Business Valuators often are asked "Just what, exactly, is a business valuation?" With the recent global financial meltdown, the concept of fair market value, and in particular the methodologies of determining fair market value, have come into question.
It is important to note that the valuation of any entity, whether public or private, is determined at a point in time. Thus, it is the factors that exist at the valuation date and the market's future expectations at that point in time that affect the value of a business.
The values of publicly held companies are primarily determined by market forces, as publicly held shares transact on the open market. The economic laws of supply and demand come into play in the pricing of publicly traded shares. When there is speculation that a company will exceed its financial forecast, the market responds by raising the stock price due to increased demand. Conversely, if the company is expected to miss its forecasted results, the market will adjust and reduce the stock price as demand falls.
The stock price of a publicly traded share is impacted by many issues. The issues tend to be forward looking. With the recent credit crisis and the increase in global risks, the future earnings of public companies come into question. As negative economic signs become more prevalent, the market adjusts economic forecasts downward, devaluing the stock.
Unlike publicly held shares, private companies are valued in a notional setting without the direct impact of market influences. However, market and general economic conditions are considered by Business Valuators in assessing the risks and the ability of the entity to achieve expected results. A business valuation in a notional setting is conducted by an experienced Business Valuator with the insight and experience of an organization's senior management team.
Valuations of privately held businesses typically are performed for purposes of strategic planning, divesting of business interests, acquisitions, corporate restructuring, succession planning, and resolving matters between shareholders and spouses.
Business valuations play a significant role in any estate planning exercise with respect to transferring wealth and the growth of a business. It is the Canada Revenue Agency's intention that appropriate business valuations be completed in this area and significant penalties can apply where it deems a valuation to be inadequate. Having a Chartered Business Valuator prepare the valuation will help to avoid such sanctions.
The Valuator either will have the necessary industry background or will gain the industry knowledge through research. The Valuator's understanding of the business is necessary for the purpose of understanding key value drivers and risks, as well as the expected future operating results of the entity. Appropriate research will uncover variables that might impact value and affect the Valuator's conclusions. At this stage, the Valuator often will assess the need for additional specialists to assist with various aspects of the valuation.
The Valuator will assess and select from a number of different valuation approaches. The selection of the appropriate approach is based on the nature of the business, its asset base, historical performance, future expected operating performance, and other factors.
Under the liquidation approach, the Valuator will select between an orderly or a forced liquidation framework. The conclusions derived from each approach can vary significantly.
With the going concern approach, sustainable earnings (or cash flow) is a key variable. The Valuator will assess the future sustainable earnings of the business, often requiring some level of judgment on the part of the Valuator. The Valuator often will turn to the business's historical performance and financial forecasts, adjusting for cost structures and revenue streams that are not normal to the operations.
The appropriate determination of a capitalization rate depends on the approach used and whether the valuation is performed at the enterprise level or the equity level. The cost of equity forms one component of the weighted average cost of capital. Typical methods for determining the cost of equity include the capital asset pricing model and the buildup method, among others. Assessing appropriate capitalization rates requires significant judgment and experience.
Redundancies must be considered in any valuation. Fair market value and normalized earnings/cash flow are adjusted for these redundancies, which may be apparent or hidden. Assessing the value of redundancies requires experience and significant judgment.
Inherent in the value of a going concern entity is commercial goodwill, which is attributable to the product or service, the location of the operations, the systems and processes of the operations, the customer base, and other key value attributes. The difference between the going concern value of an entity and its tangible asset base is considered goodwill. In order for goodwill to retain any value, it must be transferable with commercial value. Personal goodwill typically rests with the individual and is not transferable, and therefore has no value. The Valuator uses his/her judgment along with management's insight to assess the transferability of goodwill.
Valuators typically consider the en bloc value (the entire value) of the business. If a particular shareholder's interest in the corporation is being valued, the size and level of control of the interest are relevant factors. A shareholder's control is measured by the ability to elect key Directors, control dividend flow, and make key strategic decisions. Minority and marketability discounts must be assessed with respect to partial interests. Control premiums must also be assessed in situations of controlling interests. Again, assessing discounts and premiums involves significant judgment and experience.
A business valuation is a complex process for uncovering the true value of an enterprise through a series of questions, research and techniques. A trained and experienced Business Valuator is critical to the process.
Contact your valuation professional at Collins Barrow for further information or assistance.
Andrea Pontoni, CA, CA-CBV, is a Partner in the Windsor office of Collins Barrow.
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