Time and again business people ask: which business valuation method is the best? The answer is, it depends.
If the business operates in a market niche where many similar companies sell, the market approach methods are a good choice. You can easily support your business value conclusions by pointing to a number of recent business sales as supporting evidence.
The downside is that no two companies are the same. A closer look may reveal that your business is unique in some respects making market comparisons misleading.
The asset approach to valuing a company is very supportable as long as the industry is not going through a rapid technological or economic change and the underlying business assets can be evaluated for their physical condition and marketability.
The downside is that the investors may not be currently interested in investing in these types of business assets. If the market is sluggish, the asset approach to valuing a company may look somewhat contrived.
The income approach to business valuation gives you the tools that are preferred by professional investors. Using such methods as the discounted cash flow technique, you focus on the fundamentals of the business itself that define its risk profile and earning power. This combination of risk and return is at the hart of business value measurement.
The difficulty is in creating accurate forecasts of future business earnings. No one has a crystal ball, and future events may not play out the way you like. Your business valuation results are no better than your assumptions.
In the end, business valuation is a statement of opinion. If you trust your judgment or that of your business appraiser, all is well. If you doubt the conclusions, ask for a second opinion.
If you are happy with the business valuation result, and can defend it convincingly to others, you probably have the right answer.
If you ever valued a private company, financial statements normalization or adjustment requirement should sound familiar. This key step is needed in order to reveal the true earning power of the company, the essential element underlying its economic value.
Put differently, misstating the financial condition of a business is a major error in business appraisal. Underestimate business earnings, and the business value is likely to come way under the true figure. Overestimate it, and your business valuation would look overly optimistic.
Financial statements prepared for public companies tend to be far more consistent as they must be filed with the US Securities and Exchange Commission, or SEC for short.
Consistent financial reporting is needed to help individual investors make informed decisions. The set of rules is known as the Generally Accepted Accounting Principles, or GAAP. While you won’t find a single place to go to review the GAAP rules, the accounting profession has developed a good handle on what GAAP means and how to implement it. Financial Accounting Standards Board (FASB) promulgates the actual rules.
The foundation of GAAP is the historical cost. This is important as only the business assets actually paid for are recorded on the company’s books. Your CPA can then trace any asset to its original purchase invoice. It is an elegant system that works flawlessly for tangible business assets such as property, land, machinery, furniture and fixtures. Taking stock of your business assets is straightforward – just trace their purchase, then chase the asset to its current place of use. If you can find it, you can inspect its current condition and add it to the asset tally.
This system works given two assumptions. First, the company’s assets are physical or tangible objects. Second, the asset values do not change rapidly over time. This works great in many traditional manufacturing and distribution industries. However, things are not as smooth when it comes to modern high tech businesses, especially software development companies.
Not to mention that many business software applications today are distributed or outsourced. How do you go about estimating the market value of software in a typical business?
Original purchase cost? What about the countless all-nighters your IT gurus had to pull in order to customize the software to its current working condition? Is the deployed application worth anything today or due for a major upgrade that costs thousands? An auditor’s worst nightmare, to be sure.
Clearly then, GAAP was conceived in the good old days before the age of the Web, software, and intangible assets such as copyrights and trademarks. Intellectual property assets, especially internally developed trade secrets, technology, and procedures, do not have a historical cost tied to the original purchase.
Today’s interpretation of GAAP demands that companies expense all investments made in developing and maintaining valuable intellectual property. Under GAAP, you can capitalize the cost of developing business software, not its true fair market value.
This real gap in GAAP is one reason business valuation methods such as the asset accumulation technique exist. To determine the business value, you compile the list of all business assets, tangible and intangible, costed, or internally developed, along with all the liabilities. The difference is the business value.