Whatever methods you choose for your business valuation, proper selection of the inputs is critical to the accuracy of your results. This is especially important if you are working with the income-based valuation methods such as the Discounted Cash Flow.

Business valuation is about the economic value of the company. So accounting measures of income such as revenue, net income or gross profit are generally not suitable for business valuation directly.

Instead, the discounted cash flow method requires a cash flow based earnings basis that truly captures the economic benefits the owners can derive from the business.

The typical earnings basis used in professional business appraisals is net cash flow. It is the measure of earnings that you can extract from the business without adverse effects on its operations.

Net cash flow – removing the capital structure from the equation

Here is how you can calculate the net cash flow of a company:

• Start with the business pre-tax net income
• Add depreciation and amortization expense
• Add tax-affected interest expense
• Subtract changes in working capital
• Subtract capital expenditures
• Add dividend payouts

Note the conspicuous absence of the debt principal repayments. In fact, you may notice that the effect of capital structure is completely factored out of the net cash flow. In other words, we determine the cash flow to total invested capital, both equity and debt.

Business value to total invested capital

This makes sense if you consider business valuation on the typical business enterprise basis. The idea is to determine the total value of the company regardless of how its assets are financed.

Business owners have complete discretion about how to finance the company. Should the business be acquired or merge with another firm, the ownership may well decide to change the capital structure by reducing the leverage, renegotiating loan terms or injecting additional equity capital.

Bear in mind that such policy decisions can bring about positive changes in the long term. However, they do not have an instantaneous effect on business value.

If you plan to value a business using methods under the income approach, the discounted cash flow technique us likely to be high on the list.

Using this venerable business valuation method requires that you forecast the business earnings over some future period, usually measured in years. In addition, you would also need to assess the business risk and calculate the discount rate. Finally, you would compute the residual value, also known as the terminal value of the company, based on your expectation of earnings growth.

The Financial Accounting Standards Board (FASB) has issued interesting recommendations on the use of the discounted cash flow valuation in its Concept Statement No 7.

Business valuation problem: earnings forecast uncertainty

The basic idea is that any cash flow projection you create is at best speculative. After all, who knows whether the company will really win the customer acceptance it anticipates or how the competitors will react to the introduction of a new product line. Overall market conditions could suddenly deteriorate limiting the customers ability to buy the company’s products or services. All this could fall outside the management’s expectations and significantly change the actual earnings for the business.

Given this uncertainty, FASB has suggested a somewhat different approach to business valuation. Instead of a single cash flow projection, they recommend that you create a number of possible cash flow forecasts.

Use multiple cash flow forecasts to improve your valuation

Each forecast can be assigned a probability of occurrence. Let’s say, you foresee a possible best case scenario where the firm lands a number of major customer contracts. You can create a cash flow forecast that reflects this outcome. On the other hand, unexpected problems may crimp the earnings going forward. You capture this situation by creating an alternative worst case cash flow projection.

To round out your analysis, you may put together yet another earnings forecast that is somewhere in the middle of these two extremes.

You then assign a probability to each scenario. For example, the best case gets a weight of 30 percent, worst case 20 percent and the middle or most likely case 50 percent.

Finally, you calculate the business value as the weighted average of the above scenarios, using the risk free rate as the discount rate. Usually, the yield of long-term US Treasuries is selected for the risk free rate.

While this approach to business valuation has some merits, most business appraisers prefer to capture the company risk directly and calculate the discount rate based on the full assessment of the subject business risk profile.

Match earnings forecast and discount rate to increase valuation accuracy

One way you can combine both methodologies for a highly effective business appraisal is to use the multiple cash flow projections each with its own discount rate. The idea here is that each outcome is associated with its unique business risk. This should be reflected in the scenario specific discount rate.

If you use the build-up model for discount rate calculation, one element that is likely to vary a lot is the company specific risk premium. This makes sense – in each possible outcome the company management can make decisions that change such factors as the capital structure, customer concentration, and earnings stability.

The result is a different level or risk and different discount rate. These key inputs will in turn affect your business value calculation.

Looking back at the first decade of the 21st century, you can see the investor psychology at work in setting the valuations of businesses and other income producing assets. Once the frenzy sets in, business valuations can rise to lofty levels rather quickly, at least in the short term. This is often driven by market comparisons: if one company sells for 10 times the gross revenues, then a similar firm should trade at about the same price.

This is the essence of the market approach. At any point in time, investors tend to compare the current prices of similar businesses to see what a given company is worth. And it can happen despite the fact that such prices may well fly in the face of historic reality. After all, how often have companies sold at 20 – 50 times their revenues?

Investor excitement aside, your business valuation must pass two key tests:

1. the market comparison should make sound financial sense
2. and the business sale comps must be truly similar to the subject business.

One of the most accessible and reliable sources of business sales data is the public company transactions. These are usually available based on well established financial reporting standards and cover practically every industry sector. However, there is little comparison between a seasoned public company and an emerging start-up.

To make market comps work, you would need to consider a number of adjustments:

Company size risk premium

Smaller companies tend to be riskier. As a result, investors will demand higher returns to put their money into such firms.

Earnings track record

Start-ups with a limited track record are inherently more risky. Only future will show how successful the company is at executing its business plan.

Lack of marketability discount

Investments in private companies are essentially illiquid. This means considerable risk to the investors should they try to sell their shares of the business. Such lack of marketability can lead to considerable discounts on the company’s value.

Company specific risk premium

Private business owners are notoriously under-diversified. Their entire capital may be tied up in a single company. Unlike public company investors, owners of small to mid-size firms incur additional risks associated with the company itself. Examples are company capitalization, management team quality, market concentration and competitive position.

Reliable business valuation uses all three approaches

Your business appraisal should account for these factors to be defensible. To come up with a solid business valuation, consider using methods under all three approaches. Pick up an income-based method, such as the Discounted Cash Flow, to sanity check your market comparisons. Look at the asset base of the business using the Capitalized Excess Earnings method. This could be very valuable in cases where the company has built up considerable goodwill.

This combination of valuation methods may give you a range of business values. If your market comparison was based on sound reasoning, the income and asset based appraisal results should be close. If not, it is likely that the assumptions made in your business sales data selection or adjustments are the source of error.

Curiosity aside, business appraisals are almost always triggered by a pressing need. Business people generally are interested in what the business is worth for these reasons:

• Business sale transaction, including sale of the entire company or offering a block of stock for sale.
• The need to raise additional debt or equity capital.
• Gift or estate taxes.
• Partner buy-in or buyout of a departing partner’s ownership interest.
• Litigation such as divorce or shareholder disputes.

In just about all of these situations business appraisal is a zero sum game: one side usually wants a higher result while the other is interested in lower business valuation.

Valuation of a business for sale

If you are a business buyer, you would naturally seek to lower the purchase price, hence the need for conservative valuation. On the other hand, if you plan to sell your business you would be most likely interested in getting the highest price possible for the company.

This adversarial relationship between parties to a business appraisal brings up an interesting question: is there a way to strike a balance between the conflicting interests of the parties involved?

Business fair market value is revealed in the market place

Since it is harder to argue against obvious facts, business people are likely to reach a sensible compromise provided there is sufficient evidence as to what the business assets are really worth. When in doubt, you can refer to the market place. If there are enough transactions involving similar businesses, the prices paid by others serve as a good starting point in your own negotiation.

Sale comparables and business value

The idea is that comparable business assets should sell for about the same price. In the consumer market this is very clearly the case. Consider the prices paid by a dealer for a used auto you offer as a trade-in for a new car. While your objectives and those of the dealer are directly opposed to each other, to make a deal you are likely going to agree on a price that fits somewhere in the range other car owners have accepted.

For a given car brand and condition, there are usually plenty of sales data to go by. So comparable selling prices tend to help you keep your negotiation relatively simple and straightforward.

The situation is similar with business assets. Those that can be easily substituted and sell often tend to have a pretty well defined price range in the market. But if your company owns some highly specialized assets, the situation could be more difficult.

Business valuation: beyond sale comps

The same applies to the business itself. If comparison is hard to make, arguments as to the business fair market value are likely. That is one reason a well considered, comprehensive business valuation is very important. You can demonstrate what the business is worth by using a number of methods, not just the market comparisons.

The more unique the business, the more such considerations as the earnings prospects, unique business value drivers and industry growth potential define its true value.

In most jurisdictions, private businesses are required to pay the so-called ad valorem taxes on business personal and real property. Most business people treat these taxes as a necessary evil – you have to pay them regardless of how well or poorly the company did in a year. You simply have to fill out the local assessor forms about the business property changes, additions and asset retirement, then send in the check.

Interestingly, most assessors do not appraise the business property at its true fair market value. This is a defensive tactic. If a business owner gets a tax bill that shows the business asset values as overstated, he is likely to object to the amount. It is harder to argue if the assessed values are below what the assets are actually worth.

It turns out that the assessed value of a business asset does not matter in so far as the tax bill is concerned. There are two key elements to a business property tax. First, is the assessed value. Second is the overall tax revenue the local government expects to collect. The tax rate is determined based on the overall property valuation and the revenue goal.

So it does not matter if your firm’s assets are appraised at 100% or 50% of their fair market value. The business property tax expense is exactly the same.

Since the tax revenues are split across the entire local asset base, it does matter if your business property valuation is relatively higher than that of other local companies. There are two reasons this may happen:

• You have overstated the values of your company’s assets.
• The assessor has not properly equalized the value of your firm’s assets in relation to other companies in the area.

In fact, business property tax bills usually do not detail the equalization rate applied to calculate your firm’s property tax burden. The assessor applies the effective equalization rate to all local companies in order to spread the business property taxes on an equal share basis.

The important part to remember is that the business property values and, therefore, the taxes are based on the asset values your company has reported initially. The assessor then calculates your tax bill based on the these initial asset values along with any adjustments for depreciation and inflation.

One point to bear in mind is that the assessor is unlikely to adjust your business property tax for any economic or technological asset obsolescence.

To minimize your business property tax bill, be sure to report the newly added assets at their true market values. As time goes by, make appropriate adjustments to the asset values as property is being used up and replaced.

Valuation of specialized assets is among the hardest tasks a business appraiser may undertake. Just about all businesses have such assets on hand. Imagine a technology company with specialized lab space and equipment. Or a manufacturing firm with its own set of machinery and factory floor layout. In each case the managers have adapted the business assets to their highest and best use for the company.

Yet the question of valuing such special assets plagues many business valuations when the intended use of the assets going forward is about to change. What happens to the value of a real property currently occupied by a restaurant if the new owners decide to put in a retail operation in its place?

Clearly, there are going to be some conversion costs associated with the makeover. Business buyers may figure this into their acquisition proposal to make sure the net value is positive. On the other hand, the seller may feel the offer falls below expectation.

The key point to remember is that the value of such business assets depends on their intended use and must be compared to alternative assets available. If the costs of converting the subject property are higher than suitable alternatives, a rational business investor would elect to go with the “plan B”.

Assets that cannot be substituted

Notice that this thinking is in sharp contrast to the situation involving unique assets available in the arts market. If a work of art comes up for sale chances are there is no way you can get an alternative. If the buyer really wants the painting, it is down to his ability to negotiate with the seller.

Alternatives to business assets dictate their value

In the business world alternatives always exist. The next best real property or business equipment is likely to be only marginally different from the target asset. In other words, you as the business appraiser can always make the assumption that one business asset can be substituted for another. As a result, you can determine the value of a business asset on the fair market value basis.

Do you need to determine the value of an auto dealership? Here are some industry statistics to consider.

New and used car dealerships are a significant part of the automotive retail and services industry. Classified under the SIC code 5511 and NAICS 441110, there are some 43,600 such establishments in the US alone. The industry sector generates a respectable $343.1B in annual sales employing over 953,000 people. An average auto dealership is a privately owned firm with about $13M in annual sales and a staff of 33.

Auto dealership business valuation by market comparison

Auto dealerships are ubiquitous, many successful companies becoming institutions in their markets. There is a growing trend toward consolidation with smaller independent dealers being bought out by larger companies. As a result, successful privately owned dealerships are frequent acquisition targets.

This is good news if you decide to value an existing auto dealership using the market approach, i.e. by comparison to recent sales of similar companies – there are plenty of business sales to compare against.

The usual tools to value an auto dealership under the market approach are valuation multiples.

The multiples are ratios that let you calculate what is known as the enterprise value of a company based on the selling prices and financial performance of similar firms.

The valuation multiples commonly used for valuation of auto dealerships are these:

• Enterprise value (EV) divided by revenues (net sales)
• EV to EBITDA

The product inventory may be factored out of the multiplication and added on top to come up with the enterprise value of the business.

Example: Valuation of an auto dealership business

To demonstrate the concept, let’s pick a typical new and pre-owned car dealer with the following financials:

• Revenue: $13,000,000
• EBITDA: $1,000,000
• Inventory: $2,250,000

Next, we choose a set of reasonable valuation multiples to calculate the business value estimates:

Another way to report these results is as a range of values, from low to high, i.e. $3,940,000 – $4,700,000. The expected business value then should fall somewhere in between.

If you are valuing a private company, one of the key elements of the appraisal is assessment of the business risk. You can quantify your risk assessment as the discount or capitalization rates. To calculate these rates use any number of the cost of capital models such as the build-up or CAPM.

Regardless of the model you use, you will notice that they rely upon the estimation of the so-called equity risk premium. This risk element captures the overall uncertainly as to the size and timing of returns from a diversified portfolio of public company stock investments.

You can use such public capital markets information to assess the risk of a privately owned business. Prudent investors rely on the public market data to make decisions on investment in a public or private company. They will invest in a given company if the returns they receive are commensurable with the risk. So the equity risk premium is an opportunity cost that the business owners incur to attract and retain the much needed capital for their business.

Along with the risk-free rate of return, the equity risk premium sets the lower limit on any privately owned company discount rate. In other words, smart investors will not put their money into a company unless the returns they get match or exceed the sum of the current risk-free return and the equity risk premium.

Usually, risk associated with a privately owned company will also include such elements as its size, the industry sector it operates in, and a set of company specific risk factors.

If you are thinking of valuing an environmental consulting company, here are some key industry statistics to ponder. The industry sector, classified under the SIC code 8748-9905 and NAICS code 541620, consists of over 13,370 firms, mostly in private ownership. Many companies specialize to provide high value services to their public and private clients, including:

• Environmental management consulting
• Environmental inspections, service assessment and remediation
• Hazardous waste disposal
• Resource conservation
• Energy infrastructure management
• Technology and information systems consulting

Together, these companies generate an impressive $9.32B in annual revenues and employ over 96,800 people.

Yet an average environmental consulting company is quite small – with $800,000 in annual sales and 7 professional and administrative staff.

Business valuation of environmental consulting and engineering companies

Strong relationships with existing clients and new business referrals tend to contribute to steady earnings and solid project pipeline that ensures the company’s future. Successful environmental businesses often become respected institutions in their market which fuels business growth.

Such profitable firms are highly desirable acquisition targets. Recent selling prices in the sector can provide you with a foundation on which to base the appraisal of your own company.

The usual way to do such market-based comparison of business value is to use the valuation multiples. These are the ratios that relate the business selling prices to the sold firms’ financial performance measures.

Here is the short list of typical valuation multiples you may consider in valuing an environmental consulting business:

• Business enterprise value (EV) divided by revenues (net sales)
• EV to EBITDA
• EV to seller’s discretionary cash flow (SDCF)
• EV to total business assets
• EV to book value of owners’ equity

Example: Environmental consulting business valuation using multiples

To demonstrate the idea, let’s pick a typical professional environmental company with the following financials over the last twelve months:

• Revenue (net sales): $800,000
• EBITDA: $250,000
• SDCF: $323,000
• Total business assets: $370,000
• Book value of owners’ equity: $545,000

Next, we use the the valuation multiples derived from similar sold firms so that we can calculate the business value for our sample company:

Surprised by the spread of values in this table? Actually, this is not unusual when doing market comparisons. The reason is that each company is different. So, for example, our sample business profitability, expressed as EBITDA, is high for its level of sales.

In addition, the owners have accumulated considerable equity, perhaps by retaining earnings or managing the company capital structure with minimal debt. As a result, the business value estimates based on these two measures appear higher.

Alternatively, you can view these results as establishing a range of values for the business, from low to high like this:

If you are considering valuation of a company, private or public, the choice of valuation methods may seem bewildering at first. Business appraisers and economists recognize that there are three ways to value any company:

1. Asset approach – which looks at the company’s assets and liabilities.
2. Income approach – that establishes the company’s value based on its earning power and risk assessment.
3. Market approach – where you determine the value of a company in comparison to selling prices of similar firms.

Under each approach to company valuation you have the choice of methods, the techniques used to calculate the value. All company valuation methods usually fall under one of the above three approaches. Some may share characteristics of several approaches at once.

Here are the mostly commonly used methods for company valuation under each approach:

Asset based valuation methods

• Asset accumulation method
• Excess earnings method

The Asset Accumulation method lets you establish the value of a company based on the tabulation of the market values of its assets and liabilities. Sounds like a familiar balance sheet? Not quite. Using this method you would need to adjust the values of each asset and liability to market.

In addition, the method requires that you include many of the off-balance sheet assets and liabilities such as internally developed intangibles and contingent liabilities. Examples of the former are intellectual property and key supplier / customer agreements. The latter may include pending legal judgments and regulatory compliance costs.

The Excess Earnings method is actually a hybrid with elements from both the asset and income approaches. One of the greatest strengths of the method is the ability to determine the value of business goodwill. The most common implementation of this valuation method is known as the Capitalized Excess Earnings because it uses the capitalization technique to calculate the company’s goodwill.

Income based company valuation methods

All methods under the income approach come in two basic flavors: capitalization and discounting. The famous examples are the Multiple of Discretionary Earnings and Discounted Cash Flow methods. The difference is in what income measure is considered when calculating the company’s value.

The capitalization methods use a single measure of earnings and an estimate of company’s risk known as the capitalization rate. The discounting methods take an earnings forecast, usually over a number of years, along with the discount rate. If the company’s earnings grow at a constant rate both types of methods give you identical results.

Market based valuation methods

You can estimate your company’s value by comparison to similar firms in a number of ways:

Using a Comparative Transactions method where the comparison is made against actual business sales of similar private companies. The challenge may be in finding reliable sources of data that can be used for defensible business appraisals.

Applying the Guideline Public Company method. Here you opt for comparisons to similar public firms that resemble your subject company. Since public companies are required to disclose their financial condition as well as major transactional activities, data for comparison tends to be both publicly available and consistent.

Using the Past Subject Company Transaction method. If the ownership of the company being valued changed in recent past, you can review the selling prices of such ownership interests to get an idea of what the company is worth.

Regardless of the method choices you make for your company valuation, the results you get will depend on your assumptions and expectations. It is a very good idea to pick a few methods to make sure you haven’t missed an important point in your analysis.