We talked about assumptions that underlie any business appraisal. Business valuation results differ mainly because the analysis relies on a different set of factors that drive business value.
Just how sensitive your business appraisal result is to changes in these assumptions in an important question. It is a good idea to show in your report how much the business value would change should a key assumption turn out differently than expected.
Take a look at any business appraisal and you will find quite a number of assumptions. Most center around future expectation in business sales, expenses, interest rates and taxes in addition to capital outlays and working capital requirements.
To account for how each of these parameters can affect the business value conclusion is not practical. However, you can state clearly how the various choices have been made and describe how changes in the top parameters can affect what the business is worth.
One way to do this in practice is to create several scenarios: best case, worst case and most likely case. Each is associated with a set of key assumptions that differ based on expected business outlook. You can determine the business value for each scenario and report your result either as a range of business values or an average number.
Credibility of your business valuation depends largely on how clearly and convincingly you describe the assumption set. Those reading your business valuation report can review these key parameters and make up their mind whether to accept the business valuation result.
Calculating Business Value
It is well known that all business valuations are done as of a certain date. It is possible to prepare a business appraisal at some point in the past. One benefit of this is that you have some ideas as to how things actually turned out.
In fact, professional business appraisals are sometimes done as of an earlier date. This may be a requirement in divorce or a merger and acquisition deal when the initial cost basis needs to be known.
Such cases aside, most business valuations you are likely to see are done as of the current date. Business valuation methods, especially those under the income approach, rely on a number of critical assumptions that affect business cash flow going forward. Among these are expectation of future revenues, operating expenses, competitive environment, regulatory compliance, interest rates and taxes, to name but a few.
In fact, you cannot use any income business valuation methods without outlining your assumptions. Both the earnings forecast and risk assessment, the two types of inputs these methods take, are forward looking and call for a leap of faith. In other words, all business appraisals require an educated guess about the future.
Business Valuation: Methods and Tools
The concept of control premium in business valuation is this: to obtain control of a business the investor usually has to pay the per-share price that is higher than what a single share of the company stock sells for.
Why would an investor seek a controlling share of a company? Because with control come a number of important benefits. If you own, say 50.1% of the outstanding stock, you can elect yourself to the company’s board of directors. You can hire the executives you believe will run the company the way you want. You can decide on the dividend payouts, define the firm’s financing strategy, exit or enter markets, merge or acquire other businesses. In short, if you own a controlling stake in the company, you are the boss.
Now let’s take a look at what it takes to get a controlling share in a company. Public company investors usually hear about a tender offer open for a certain time and stating the terms and price per share that the acquirer is willing to pay for a controlling share of the firm.
Note that public company investors need an incentive over and above the current share market price to part with their stock. After all, they can easily sell the shares should they choose to do so without any tender offers. If the offer price is uninspiring you can get a handful of investors to sell but you will likely not gather the required 50.1% of the company stock to control it.
To motivate a sufficient number of investors to take the tender offer, the acquirer needs to raise the price above the market just before making the acquisition bid. The difference between the market price per share and the tender offer price is the control premium.
If the control premium is sufficiently high, you can entice enough smaller investors to hand over their stock and forgo the potential future dividends and appreciation as company value increases. In addition, the control premium also must cover the capital gains tax expense the investors will have to pay.
What does the control premium mean when valuing a business? The entire business enterprise value is generally higher than the current sum of individual shares.
Business Valuation of the Entire Company