Valuation methods & fair market value

Valuation methods

The asset approach

Simplified, the asset approach equals the value of the company´s normalized assets negative the company´s debts. Assets such as expensive equipment, heavy machinery etc, is typically depreciated faster in the books, as compared to the actual depreciation in market value. The company´s debts can also be normalized if needed, but it is rare.

The asset approach, in its simplest form, is a very simple and easy way of valuing a company. All the “actual work” within the asset approach, is the normalization.

Using the asset approach will only result in a somewhat accurate value, if the company has lots of expensive equipment, and is not profitable. The asset approach will also show a somewhat accurate value for companies that are so called “one man shows”, which in plain English means someone self employed, without patents or digital platforms etc, it is basically just one person working in the business without any transferable value.

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Sub category: Liqudation valuation method

The liquidation valuation method is a sub category to the asset approach. Sometimes you can keep the definition of asset approach and apply a discount for lack of marketability.

In plain English, the difference can be described as you sending off all the equipment to be auctioned off, as compared to the market value of said equipment.

Valuation method: Income approach

The income approach is one of the most commonly used methods within business valuation. There are 4 main things to consider when using the income approach.

1, Normalization of the P&Ls from the last 3-5 years. The most common normalization is done to the salary of the owner or owners. It is common that business owners work 70h a week, and take out less salary then their market rate as CEOs. Other business owners don´t work at all, but still take a healthy salary, mostly because they can. Both of these, need to be normalized for.

2, The weighting between different fiscal years. Which year or years should be considered as representative and why? Oftentimes, the most reasonable is to spread it out between several fiscal years with different weighting.

3, Choice of multiple.

“One man shows” typically receive a multiple between 1 and 3.

Business that are above “one man shows” but under the size where they get attention from private equity firms, typically receive multiple 3 without assets included. If the assets are included they typically receive a multiple between 3-5.

When you reach the size where you get attention from private equity firms, the multiple is usually in the 4-7 range, but it varies heavily. Companies that are technologically advanced receive much higher multiples.

4, The definition of the multiple.

SDE stands for Seller´s Discretionary Earnings. In plain English, it is profit and owner salary combined.

EBITDA stand for Earnings Before Interest Taxes Depreciation and Amortization. In plain English, it is somewhat similar to a gross profit.

Normalized net profit is the only thing that one really should consider.

Sub category: Discounted Cash Flow

Discounted Cash Flow is a sub category to the asset approach. Simplified, the DCF uses a calculated interest rate, and calculates the return on the investment over time. The interest becomes relevant because money today is more worth than money tomorrow. This valuation method is mostly suitable for startups.

A few things to consider:

A, Cash flow and accounting profit differ. Cash flow is literally what it sounds like, the cash flow, which does not take into account amortization etc. Accounting profit is also what it sounds like, which is typically a much better way to measure profitability, but only when the company is not distressed and when it is properly normalized or audited.

B, A cash flow valuation and discounted cash flow differ, with the difference being the applied interest rate, in the discount cash flow valuation.

Banks are typically primarily interested in cash flow, but you as the owner of the business should be more interested in normalized accounting profit.

The market approach

The market approach is common when the business in question only owns commercial property, then it is more of a commercial property valuation, than a business valuation.

The market approach is also common to apply when the business that is being valued is in an industry where transaction are very frequent, like restaurants and bars etc. The market approach is not suitable for most other industries, and is therefore not applied to most other industries.

Nielsen Valuation Group only employes the market approach, when there is enough reliable data of other transactions. In the real world, there is often a lack of data, for the market approach to be used alone, without the combination of other approaches. Ones good way to employ the asset approach in combination with the income apporach, is to use the same multiple as other comparable transactions.

Combination of the valuation methods

When valuing according the asset approach, the central aspect is the earnings, which arguably is highly relevant. The profit multiple has a tendency of not reflecting the value of the company well, when assets aren’t taken into account. A company with lots of assets might receive a non-attractive profit multiple, which during the circumstances would misrepresent the value. Something with a material value is usually somewhat easier to sell, while immaterial assets mainly are valued for expected future returns.

When valuing according to the asset approach, or liquidation valuation method, the earnings are not taken into account. The risk with this, is that the valuation can become lower than other methods. This method is common among smaller companies, so called “one man shows”, which don´t have any transferable intangible value.

When valuing according to the market approach, the valuation faces the risk of not becoming objective, as it doesn’t take into account the assets nor the profits. The market approach is arguably the best valuation method to use if complete information about similar company transactions are to be considered public knowledge within the industry, and made publicly available. In fact, the market approach can only used properly when all the information about previous transactions are publicly available.

We claim that a business valuation needs all the perspectives from the above mentioned valuation methods and that it isn’t complete without it. All valuation methods have the intention of reaching the company´s value in the event of a transfer of ownership. The difference is what perspective that is used to analyze the value of the company. We combine the different valuation methods to balance out the differences and deliver a business valuation that is as reliable and accurate as possible. A qualified business valuation must take multiple perspectives into account, to even out the differences that otherwise are to occur.

Definition of fair market value

Fair market value is a definition two parties that are both equally willing and motivated to transact. This can be seen in contrast to a situation where one of the parties is finding themselves in a distressed situation and in need to transact. Fair market value can also be seen in contrast to a situation where one party is only “testing the waters” without intention or motivation to transact. If this applies to the situation that the valuation is being used in, then the parties involved in the transaction are free to negotiate toward the benefit of a single party. It is usually but now always the selling party that is either distressed or unmotivated. Below are four examples of what distressed seller, distressed buyer, unmotivated seller and unmotivated buyer typically are recognized as.

Distressed seller: Low price, sometimes in combination with the seller being transparent about the distressed situation and the motivations behind why a fast transaction is desired.

Unmotivated seller: A seller that is only testing the waters is recognized by their high asking price and often insufficient description of the business.

Distressed buyer: Buyers are typically never distressed except under the following circumstance. This is when the subject is already a business owner, but for some reason cannot remain at his current or former location.

Unmotivated buyer: Buyers that are unmotivated are sometimes referred to as “bottom feeders.” They are recognized by them submitting a large number of low offers without much attention paid to each individual offer.

Business valuation is the process of determining the most likely value of the business, in a transaction, where both parties are equally motivated to transact. A qualified valuation of a business should be according to the concept of intrinsic value and include an unbiased normalization of the financial statements. The final calculation of a business appraisal is fairly simple and quick, which is typically what you only get, when ordering an online valuation, without an on-site visit. The process of normalizing the financial statements along with weighing in the different valuation methods against each other, is what requires the most amount of time and competence, by the business valuator. The normalization of the financial statements is typically what affects the valuation the most. A company valuation should only be considered as reliable when it is properly independent and unbiased.

The most common methods for valuing a company are; the market approach, the income approach and the asset approach. They all have their strengths and weaknesses, and their own subcategories. No valuation method is complete enough, to solely be used to value a company.

The market approach doesn’t properly weigh in the profitability or assets of the company, which arguably are the most central aspects when valuing a business. Therefore, most valuations according to the market approach, are not of intrinsic value.

The income approach doesn’t take the assets that the company owns, into account. Therefore, companies with lots of assets get deceptive valuations.

The asset approach doesn’t take the profitability into account. Therefore, profitable businesses get deceptive valuations.

Want to go with a cheaper option or even do the valuation yourself?
Nothing is stopping you, but...

You may lose the lawsuit, due to the valuation failing to be waterproof.

You may never settle the conflict, hurting the relationship with your counterpart.

You may get deceived while entering or exiting your partnership.

The contact form does not work, please email christoffer@nielsenvaluationgroup.com

Christffer Nielsen, cell phone (737) 232-0838

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