2. 19 Business Valuation McGraw-Hill/Irwin
Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

3. Business valuation
Business valuation in the most general sense deals with the appraisal of various financial assets.
Business entities
Government entities (municipalities).
Real estate (raw land, office buildings, leaseholds).
Securities (common stock, bonds, options).
Intangible assets ( patents, royalties, copyrights, trademarks).
Trusts (all types).
Individual tangible assets (plant and equipment).
Estates (marital, testimonial, bankruptcy).
Contractual rights (buy-sell agreements).
Economic damages and insurance losses (business interruption).
Individual or partial interests in any of the preceding items.

4. General Valuation Objectives
There is no one right way to value an asset, and in many cases, the process of assigning a single dollar value to a complex asset is as much art as it is science
Business appraisers strive to achieve results that meet certain general requirements
Consistency Ideally, different skilled appraisers should produce a similar valuation for a given asset.
Defensibility There is always the general possibility that any valuation could be subjected to legal challenges.
Suitability for purpose Valuations must be suitable to the purposes and circumstances of the individuals needing the information.

5. The International Valuation Standards Committee
International Valuation Standards Committee (IVSC): A UN organization that works with various national and international organizations and UN member states to internationally harmonize valuation standards.
The IVSC publishes the following:
Valuation concepts and principles.
Code of conduct.
Individual valuation standards.
Applications (of standards).
Guidance notes.
Information papers.
The IVSC focuses on developing valuation standards relevant to developing international accounting standards.

6. Basic Valuation Theory: Standards of Value
Key concepts: standard of value, valuation premises, valuation approaches, valuation adjustments, and valuation methods.
Standards of Value (value that is relevant to a particular entity or individual)
Fair Market Value
Intrinsic or Fundamental Value
Investment Value
Fair Value

7. Valuation Premises
Valuation premise is defined primarily according to the circumstances surrounding a hypothetical disposition
Two factors define such circumstances: the extent to which synergistic value is derived from the sale of a group of assets and the speed or effort of the sale.
Synergy
High synergy (going concern value premise)
Medium synergy (assemblage of assets value premise) .
No synergy (individual asset disposition premise)
Speed of Sale
Normal speed of sale (orderly sale premise)
Fast speed of sale (forced liquidation premise)

8. Synergy and the Speed of Sale

9. Estimating Market Value: The Fair Value Hierarchy
Level 0 Based on a sale or exchange of the asset being appraised.
Level 1 Based on quoted prices for an identical asset that is traded in a currently active market.
Level 2 Based on quoted prices for a similar asset with adjustments made for differences between the subject asset and the similar asset.
Level 3 Based on mathematical models that use directly related market variables as indicators of market value. Level 4 Based on mathematical models that use indirectly related market variables as indicators of market value.
Level 5 Based on mathematical models that use internal business inputs as indicators of market value.

10. Using the Valuation Premise and Value Hierarchy in Financial Reporting
Financial reporting as defined by both U.S. and international standards is moving away from historical cost reporting and toward fair value reporting on the balance sheet. With respect to financial reporting, the normal value premise is that the business is a going concern and that its assets would be sold in an orderly manner. Some additional assumptions also apply.
Marketplace Participants
Most Advantageous Reference Markets
Transaction Costs
Highest and Best Use
Liabilities

11. Valuation Approaches
Three broad valuation approaches are used to value businesses or other assets: the income approach, the market approach, and the asset approach
Under the income approach, an asset’s value is the present value of the future economic income associated with the asset.
Under the market approach, the value of the asset is what the asset can be sold for in an open market within some reasonable time period.
Under the asset approach, the value of an asset, especially a business, is the sum of the individual assets that it comprises.

12. Valuation Adjustments
Valuations determined under each valuation approach may require upward or downward adjustments
Extent of Ownership Control over Income-Producing Assets
Marketability and Liquidity
Restrictions on Transferability
Business-Specific Risk
facing new, strong low-margin competitors.

13. Valuation Estimates
In general, the valuation analyst chooses the approach or combination of approaches that are most relevant to the valuation objective. The end result is the final valuation estimate, which can take two basic forms:
A single dollar figure For example, the analyst could determine that the final value estimate for a given business is $2,235,000.
A range of dollar values For example, the analyst could determine that the final value estimate is between $1,000,000 and $2,000,000.

14. The Process Of Valuing A Business
The following also apply to valuing financial assets in general
Define the valuation assignment.
Collect and analyze information about the business.
Research the industry in which the business operates.
Study and analyze the business’s financial statements.
Select and apply a valuation method (with related assumptions given the standard of value, the valuation premise, and the valuation approach) to produce a valuation estimate.
Make any appropriate adjustments (as discussed above) to the valuation estimate to produce a final valuation estimate.
Produce the valuation report.

15. Valuation Method Associated with the Income Approach
The Discounted-Income Method
Select a measure of future economic income such as accounting income or cash flow from operations.
Make a schedule of projected future income or cash flows using the selected measure. The schedule typically includes the future income or cash flows for Year 1, Year 2, Year 3, and so on. All future years are included through some assumed final terminal year.
Select an appropriate discount rate to be used to compute the present value of the projected income or cash flows.
Compute the present value of the projected income or cash flows using the selected discount rate.

16. Estimation of Future Income or Cash Flows
Various measures of income and cash flows are used as surrogates for projected economic income.
Projected accounting income after taxes.
Projected dividends.
Projected free cash flow available to equity (FCFE), defined as the amount of cash available to shareholders after all expenses, reinvestment, and debt and preferred dividend payments.
Projected free cash flow to equity before debt payment, sometimes called debt-free cash flow available to equity (DFCFE).

17. The Income Approach: The Capitalized Income Method
The capitalized income method is a variation on the discounted income method. The main difference with the capitalized income method is that the income or cash flows are assumed to exist for an indefinite period in the future. When this happens, the present value formula reduces to very simple terms:
Present Value = Economic Income / Discount Rate
The basic perpetuity model can be expanded to accommodate growth: PV = EI / (k – g)

18. Valuation Methods Associated with the Market Value Approach
Four basic steps are involved in the guideline publicly traded company method: (1) Select guideline companies, (2) adjust the financial statements of the guideline companies to make them comparable to the subject company, (3) compute various price-based financial ratios for the guideline companies, and (4) apply the price-based financial ratios to the subject company.
The guideline method is frequently used by security analysts who value companies using price-earnings multiples of comparable companies.
The price of the subject company equals the price-earnings ratio of the guideline company times the earnings of the subject company. Other accounting numbers (e.g., sales) can be used in place of earnings.

19. The Projected Guideline Publicly Traded Company Method
This method works the same way as the guideline publicly traded company method except that the price-based ratios are based on projected rather than historical accounting data.

20. The Guideline Acquired and Merged Company Method
The guideline acquired and merged company method works the same way as the guideline publicly traded company method except that the comparative data are based on acquired and merged companies. This method is applicable to situations in which a controlling interest is being valued.
Obtaining comparable data could be difficult, and many acquisitions involve both cash and other consideration that may be difficult to value, Finally, many acquisitions may reflect the investment value of the acquirer (because of unique synergies between the acquirer and the acquired company) rather than the general fair market value.

21. Valuation Methods Associated with the Asset-Based Approach
The primary asset-approach method is the asset accumulation method. It involves restating, as needed, all individual assets and liabilities on the balance sheet to market value (or other value, such as liquidation value, as required by the appraisal objectives). Next, any off-balance-sheet assets and liabilities are added to the balance sheet. Finally, the business is valued as the difference between the resulting assets and liabilities.
Valuing each asset for anything but a very small company can be a difficult task. In many cases, the analyst needs to consult specialized appraisers to estimate individual asset values.
The results are presented in balance sheet format and are easy to understand, and are appreciated by lenders.

22. The Capitalized Excess Earnings Method
Apply the asset-accumulation method to estimate the value of the firm.
Estimate the value of goodwill by estimating and capitalizing excess income using a three-step process:
Estimate a “normal” income for the net assets determined by the asset-accumulation method. This done by multiplying the value of the net assets by a rate of return that is determined using factors similar to those used to determine the capitalization rate in applying the income approach.
Subtract the normal income from the actual income. The difference represents the income associated with goodwill (and any assets excluded from the asset base). This is the excess earnings. In computing actual income, it is important to adjust the compensation of owners upward or downward to a reasonable level.
Capitalize the excess earnings
Add the accumulated net assets to the capitalized earnings.