Tuesday, April 23, 2013

Step 4 to Reviewing a Valuation Report - Valuation Approach

How many different valuation approaches are there?  How does a valuator select which valuation approach to apply?  What if the valuator adopted an incorrect valuation approach?
The business valuator is responsible for selecting an appropriate valuation approach and for ensuring that it has been correctly applied.  Step 4 to reviewing a business valuation report involves identifying and assessing the valuation approach adopted by the valuator. 
In valuing a business, there are many valuation approaches to select from.  In the context of a legal dispute,

"There are many ways to approach an analysis of a loss resulting from a particular set of facts. Part of the expert’s role is to identify all of these alternatives and determine which is the most appropriate." [1]

There are two fundamental bases on which to determine the value of a business: going-concern and liquidation.  In the case of a company that is expected to continue operating well into the future, the prospective investor will evaluate the risks and expected returns of the investment on a going-concern basis.  If for any reason the company is likely or expected to liquidate, liquidation values for the assets, as well as costs associated with liquidation would prevail.
All methodologies applied to the valuation of business may be broadly classified into the asset-based, income-based or market-based approaches.  Each of these is discussed briefly below.
The asset-based approach is applicable when the underlying asset values constitute the prime determinant of corporate worth.  The application of this approach depends on the nature of the company’s operations (such as an investment or real estate holding company) and/or if the outlook for a particular company’s earnings is somewhat uncertain, or returns based on earnings are insufficient to justify the investment in assets.
This approach focuses on individual asset and liability values from the company’s balance sheet, which are adjusted from book values to fair market values.  The asset-based approach can also be applied in situations where liquidation is likely or expected.
The income-based approach involves estimating the present value of the projected future cash flows to be generated from the business and theoretically available to the capital providers of the company.  In general, a discount rate is applied to the projected future cash flows to arrive at a present value.  The discount rate is intended to reflect all risks of ownership and the associated risks of realizing the stream of projected future cash flows.  It can also be interpreted as the rate of return that would be required by providers of capital to the company to compensate them for the time value of their money, as well as the risk inherent in the particular investment.
There are different variations of the income approach.  Common income approaches include the capitalized earnings ("CE"), capitalized cash flow ("CCF"), excess earnings ("EE") and discounted cash flow ("DCF") approaches.  An income-based approach is typically the most common valuation approach adopted in the valuation of privately held operating companies.
Market-Based Approach

The market-based approach involves comparing the subject business to similar "guideline" companies whose securities are actively traded in public markets or which have recently been sold in a private transaction.  Certain valuation metrics (e.g. EV/EBITDA, EV/Sales, etc.) obtained from a sample of comparable public companies and/or industry transactions are applied to the subject business to arrive at a value range.  This approach is generally appropriate when the subject business is publicly traded and may also be useful for indicating what a privately held business would be worth in the public market.
It is dangerous, however, to blindly apply a market-based approach to a privately held company without carefully assessing the comparability of the target business to the "guideline" companies.  Certain adjustments may be required to the public company and/or industry transaction multiples (e.g. to account for differences in size, growth, control, marketability, etc.) before they can be applied to the target business.  In addition, it is very difficult if not impossible to assess the extent to which purchaser perceived synergies, relative bargaining abilities and emotional considerations influenced the price realized in an actual industry transaction. 
As a result, a market-based approach may not be appropriate as a primary valuation approach.  It can, however, be useful as a reasonableness check on the value otherwise determined under an income-based approach.
It is the valuator’s role to determine which approach is appropriate in light of the company-specific facts and circumstances and the valuator should adequately explain and justify the reasons for his/her selection. 
In reviewing the valuation report, the following questions should be addressed:
  1. What valuation approach was adopted?
  2. Is the valuation approach appropriate under the circumstances?
  3. Would an alternate valuation approach be more suitable?
  4. What would be the impact if a more suitable valuation approach was applied? 
  5. Would adopting an alternate valuation approach corroborate or refute the values determined under a primary approach?
In my experience, business valuators will typically agree on an appropriate valuation approach.  It is the application of the approach and/or the underlying assumptions where valuators will often differ.  However, identifying and understanding the valuation approach adopted is critical to an effective review of a valuation report.
If you have any questions regarding matters involving the valuation of your business or if you would like an independent business valuator to assist in your review of a business valuation report, contact us at www.vspltd.ca.

1.  The Litigator's Guide to Expert Witnesses, Mark J. Freiman and Mark L. Berenblut, p. 87.

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