Business Valuation Methods: How to Determine the Fair Market Value of a Business

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There can be many reasons for which a qualified business appraisal might be needed to determine the fair market value of a company such as for gift and estate tax purposes, litigation including divorce, sale/merger transactions, capital financing purposes, fairness opinions, recapitalizations, stock redemptions, or for various financial reporting purposes.

For business appraisals that will be related to a tax filing, it is important that a qualified appraiser is hired to perform the work and that the final appraisal report comports with professional standards and IRS regulations.

Some of the different methodologies that are often referenced for determining the value of a business include:

  • Market value: Appraisal experts look at similar businesses that are either publicly traded or have recently sold. This method works best with sufficient market data for similar companies in the industry, whether those companies are publicly-traded or were recently sold. Typically a valuation multiple(s) is determined to be appropriate from the market data and applied to the subject Company’s results in order to determine the value of the business.
  • Asset-based: In this approach, the appraiser totals up all the company’s assets by their market value and subtract liabilities. Within the asset-based approach, there are two ways to calculate value. First, the going-concern approach assumes the business will continue operating. It calculates current equity by subtracting liabilities from existing assets. The second approach is the liquidation-value approach, which determines the total amount of earnings the company would receive if it sold off every asset and makes the most sense when the company is slated for liquidation.
  • ROI: This approach determines a company’s worth based on the potential return on investment (ROI) an investor would earn from buying stock in the business.
  • Discounted cash flow (DCF): This approach values a company based on its predicted cash flow after adjusting that amount to its present value based on risk factors associated with the specific company achieving the projected results. Experts consider the DCF approach to be one of the most objective as it uses more direct company financial data.
  • Capitalization of earnings:The capitalization of earnings method calculates a company’s future profitability based on cash flow. Unlike DCF, this method also considers annual ROI and expected value. The goal is to value the company based on its future profitability. It works best for businesses with a stable, predictable income.

The methods listed above each generally fall within one of the three broader fundamental valuation approaches – Asset, Income or Market approach.

 The Three Fundamental Valuation Approaches

When valuing a business for tax purposes, the IRS recognizes three valuation approaches — the market, the asset and the income approach. Within these three approaches, there are a number of methodologies that can be utilized depending on the particular circumstances and nature of the entity being appraised. Qualified appraisers may use more than one approach and must use their judgment to determine which ones are appropriate for a valuation case.

Market Approach

Market Approach

The essence of the market approach is to use companies in the same general industry as the subject business to provide valuation guidelines. Valuation indicators for such companies or transactions can be determined and analyzed. The appraiser would then make a judgment as to whether investors would find the subject business more or less attractive than such guideline companies. The market approach is an authoritative, widely recognized and accepted valuation approach.

Two common methods utilized in the market value approach include:

Guideline public company transactions: This calculation relies on stock market data from publicly traded companies. These companies rarely provide an exact comparison, therefore, a skillful, qualified appraiser must adjust the data to make it more comparable to the subject company.

Guideline Acquired Company transactions: The precedent transactions method can be utilized for those situations where there aren’t any guideline public company comparables. In this method, the appraiser looks at transaction data from the sales of similar companies.

Precedent transactions in the Subject Company:  another form of the market approach is when the appraiser observes various transactions in the Company’s equity and derives value based on the transactions if such transactions were completed within a reasonable amount of time from the valuation date.

The market approach is often used in conjunction with the income and asset approaches. In the case of the income approach, risk-adjusted rates of return are derived from the public markets. In the case of the asset approach (specifically, the NAV method), discounts from NAV are typically appropriate to reflect lack of control. These discounts are derived from market evidence for transactions in publicly registered/traded investment funds that invest in assets similar to the entity being appraised.

Investors in these publicly registered/traded securities pay prices that are typically below (and in some cases, above) NAV. These differentials from NAV importantly take into consideration the disadvantages of indirect ownership, the lack of control over a portfolio of assets and potentially certain quantitative factors, such as rates of return (which will be examined in-depth later in this report).

Income Approach

The income approach involves projecting the future benefits of owning an asset (usually some measure of economic income such as cash flow, earnings or dividends) and translating those future benefits into value based upon the time value of money and the investment risks associated with ownership.

Two common methods utilized in the income approach include;

Discounted cash flow (DCF): The discounted cash flow method is an authoritative, widely recognized and accepted valuation methodology within the income approach. The DCF method involves estimating the future cash flows that the business is reasonably capable of producing, and then discounting those future cash flows back to present value at an appropriate discount rate. When employing this method, it’s crucial to estimate cash flows realistically rather than conservatively or optimistically. It’s also essential to apply a suitable discount rate. A great deal of expertise and professionally informed judgment is required in using the DCF method.

Capitalization of Earnings: The capitalization of earnings method within the income approach is another authoritative, widely recognized and accepted valuation tool. The capitalization of earnings method involves estimating the amount of income that a business is capable of producing and then determining the appropriate relationship between income and value. The key step in the capitalization of earnings method involves the conversion of a company’s normalized earnings capacity into an estimate of value. This is accomplished through the application of the appropriate capitalization rate to earnings (cash flow) capacity.

The capitalization of earnings method assumes a business will achieve steady, predictable earnings. Therefore, this method works best for companies with consistent revenue, income and operating expenses and past earnings that are a reliable indication of future income.

Asset Approach

Asset Approach

The asset approach involves the determination of the total asset value of a corporation or business and reducing that value by the amount of its outstanding liabilities. The starting point in using the asset approach is an entity’s NAV (net asset value). The NAV method within the asset approach is often the appropriate method to use to evaluate an investment holding company formed for the purpose of owning and managing securities of other companies, real estate or natural resources.

The asset approach may also be appropriate to use in the case of an operating service-based company with marginal earnings or operating losses. Furthermore, to the extent that an operating company has non-operating assets, the asset approach is used to value that portion of value attributable to those non-operating assets.

Selection of Valuation Approach

The appraiser will need to determine which of the three fundamental approaches to use in any given valuation case. In many cases, it will be determined that some combination of one or more approaches is suited for a company appraisal. If more than one approach is used, the appraiser will then ultimately weight the approach conclusions in deriving the fair market value of the company.

Why Do You Need a Business Valuation?

Why Do You Need a Business Valuation?

  • Gifting or donating business interests: Family business owners often gift equity in their company to family members. They might also donate company stock to a charitable organization. In any of these cases, the IRS needs a qualified business appraisal to tax the gift or donation accordingly.
  • Looking to sell: A valuation can help you set a fair asking price or act as a starting point for negotiations. Most buyers and equity investors want to look at a credible business appraisal before making a purchase decision. You’ll need a third party with no vested interest in the deal to value your business.
  • Looking to merge with or acquire another business: A valuation can tell you about your company’s future growth potential and if it is well-positioned to acquire or merge with another business. The data from an appraisal can show lenders your company is fiscally healthy, helping you obtain the funding you need to support a merger. Your appraiser can play a crucial advisory role in mergers and acquisitions, providing a fairness opinion to all parties involved.
  • Establishing partner ownership percentages: When a business has multiple owners or is looking to add a partner, a valuation is crucial for determining ownership percentages. It serves to determine precisely how much each partner owns and can help settle disputes of ownership.
  • Going through divorce proceedings: If a business owner faces divorce, a valuation helps the courts decide how to divide the marital estate. Sometimes, both parties obtain their own appraisals.
  • Adding shareholders: When a privately held business adds shareholders, a valuation determines how much an investor should pay for their equity. It also helps identify how much value each shareholder owns.
  • Looking for business financing or investors: Lenders and investors look for indications of value and financial health before they decide to invest which an appraisal will provide.

Business Appraisals With MPI

Business Appraisals With MPI

Business valuation is a complex process requiring a unique approach for every company. Professional appraisers may use several methods and while each approach requires mathematical calculations, the process also involves a lot of professional judgment. Working with a highly qualified team of appraisers with experience valuing businesses is critical.

MPI brings this expertise and over eight decades of experience to every valuation assignment. We make the process smooth and straightforward for our clients. We answer every phone call and email promptly and complete projects by their deadlines. We will choose the best appraisal methods for your needs and make sure you understand the process.

Want to learn more about how MPI can help you appraise your business? Contact us.