The Three Ways of Determining Firm Value
There are three primary approaches business valuation professionals utilize to establish a firm’s value: the income approach, the market approach, and the asset-based approach. No one approach is applicable in all instances, and valuation professionals will select one or possibly two methods that are best suited to a firm’s particular circumstances.
When utilizing the income approach, value is based directly on a firm’s ability to generate future profits and cash flows by estimating the present value of those profits and cash flows. It is best suited for valuing established, profitable firms.
The discounted cash flow (DCF) method is the most frequently used analysis under the income approach. The DCF method applies a discount to a company’s projected future cash flow streams, with amounts further in the future subject to a greater discount. The DCF method projects future debt-free cash flows over multiple periods, such as five or six years, and is widely used, especially when future expected cash flows and growth rates are expected to vary over time. Future cash flow estimates rely on assumptions regarding net revenue, labor and benefits costs, operating expenses, and pre-tax, pre-bonus profits among other factors. Multiple models can be constructed based on how conservative a buyer may or may not be.
An alternative is the capitalization of earnings method, which relies on future benefits represented in a single period. It is less rigorous and better suited for mature, well-established companies with little variation in earnings and growth.
An advantage of the income approach in the A/E industry is that it considers the economic benefit stream generated by a firm, which most directly measures its true worth. The downside, however, is that it requires significant analysis to estimate and quantify and is based on future projections and assumptions that are inherently uncertain.
When a market approach is utilized, a firm’s value is based upon the sales of comparable firms. Since it is based on how similar firms have been priced in the market in the recent past, it is the most direct approach for determining a firm’s market value.
A market approach requires the calculation of appropriate pricing multiples, such as price-to-revenue or price-to-earnings ratios. Since the A/E industry has so few publicly traded companies, business valuation professionals who employ a market approach will require both industry experience and access to a robust database of transactions. (At Morrissey Goodale, we rely on a proprietary database of M&A transactions in the A/E industry.)
The advantage of the market approach is that it’s readily accessible and easy to understand as the market provides a direct indication of firm value. The disadvantages are (1) without industry expertise and knowledge it can be difficult to identify comparable firms that have been involved in recent transactions; (2) reliable data may be hard to obtain without significant investment as transaction data are typically not disclosed to the public; and (3) the approach essentially assumes that every firm is average and does not account for firm-specific circumstances and prospects.
With an asset-based approach, a firm’s worth is based on the value of its assets net of liabilities. The two main asset-based approaches are the book value method and the adjusted net asset method. When using the book value method, valuation professionals subtract the book value of a firm’s liabilities from the book value of assets as they appear on balance sheets. The adjusted net asset method relies on fair market value rather than book value and is calculated by subtracting the estimated fair market value of outstanding liabilities from the estimated fair market value of assets.
While an asset-based approach has the advantage of being relatively straightforward and easy to understand, the downside of using it in the A/E industry is that value is based on physical assets, such as vehicles and computers, but not on intangible assets, such as design or marketing skills, that are critical in a service-based industry. The asset-based approach is better suited for capital-intensive businesses—such as equipment rental companies or hotels—in which assets are fundamental to income production.
Business valuation professionals who rely heavily on an asset-based approach likely have little knowledge of the A/E industry. The income and market approaches are much better methods to employ when determining the value of an A/E firm.
The Pros and Cons of Valuation Formulas
A/E firm owners often determine the value of their companies’ shares by using a formula specified in a buy-sell agreement rather than by undertaking a more comprehensive third-party appraisal.
The biggest advantage of a valuation formula based on the firm’s financial metrics is that it’s simple and easy to calculate in a matter of minutes. It’s also an objective, transparent method of determining firm value since anyone with access to the company’s financial statements can verify the computation.
Using a formula makes the most sense when stock transactions occur frequently and in relatively small amounts, when transparency is more important than accuracy, and when a company is financially stable and operating in a steady economic environment.
While formulas have their advantages, they have serious pitfalls as well. Although convenient, valuation formulas may not provide the most accurate assessment of firm value because they lack flexibility and often fail to account for broader economic conditions or changes in firm circumstances that can impact a company’s worth. By taking into account only past results and not future prospects, formulas are also backward-looking and can fluctuate excessively from one year to the next. They also fail to incorporate unique factors such as location, business model, and working capital management that materially impact value.
Valuation formulas should not be used when a sizable ownership transfer is being contemplated, an accurate valuation is paramount, or an independent, third-party appraisal is required.
If you do utilize a valuation formula, keep the following tips in mind:
Don’t rely on just one year or just one metric. Since the financial results of a privately held firm may vary significantly from one year to the next, formula results should be averaged over a three- to five-year period to mitigate the impact of outliers.
Stay simple. Don’t overcomplicate formulas with too many inputs or variables, which can lessen the effectiveness of the calculation and obscure the factors that most drive the company’s value. Morrissey Goodale recommends no more than six inputs.
Engage in regular checkups. It’s a good idea to invest in a third-party expert to provide an opinion on the continuing validity of your formula and calibrate it to a forward-looking appraisal every few years, whenever economic conditions change, and especially when the firm has grown or contracted or is undertaking a significant transfer of ownership.
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