Business Valuations

For a transaction to occur, the buyer and seller must both agree on a value. Generally, the investor is looking at two aspects in a company or subject interest:

1. An annual return (cash flow) from the company or assets owned, and
2. The possibility of appreciation in the value of the company or assets it owns.

The seller will only be willing to sell if the price is adequate to compensate him or her for giving up the above two opportunities to receive the annual cash flow or further appreciation. Often a company or asset that is growing fast requires a higher price; this is sometimes referred to as market momentum.

The following is an observation about the business calculation process in Revenue Ruling 59-60:

A determination of the investment value, being a question of fact, will depend upon the circumstances in each case. No formula can be devised that will be generally applicable to the multitude of different calculation issues arising…A sound calculation will be based upon all the relevant facts, but the elements of common sense, informed judgment and reasonableness must enter into the process of weighing those facts and determining their aggregate significance.

Closely held companies are typically valued by methods appraising earning power or net asset value, or combinations of these methods. Section 5 of Revenue Ruling 59-60 provides that:

Earnings may be the most important criterion of value in some cases, whereas asset value will receive primary consideration in others.

Operating Companies

As mentioned in Revenue Ruling 59-60, privately held companies that earn significant net cash flow based on manufacturing, and selling products or services are generally valued by:

• The income valuation approach based on fundamental earning capacity. The income approach has two common valuation methods:
  1. The capitalization of net sustainable cash flow method; this method is used when the subject company has stable earnings growing at a consistent annual rate.
  2. The discounted future cash flow method determined as the net present value of the future benefit stream; this method is used when the future earnings and
     growth rate are expected to vary.
• The market valuation approach (relative value) based on comparable businesses in the industry. The market approach uses two types of data, as follows:
  1. The private transaction method; this method uses a multiple derived from private company transactions that are published in various databases.
  2. The public guideline companies method; this method uses a multiple derived from information about publicly registered companies reported on the various stock markets.

The asset approach is generally not used for profitable companies because the values of intangible assets, e.g. goodwill, patents, trademarks, etc., are not captured. However, the asset approach may be appropriate for operating companies that are losing money as providing a base value of tangible assets.

Holding Companies

As mentioned in Revenue Ruling 59-60, privately-held holding companies are often valued using the asset approach; this method can establish 1) a net asset value based on the going concern assumption, or 2) the liquidation value (either forced or orderly). The net asset value uses a balance sheet with assets and liabilities adjusted to fair market value. The “net asset value” is the equity determined by subtracting liabilities from assets. This is generally used for most businesses that are expected to continue business in the future.

Two important holding company financial variables that drive value up or down are: 1) yield to owners, and 2) the company debt. Often investors are buying net cash flow. If the subject entity or property has significant debt, investors may see this as a risk to them. Generally for holding companies, the more the investment risk to investors, the less the hypothetical buyer will pay, i.e. less value for the subject company or interest.

Holding companies can also be valued based on the income approach or the market approach. Use of the market approach requires that the analyst can find comparable transactions. Often for real estate limited partnerships (RELPs) or real estate limited liability companies, the analyst considers the secondary market transactions of publicly registered limited partnerships, and also the value of real estate investment trusts REITs) that are publicly traded.

Sampling of Valuation Situations