Business valuation is an exercise undertaken to determine the economic value of ownership interest in a business. The theory and practice behind business valuation is complex and the exact approach depends on the business size, size of ownership interest (minority vs majority) under consideration, definition of value (intrinsic value, market value, breakup value, etc.) and purpose of valuation (legal, taxation, merger and acquisitions, etc.).
Typically, business valuation is carried out when:
- One business is merged with another: to determine the consideration to be paid by the acquirer to shareholders of the target.
- One business line is separated from another: to determine the value to be paid for the sold-off division.
- Ownership interest is purchased or sold: to determine the value at which shareholders purchase/sell ownership interest.
- Taxation: to determine inheritance and capital gains taxes and find out the most efficient estate planning approach
- Dispute resolution: to resolve disputes between shareholders by transfer of ownership stake between shareholders, and
- Divorce: to determine settlement between partners
There are three main methods of business valuation: (a) market approach, (b) income approach, and (c) asset approach.
In the market approach, value of a business is determined by identifying comparable companies/transactions, working out their price multiples such as price to earnings ratio, price to book ratio, etc. and applying that ratio to the business under consideration.
Market approach is a relative valuation method because under this approach, value of a business is determined relative to similar companies and similar actual sale and purchase transactions.
Market approach is theoretically sound because the value is validated by actual market transactions. However, lack of adequate comparable transactions in most cases limits usefulness of this method.
In the income approach, value of a business is determined by discounting the future earnings of the business (measured in terms of income or cash flows).
Strength of the income approach lies in its flexibility and effectiveness. Since it does not rely on comparable data, lack of relevant transactions data is not a limitation in this approach. Future earnings/cash flows are determined keeping in view the company’s competitive position, its cost structure and taxes, etc. The discount rate used in determining the value can be worked out using different models, i.e. the capital asset pricing model and build-up approach.
In the asset approach, value of a business is determined by ascertaining the value of each individual asset of the business. For example, inventories can be valued at the net realizable value, accounts receivable can be value after allowing an appropriate provision for bad debts, fixed assets can be valued at their fair value less costs to sell, etc.
In most cases value of a business is significantly higher than the sum of values of all individual assets due to goodwill. Hence, the asset approach to valuation is not the best approach in most cases. It is appropriate only in case of companies who are in liquidation. In case be used for businesses in going concern only where the other two approaches cannot be reliably applied.
Robert Lee owns Lee Dental Arts, which he established 30 years ago in Charlottesville. He is 65 now and wants to retire and sell the practice.
In the initial meeting to discuss engagement, he disclosed that he started thinking about retirement when one of class mates from his college who was also a dentist recently sold his practice, Jefferson Dental Works, for $3,000,000. Lee’s revenues for the most recent were $1.5 million and Jefferson’s were $2.5 million.
By searching a popular valuation database, you found out that typical capitalization rate used for dental practices is 20%. Lee’s net cash flows per year are $400,000.
You visited the dental practice and obtained a list of fixed assets, which costed $2 million, have written down value of $500,000 and can be sold for $800,000. Lee has receivables of $50,000 from different insurance companies of which $5,000 are not expected to be collected. An amount of $20,000 shall be spent on liquidating all the assets.
Determine his practice value based on the three common valuation approaches and suggest which approach is the best. Let’s determine the value under the three approaches:
Jefferson Dental Works generated revenue of $2.5 million per year and was sold for $3 million. Its price to sales ratio is 1.2. Assuming both practices are identical, value of Lee Dental Arts should be $1.8 million (=1.2 * $1.5 million).
Value of Lee Dental Arts equals the present value of its net cash flows. Since the cash flows are assumed to be perpetual and we identified that approach capitalization rate is 20%, value should be $2 million (=$400,000/20%).
Value equals the individual value of all assets. In case of Lee Dental Arts, value based on asset approach equals $825,000 (=market value of fixed assets ($800,000) + net receivables ($50,000 - $5,000) – cost of liquidation ($20,000)).
The best approach to value Lee Dental Arts is the income approach. Market approach is not very useful because only one transaction data is available, that too 2-years old data from another city. Asset approach is not useful because it assumes liquidation and doesn’t account for any goodwill. Asset approach is to be applied only if no willing buyer can be identified for the whole practice.