Company valuation methods

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.

Business valuation standards

If you are preparing a business appraisal for yourself or a client, following established business valuation standards could lend considerable credibility to your work product.

Over the years the business appraisal profession has come up with a number of standards seeking to define everything from the methodologies to the scope and format of business valuation reports. Here are the main ones that are widely recognized by the business appraisers, courts, and tax authorities:

Uniform Standards of Professional Appraisal Practice (USPAP)

This is perhaps the best known of the standards covering the valuation of businesses and professional practices, among other types of assets. It is published and regularly updated by the Appraisal Foundation. USPAP is widely used throughout the world, either directly or as part of national business valuation standards.

Standard 9 defines the approaches and methods to be used when valuing a company. It also covers the definitions and premises of value that serve as the foundation of any defensible business valuation.

Standard 10 specifies what a business appraisal report should look like. Hence, you should review both standards to make sure your business valuation is USPAP compliant.

American Institute of CPAs Statement on Standards for Valuation Services (AICPA SSVS No 1)

Created by the AICPA and made public in 2008, this is a newer standard intended to be followed by the AICPA members. Since many business appraisers are actually accountants, this standard has rapidly grown in importance.

As you would expect from an accounting organization, AICPA SSVS No 1 offers considerable level of detail in its definition of professional valuation engagements, methods to be used, and structure of business valuation reports. In addition, there are plenty of materials explaining how you can apply SSVS No 1 in practice.

International Valuation Standards (IVS)

This standard is published by the International Valuation Standards Board. As the name implies, the organization aims to create a set of guidelines that help make business appraisals uniformly applicable regardless of where they are done.

IVS and National Business Valuation Standards

A number of countries have incorporated IVS into their national business valuation standards. Notable among these are the UK, Australia, New Zealand and South Africa. In addition, there is growing support for IVS in just about every developed and developing country.

This makes IVS a very important standard indeed and well worth your attention, especially if you plan to share your work with international clients or colleagues.