld of emerging markets. Big companies are generally not interested in such opportunities until they become large enough to warrant their attention. If and when that time comes, the bigger company usually has the luxury of either making their own competitive offering or buying a start-up’s technology and bringing the key talent on board.
All these and many other factors add up to making the larger companies a safer place to conceive and bring to market new products and services. Common sense tells us that this lower level of operational and financial risk should translate into measurable evidence of lower cost of capital.
Dilemma – when data analysis fails to back the company risk premium
Some financial analysts focus on data evidence exclusively to validate this idea. Smaller companies historic returns must be higher in order to demonstrate their higher cost of capital. The problem with this approach is that if your data analysis fails to show up the difference in returns between companies of various sizes, you would be tempted to assume that smaller companies are about as risky as their larger competitors.
The mindset behind this is ‘if I can’t see it, it does not exist’.
To a seasoned business person this would sound like being asked to suspend disbelief. A pragmatic response would be, ‘if you don’t see evidence of an obvious trait, your analysis is flawed, or you are not looking hard enough in your data collection’.
When a business sells, the owners are supposed to allocate the purchase price across all tangible and intangible assets. The overage is then deemed to be due to goodwill.
In the past, it mattered little if some of the important intangible assets were lumped together with business goodwill. The reason? There used to be little difference in how business intangible assets, such as intellectual property or customer contracts, were handled in the company’s financial records.
Business goodwill impairment
Along come the SFAS 141 an 142 published by the Financial Accounting Standards Board (FASB), and everything changes. No longer is business goodwill amortized. Rather, companies must conduct the goodwill impairment test and adjust their income statements accordingly. In addition, the Generally Accepted Accounting Principles (GAAP) now require that all intangible assets be amortized. In other words, such assets as software, technology, customer and vendor contracts, patents, copyrights and trademarks, all are expected to be gradually used up in business operations.
With these new financial reporting rules, companies have an incentive to put high values on goodwill and reduce the values of other intangible assets. The benefit of this strategy is that you can increase the reported earnings without any effect on the business cash flow. Earnings per share go up, so the company stock value increases.
According to the US Securities and Exchange Commission (SEC), there are several types of business intangible assets that must be valued:
Customer related intangibles
Marketing oriented intangible assets
Technology specific intangibles
Contractual intangible assets
All these assets must be recognized as distinct from business goodwill. Contract specific assets do not need to be actually separable. However, all other intangible assets must be capable of being sold on their own.
This sounds a bit tricky. The plain English meaning is that an intangible asset must be either based on a legally enforceable right, such as a customer contract, or be sellable by itself, such as a license to use a patented invention.
To see the difference, imagine the problems with trying to transfer a trained and assembled workforce to another company. You are unlikely to have this valuable asset preserved intact, in contrast to the licensing of a trademark.
Take a look at a professional business appraisal report and you will see a discussion of the current trends in the industry and expectations going forward. No business operates in a vacuum and economic conditions, especially emerging trends in the industry sector, make a big difference to what a company is worth.
Think about a growing company in an expanding industry with great profit potential and few large competitors who could dominate the market. Compare this to a declining industry controlled by a handful of deep pocketed mega-firms and major regulatory hurdles looming on the horizon.
The effect of such industry trends often far outweighs the overall economic conditions as it has the most direct influence on the company’s ability to compete.
When valuing a business, you need to pay careful attention to the industry trends and analyze how the company plans to rise up to the challenge. This requires a careful review of management, key staff, financial strength of the firm, its product and service competitive position. Your valuation report should help the reader see how the company fits into its market and why it will continue to be successful.
This analysis underlies the assumptions you make when calculating business value. Regardless of the actual methods you use to come up with your business valuation conclusion, the results should be based on sound assessment of the company’s industry and its prospects going forward. Cranking out numbers that ask your reader to suspend disbelief will not cut it.
If you are looking to appraise a business, looking at market evidence to support your conclusions is very useful. After all, the market is the final arbiter of what a company is worth. Short of test driving the market by putting your company up for sale, looking up recent business selling prices is the next best thing.
So far, so good. But the answer you get is only as good as the data you are able to gather. The old adage of ‘garbage in, garbage out’ applies to business valuations as well.
You may be tempted to delve into data sources touted as treasure troves of valuable data by their vendors. Comparing your company to similar firms that actually sold recently could help you work up a set of valuation multiples to estimate your business market value.
The devil, as the saying goes, is in the details. High quality data on private companies is scarce. Aside from filing tax returns with the Federal and local government, private companies are not obligated to disclose their financial and operational data to anyone. In fact, most private business owners consider such data highly proprietary and confidential.
So where do the data resellers get their data from? Usually, private company sales data comes from participating business brokers. While some brokers may disclose the details of their transactions, most consider such data their competitive advantage, and keep it under lock and key. When business seller prospects look around for a broker to sell their business, those with the most knowledge of the market tend to attract future customers.
The result is that most private company sales never get published. If you consult a data source on private business sales, you are likely to see only a small fragment of the deals actually made.
Most business brokers are sales people. Many lack the financial reporting skills and may report data that obscures the actual financial picture of the company. There is no compliance requirement with financial reporting standards, such as the Generally Accepted Accounting Principles or GAAP, as is the case for public companies.
Private business owners are famous for their skill at creative accounting in order to minimize taxable income. That’s why business appraisers spend considerable time adjusting company financials before appraisal. Since data on private companies does not include detailed background information, it is very difficult to adjust reported financials to reconstruct a true picture of company’s financial performance.
The result is your valuation multiples can be quite misleading.
As the saying goes, if something looks too good to be true, it probably is. If you doubt the valuation multiples you get by crunching the numbers obtained from a data reseller, it’s time for a ‘second opinion’. The best way is to source data on small capitalization public companies in the same industry. These firms are subject to the rules that mandate consistent financial reporting and full disclosure of the company’s current situation and prospects.
To make an ‘apples to apples’ comparison to a private company, adjust the valuation multiples you get for lack of marketability. The factor, known as DLOM, accounts for the relative reduction in business value because a private company cannot sell its stock freely to the public.
The USPAP standards, published by the Appraisal Foundation, cover every element of valuation for real, personal, and business properties. When it comes to reporting your business valuation results, it’s worth consulting Standard 10.
The Standard does not dictate the choice of form, format or style in compiling valuation reports. This is left to you as an author. The important point is the content. This makes sense as business appraisals address a wide range of audiences and situations, each with its own preferences.
To comply with the USPAP Standard 10, your report should state clearly all the assumptions, special considerations, and sources of information you have used in conducting your business valuation. The idea is that your intended readers should have enough to understand how you came up with your conclusions.
Appraisal and Restricted Appraisal report options
The latest Standard 10 makes a distinction between two major options: an Appraisal Report and a Restricted Appraisal Report. The latter is only intended for the client. Whenever other parties are going to be reading the report, the Standard 10 requires that you follow the more general Appraisal Report option.
The key difference is the depth and type of information you provide in your report. It is one thing to create a valuation just for your client, who is very familiar with the company. You can assume a level of understanding of the business specifics that is not available to outsiders. For example, a lender or investor looking to put money into your client’s company would likely require a lot more disclosure to make up their mind.
Avoid one-size-fits-all boilerplate reports!
If you do prepare a full blown Appraisal Report, be sure to indicate who the intended readers are. Everyone’s needs for information are different and a ‘one-size-fits-all’ does not work in business valuation.
Elements of USPAP Standard 10 compliant appraisal report
The key elements you need to include in a standard-compliant report are these:
Identify the client and any other recipients of the report.
State the purpose of the business valuation.
Discuss what is being valued, such as business assets included in your analysis.
State if the valuation is done on a controlling interest basis.
Indicate if there is any limitation as to the marketability of business assets.
State the date of your appraisal and the reporting date, if these are different.
Outline the scope of your analysis, including the sources of information researched and used.
Describe the approaches and methods used for calculation of business value and explain how you reached your value conclusion.
Explain any unusual circumstances and conditions that influenced your valuation.
Use all three valuation approaches
A USPAP Standard compliant valuation should use all three valuation approaches. That is to say, your analysis should look at business value from the Asset, Income and Market perspectives. If you decide to omit any of these major approaches, you should explain it in your report.
For example, you may be appraising a pioneering technology company that has no equals in the marketplace. It may be reasonable to forgo the use of the market approach methods as no reliable comparables are available.
Don’t forget to sign your report and mention anyone else who may have helped in your valuation. Clearly state the scope and limitations of your analysis so that your readers know what to expect. Your business appraisal report is the finished work product and represents the quality of your work.
Part of business appraisal is assessing the value of business assets. This is especially important if the company is for sale and the purchase price needs to be allocated across its asset base.
Business equipment values are typically established by market comparison. A business machine is valued based on its functional utility and condition, regardless of where it is located and who currently uses it.
The secondary market for used business equipment is well established. Equipment dealers do business in just about any kind of machinery a company can require. As a result, knowledgeable dealers have a pretty good idea of what a given machine is worth.
A company can make a choice of getting a new piece of equipment or finding a used machine that is cost effective and can perform the same function. The comparison boils down to the age, condition, and utility relative to the price of new versus used equipment.
If you are valuing business assets, the first stop should be a few equipment dealers. These intermediaries are usually happy to provide pricing information for free because the inquiries keep them abreast of who and why uses the machinery. This could generate a useful contact for future business deals.
Equipment auctions are another source of pricing information. When businesses are dissolved, their assets go up for sale. The prices paid at such auctions offer you direct evidence of what the market values for similar equipment are. You can even trace the age of sold machines based on the model and serial number information published by the auctioneer.
Just as with the company as a whole, market values of business assets can change over time. Be sure to pay attention to the timing and relevance of comparable sales when working out the values of your company’s machinery and equipment.
Figuring out the actual values of business assets is a common task in business appraisals. Pick up the property records in a typical company, and you are looking at the book values. Sounds easy, right?
Welcome to the real world. The fact is that business assets can and do disappear, while being on the books. On the other hand, some valuable assets can be in use while not on the books at all.
Don’t expect that this difference comes out in the wash. Your accountant may want to offset such imbalances, but two wrongs don’t make it right. How do business assets wind up on the company’s books? Usually, your accountant keeps records of business assets using their original cost of purchase less depreciation.
What this book value does not represent is the true fair market value (FMV) of the asset. To make matters even more interesting, the fair market value can be estimated on the premise of the asset in use or in exchange. The first assumption is that the asset will continue being used in business operations. The second is that the asset will be offered for sale. The value may differ by quite a bit.
The key point is that the price you paid for a piece of equipment or software application years ago may bear no resemblance to what the asset is worth today. Technological obsolescence has really changed the game in asset valuation. Just because a custom software cost you, say, $100,000 in 2000 does not mean its value is anywhere near that today.
Purchase price allocation calls for business asset valuation
Even so, there are examples in business appraisals when current fair market values of some business assets are close to their book values. This is more likely to be the case if you are valuing the entire company and the assets are expected to be in use. If the business is offered for sale, purchase price allocation across the assets is one scenario when accurate asset valuation is needed.
Market value of business assets – another perspective
If the company plans to divest of some of its assets, you may find that the market place has a very different idea of what these assets are worth. This comes up when business assets are viewed as a collateral against a bank loan. Your lender is not interested in using the assets. Instead, the likely selling price in the event your company defaults is important.
Liquidation value – when assets are sold at an auction
The appraisers call this the liquidation value. It is established at an auction attended by the equipment brokers or other companies looking to get usable assets at a discount. You can bet on the selling prices being lower than the book value in these situations.
Does the value of a company depend on which country it operates in? The answer is yes, and here is why.
Business value is about risk and return. In other words, what makes a business valuable is how much money it makes given an acceptable level of risk. Investors, including business owners, look to put their money into business ventures that promise reasonable returns, both on their money and of their original investment.
Why business values differ by country
When sizing up business risk, the country’s economic and political conditions matter. Consider operating a company in a well run, developed economy such as Western Europe or North America. Political situation and the laws governing commerce are well understood and enforced. Financial markets are highly efficient and liquid. If you invest in a public company, you can unload your holdings in a few moments and move your money into a different investment.
The situation in less developed or politically troubled countries may be very different. The rule of law may be confusing or hard to discern. Exporting your money may well be fraught with difficulties or be very expensive. Bribes and protection rackets could plague the unwary investors. Your erstwhile business partners could turn out to be plain crooks.
Global financial markets abhor such instability. If the investors as a whole see systemic problems in a given country, they usually vote with their feet and take their investments to safer havens.
If you are adventurous, you may give investment in an emerging economy a shot. After all, risk and reward go together.
Unsurprisingly, the global investment community has a way to assess just how risky a business investment is in a given country. Consider how the discount rate for business valuation is built up. This discount rate captures the risk of your business investment. Note the equity risk premium, or ERP for short, in the equation.
Equity risk premium and country risk premium
For advanced, stable economies such as the USA or Western Europe, the ERP is measured by the returns on a major equities index, such as Standard and Poor 500 (S & P 500). The countries rated by the major credit agencies at the top of the scale get the Aaa rating. What this means is that investing in such countries is about as good a bet as investing in the broad portfolio of companies covered by the S & P 500 index.
Put differently, business investment in the USA, Canada, or Germany is no more risky than the equities market as a whole. Such advanced economies do not have any additional risk premium by country.
However, business values in less developed or stable countries is more risky. If you choose to invest in a company in many South American or Middle Eastern countries, your investment carries an additional country risk premium. How high the premium is depends on the risk spread of the particular country.
Example: business values in advanced vs developing countries
How does this country risk premium affect business values? Lets take an example of two companies, each generating $300,000 in net cash flows and growing at an annual rate of 5.47%. Both companies are debt free, so their cost of capital is just the equity discount or cap rate.
Let’s further assume that both companies are small, under $50M in market capitalization, and offer professional engineering services. The first company, based in the USA, has the equity discount rate made up of these parts:
Risk Value, %
Risk free rate (based on US 10 year Treasury yields)
Equity risk premium
Country risk premium
Small company size premium
Industry risk premium
Company specific risk premium (CSRP)
Equity Discount Rate
This gives the total equity discount rate of 24.35% and capitalization rate (cap rate) of 18.89%.
The second company in our example is based in Argentina, the country rated B3 by Moody’s. The country risk premium is around 9.3%, which gives us the total discount rate of 33.65% and cap rate of 28.19%.
Difference in business valuation by country
We next use the constant growth direct capitalization business valuation method to figure out what each company is worth. Remember, the only difference in this scenario is the country risk premium. Here are the results:
Business value of the US-based company
Business value: $1,675,230
Business value of the Argentina-based company
Business value: $1,122,506
As you can see, the difference in business value is considerable. Given a choice, any rational investor would go for the US company due to its lower risk. The Argentina based company would have to throw off more cash increasing its returns in order to compensate the investors for its higher risk.