Business Valuation Expert Shares 3 Methods For Determining The Value Of A Business
In its simplest form, value is a function of risk and cash flows. Value is responsive to other market forces and is dependent on a specific point in time. Even at a specific date, value is best described as a range, stretching from low to high, depending on your perspective.
Value is also forward looking. Every price of every stock is based on expectation of future cash flows. For two similar companies, Company A and Company B, the company with the higher projected growth rate will normally have a higher value. That’s why the stocks of new startup companies have value even though they have never earned a single dollar in profit. It’s all about the future.
If you have three people in the same room and ask them to compute the value of a company, you can easily get at least three different answers. Why? Because there are three main Standards of Value. They are referred to as Investment Value, Fair Market Value, and Fair Value.
A savvy business owner is very aware of his competitors and the market in general. He or she has a good knowledge of value drivers and knows about recent transactions in the industry. They use terms like “EBITDA multiple” and “free cash flow”. They usually define value of their company from the investment, or strategic standard of value. However, every buyer will place their own value on the acquisition and it will be different depending on expected cash flows and their assessment of risk. For a competitor, who already has an infrastructure in place, there may be very little additional overhead involved in an acquisition, which favors a higher value. For a large competitor, the cost of borrowing or raising additional equity is often lower than for a smaller company. Therefore, acquisitions made by a large competitor often represent the highest and best value for a seller. Savvy business owners know that to get the right price, they often need to sell to a competitor or company in a similar or compatible industry.
Contrast the investment or strategic value perspective to a “fair market value” perspective. Fair market value has a specific definition under the US Tax Code, …”the price at which the property would change hands between a willing buyer and a willing seller, when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.”
Under the fair market value standard, the buyer and seller are hypothetical parties, not a specific buyer or seller. A business valued under the fair market value standard is generally lower than if it were valued under a strategic or investment value standard. Most income tax, estate tax, and gift tax transactions are governed by fair market value. Certain states also may require the use of the fair market value standard for stockholder dissent actions.
As if that isn’t confusing enough, there is also a fair value standard. Fair value has two points of reference;
- Fair value is legally created under state laws and usually applies to minority stockholders dissenting actions. Fair value is often found in the dissolution statutes of those states in which minority stockholders can trigger a corporate dissolution. In states that have adopted the Uniform Business Corporation Act, the definition of fair value is as follows; Fair value, with respect a dissenter’s shares, means the value of the shares immediately before the effectuation of the corporate action to which the dissenter objects, excluding any appreciation or depreciation in anticipation of the corporate action unless exclusion would be inequitable. For states that have well developed case law, the appraiser has guidance on how to approach the engagement. However, for states that do not, the appraiser must look to the attorney for interpretation of the applicable statutory case law from a valuation perspective.
Fair value also has a specific meaning for purposes of financial reporting under generally accepted accounting principles (“GAAP”) and international financial reporting standards (“IFRS”). Fair value under GAAP is defined as; The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Under this definition, fair value represents an exit price, the price to sell an asset, rather than the price to buy the asset, from the perspective of a market participant, representing buyers and sellers who are independent and knowledgeable.
When you hear the word “value”, do you instantly think fair market value, fair value, intrinsic value, investment value, book value, ad valorem value, or some other term? Unless specifically defined, the word can have a wide interpretation between different people. The appraiser can help the client and their advisors to arrive at the right definition of value that is appropriate to the specific purpose of the valuation engagement.