Business Valuations Basics

DavidBusiness Valuations Basics
Presented by David Coffman
Founder, Business Valuations & Strategies
Contact David at: dave@bus-val-strat.com

June 12, 2001

Visit the AccountingWEB Workshop Calendar for upcoming sessions.


Summary

Are you curious about business valuations? The Business Valuation Basics Workshop provided information about the key terms and principles used in business valuations. Participants learned the common approaches and methods of valuing a business and found out what to do if approached to do a valuation. Suggestions were offered on how to add business valuation services to your practice.

You can read the complete transcript of this workshop.

What are some key valuation terms and principles?

  • Appraisal vs. valuation
  • Fair market value
  • What is the value of a business?

What approaches and methods are used to value a business?

  • Income approach
  • Market approach
  • Asset based approach

Should you be performing business valuations?

  • Professional standards
  • Training and experience
  • Resources

How to get started in business valuations?


June 12, 2001 session sponsored by Alliance of Merger & Acquisition Advisors

Alliance of Merger & Acquisition Advisors


Workshop Transcript

Session Moderator: I would like to thank David Coffman today for presenting this informative workshop on AccountingWEB.

David is a Certified Public Accountant/Accredited in Business Valuation and Certified Valuation Analyst specializing in business valuation/appraisal services. Mr. Coffman has been performing valuations since September 1997. He has performed dozens of valuations primarily involving small, closely held companies. He has courtroom experience including testimony and depositions. His background includes over twenty years experience in accounting, tax, and small business advisory services with national, regional, and local public accounting firms.

In addition, he also has experience with starting, owning and operating small businesses, economic development, business brokerage, corporate accounting, and teaching professional continuing education and college courses.

I would like to thank the Alliance of Merger & Acquisition Advisors for their sponsorship of today's Business Valuation workshop.

David, the floor is yours, welcome!

David Coffman: Welcome to the Business Valuation Basics workshop. This workshop is designed for CPAs who have little, if any valuation experience, are curious about it, and are possibly considering adding this service to their practice.

I have been a practicing CPA for 25 years. In 1997, I opened my practice specializing in business valuation and small business consulting services. Since then I have valued dozens of businesses and testified in court a few times.

Prior to opening my practice I had a number of occasions where a client asked me how much their business was worth. I would do a basic capitalization of earnings calculation using a purely subjective capitalization rate. You may have had similar requests and done much the same. My goal is that after this workshop you will realize that these "quick and dirty" valuations are dangerous. You should either get up to speed on valuations or refer them to a specialist.

Now, let's get started. Please join in the discussion when you have a question.

I. What are some key valuation terms and principles?

1. Appraisal vs. valuation

When you hear the term appraisal you typically think of real estate appraisals. Technically, the terms appraisal and valuation are synonymous, and are commonly used interchangeably. Many valuation professionals make a distinction. Appraisals estimate the value of tangible/physical assets like real estate, equipment, vehicles, antiques, etc. Valuations estimate the value of intangible as well as tangible assets.

A good example of when a valuation, as opposed to an appraisal, is appropriate is when valuing an operating business. The value of a business entity typically includes the value of tangible and intangible assets. In many cases the value of a business - intangible assets, commonly and collectively called goodwill - exceeds the value of its tangible assets.

2. Fair market value

There are a number of standards of value used in valuations. The most common and well known is fair market value. Fair market value (FMV) is defined as “the price at which the property would change hands between a willing and able buyer and a willing and able seller, neither being under a compulsion to buy or sell and both having reasonable knowledge of relevant facts.”

There are a number of variations to this definition. Many people are familiar with the willing buyer/willing seller part. The willingness must be combined with the ability to act, and having reasonable knowledge of relevant facts. FMV is based on a hypothetical buyer and seller, which is why it may vary from the actual selling price. The property may be worth more or less to a real buyer.

3. Other standards of value

Investment value is the specific value of a property to a particular buyer or seller. Investment value is often used in mergers and acquisitions where a buyer is seeking synergistic benefits. Intrinsic or fundamental value is the amount an investor would consider the true or real value of a property. It is based on characteristics inherent in the property and not specific to any one investor.

Fair value is a legally created standard of value that applies to certain circumstances. Since it is defined by the statute or legal precedent, fair value may be different in different jurisdictions. Fair value is commonly used in dissenting shareholder and minority oppression cases. It differs from fair market value in these cases because the seller is not willing. Fair value is sometimes considered a pro-rata percentage of the total entity value and therefore excludes any premiums for control or discounts for lack of control.

Any questions up to this point?

4. What is the value of a business?

The value of a business depends on the premise being applied. Most valuations use the going concern premise. The same business will have different values if an orderly liquidation or a forced liquidation is assumed. In theory a business is worth the present value of all of the future benefits to be derived from owning that business. That definition makes a lot of sense until you try to put some numbers to it. It also flies in the face of a rule I learned as a business broker and buyer: never, ever pay for potential.

I believe the reliance on projections of future results has some weaknesses. Future benefits depend on who will be managing the business. In a small owner-operated business, the management team will most likely be replaced after the sale. Under these circumstances a virtually limitless number of what-if scenarios become possible. Therefore, I believe historical performance is a much better indicator of value for small owner-operated businesses.

5. Premiums and discounts

The premium for control and the discount for lack of control (minority interest) are based on the concept that a controlling interest is worth more than a non-controlling or minority interest. A common source for this premium or discount is merger and acquisition activity. The amount paid by the buyer in excess of the acquisition target's stock price is a premium that is at least partially due to the control factor. The discount for lack of marketability is based on the concept that it will take longer and cost more to sell an interest in a closely held private company than it will to sell shares of a publicly traded company.

CAUTION: The applicability of premiums and discounts depends on the valuation methods being used. For example, data from publicly traded companies generally yields a value that is a marketable, minority interest. Therefore, a discount for lack of control (minority interest) would not be applicable, but a premium for control and a discount for lack of marketability may be appropriate.

II. What approaches and methods are used to value a business?

1. Income approach

The income approach is often the primary approach used in valuing operating companies. This approach includes two methods -- capitalized and discounted future earnings. In both methods there are two variables: the earnings and the rate (capitalization or discount). Some valuators use pretax or after-tax earnings, but cash flow is generally preferred. Although sometimes used interchangeably, capitalization and discounting are different. Capitalization involves applying a capitalization rate to a single figure. Discounting involves applying a discount rate to a stream of earnings.

The discount rate is a company's cost of capital. There are several ways to calculate cost of capital. The build up method and the capital asset pricing model (CAPM) start with a risk-free rate of return (usually a long-term US Treasury bond rate) then add premiums for the additional risk of owning an equity interest in a small company.

The premiums are based on studies of the rates of return of US stock exchanges. Another risk premium is added for the specific company being valued. This premium is typically based on a subjective judgment by the valuator.

The weighted average cost of capital (WACC) averages the cost of equity with the cost of debt. It is appropriate when an invested capital formula is being used. The capitalization rate equals the discount rate less the growth rate. The methods used to calculate earnings/cash flow and the capitalization/discount rate depend on whether a direct equity (includes debt) or invested capital (debt-free) formula is used.

Direct equity formulas are appropriate when the existing capital structure will be maintained or a minority interest is involved. Invested capital formulas remove the impact of the capital structure and is best used when valuing a controlling interest.

2. Market approach

The market approach is the most direct way to establish the fair market value of a business since it is based on actual market transactions. One problem, it is often difficult to find sufficient relevant data to use this approach. The most commonly used methods under this approach are the guideline company method, the transaction method, and the industry method.

The guideline company method involves finding other companies that are comparable enough to be used as a guideline. A guideline company must be similar to the business being valued in a number of respects. Important factors to consider are size, growth, leverage, profitability, turnovers, and liquidity. Since most guideline companies are large and publicly traded, this method may not be appropriate for many small businesses.

The transaction method uses data from either public merger/acquisition activity or private sales of closely held companies. As more data becomes available for sales of privately held businesses, this method is becoming more widely used. One major drawback to applying this method is that so little data is available on each transaction that similarity is often difficult to judge. Currently, a search of private transitions by SIC Code usually results in such a small sample that the data is only valuable to support conclusions using other methods.

The industry method is commonly called rules of thumb. These rules are typically so broad that they are only useful to support conclusions using other methods. Since these rules may be widely known, addressing them in the valuation process can be useful.

3. Asset based approach

The theory behind the asset-based approach is that the value of the assets minus the value of the liabilities equals the value of the equity. The tangible assets are usually not a problem, but identifying and valuing all the intangible assets can be difficult. One way to deal with this problem is to value all of a company's intangible assets as one lump sum by using the excess earnings method.

This method is based on a simple concept that the value of a company's intangible assets is derived from its earnings in excess of what similar companies earn. These excess earnings are then capitalized to calculate the value of the intangible assets. The value of a business is increasingly dependent on creating and managing intangible assets. Therefore, identifying and valuing intangible assets is becoming more important in the valuation process.

Asset-based methods are widely used for small businesses. CAUTION: If you use an asset-based method, you should have well documented procedures to show you looked for all possible intangible assets.

III. Should you be performing business valuations?

1. Professional standards

The AICPA Code of Professional Conduct, Rule 102 requires objectivity and integrity, freedom from conflicts of interest, not misrepresenting facts, and not subordinating your judgment to others when performing any professional service.

A valuation performed by a CPA that also provides accounting, auditing, or tax services to the same client may be viewed as a conflict of interest. A valuation performed for a spouse in a divorce situation by a CPA who prepared the married couples joint tax return may also be viewed as a conflict.

AICPA Consulting Services Practice Aid 93-3, Conducting a Valuation of a Closely Held Business states that practitioners need to be proficient in the area of appraisals and that appropriate education is required. AICPA Consulting Services Special Report 93-1, Application of Professional Standards in the Performance of Litigation Services requires due professional care, adequate planning and supervision, and obtaining sufficient relevant data in the performance of an engagement.

2. Training and experience

The proficiency and appropriate education provisions of Consulting Services Practice Aid 93-3 require training and experience in business valuations. CPAs who perform valuation services without taking valuation courses, having a valuation designation or certification, or having valuation experience may be violating their professional ethics, and are exposing themselves to undue professional liability.

3. Resources

Performing valuations requires access to many sources of information. If you don't do valuations on a regular basis, the cost of these resources is prohibitive. If you do a valuation without them, you are violating the obtaining sufficient relevant data provision.

IV. How to get started in business valuations?

The first step is to get some training. There are a number of courses available from the AICPA and other business valuation organizations. The easiest way to build your credentials is to become a Certified Valuation Analyst. The National Association of CVAs administers the CVA designation. To become a CVA you must be a CPA, take the Fundamentals and Theory of Valuation course offered by the NACVA, and pass the CVA exam.

Next you should build your valuation reference library. The NACVA provides a list of reference materials and rates them by importance. Once you have taken some courses, acquired your CVA, and built your reference library; its time to get your first valuation engagement.

Now its time to start marketing. From my experience most valuation work comes from referrals from attorneys and CPAs. Your first step is to contact everyone in your professional network like clients, fellow CPAs, attorneys, etc. Then send press releases about your new certification and service to local newspapers and business journals. Next, I suggest a mailing to all CPAs, attorneys, financial planners, and bankers announcing your new service. You might also offer yourself for speaking engagements to the same group.

After you take these steps and get a few engagements under your belt, you will be well on you way to a healthy valuation practice.

Session Moderator: David, thank you for all of this great information. We all appreciate you taking the time to share your experiences with us. Are there any questions?

Ed Salek: What is the best way to determine proper lack of marketability and lack of control discount levels?

David Coffman: I don't think there is any best way. It depends on the facts and circumstances of the particular business.

Thanks for attending this workshop. I hope you all gained some insights into business valuations.

Session Moderator: Thank you all for joining us today and if there are no further questions, we will end on this note!


Biography

David Coffman is a Certified Public Accountant/Accredited in Business Valuation and Certified Valuation Analyst specializing in business valuation/appraisal services. Services include performing valuations and providing litigation support in valuation matters as an expert witness or consultant.

Mr. Coffman has been performing valuations since September 1997. He has performed dozens of valuations primarily involving small, closely held companies. He has courtroom experience including testimony and depositions. His background includes over twenty years experience in accounting, tax, and small business advisory services with national, regional, and local public accounting firms. In addition, he also has experience with starting, owning and operating small businesses, economic development, business brokerage, corporate accounting, and teaching professional continuing education and college courses.

Mr. Coffman has a B.S. in Business Administration from Bloomsburg University, PA.

E-mail: dave@bus-val-strat.com
Web site: www.bus-val-strat.com

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