Valuation methods & fair market value

Valuation methods and their sub categories

The asset approach

Simplified, the asset approach equals the value of the company´s assets. The tangible assets are often fairly simple to value, using market comparison and depreciation, while intangible assets are more complicated to value. Fixed assets, such as production equipment is usually written off at a faster pace than the depreciation of their market value. This often leads to the balance sheets misrepresenting the asset value. Depending on the circumstances, the opposite could also be the case.

Sub category: Liqudation valuation method

The liquidation valuation method is a sub category to the asset approach. Simplified, the liquidation valuation method can be described as a scenario where it has become public knowledge that the company is in a financial distress and is facing reconstruction or bankruptcy. Potential buyers are likely to drive a hard bargain if they know that they sit on the “good cards” at the negotiation table. If a bankruptcy already has been declared, you on the other hand with sit at the negotiation table with a ”foreclosure sign” figuratively speaking. Another commonly used term is; discount for lack of marketability, which relates to the difficulty of selling assets quickly. There is an entire industry dedicated to this, that is called foreclosure investing. The liquidation valuation method should typically not be applied when a business valuation is executed by the definition of fair market value.

(For the United States only)
The liquidation valuation method, may be part of a valuation according to the concept of “fair market value”, but not “fair value”.

Valuation method: Income approach

The income approach is commonly used within venture capital and private equity. Simplified, it is based on the return that the investment is expected to deliver. Relevant parallels are usually drawn to how liquid, vs how solid the investment is, and what is the average market return on other investments with comparable risks. Generally speaking, any non-public company investment is a higher risk/reward than your average index fund. Also, stocks/shares (or an entire company) in a private company is a very illiquid investment. Lastly, when valuing according to the ROI-method, it is part of the process to normalize the P&L and balance sheet. This is the most labor intensive part of any proper business valuation.

Sub category: Discounted Cash Flow

Discounted cash flow is a sub category to the ROI-method. Simplified, the DCF focuses on a pre-set interest rate, and then calculates cash flow against time. A central aspect of the DCF-method is that money today is worth more than money tomorrow. When analyzing according to this method, the companies that tie up less capital in relation to the earnings, become the winners. The interest rate varies depending on the risk. Just like the main category; the ROI-method, is the DCF-method common within investors and venture capitalists. The DCF method is especially useful when choosing where to investment a limited amount of money. Industries that needs assets that tie up capital don’t become attractive from the perspective of the DCF method.

The market approach

The market approach is common when the company owns commercial real estate, or when it comes to valuing companies in certain industries where a large amount of transactions take place. The market approach is not useful in situations when there are not transactions of ownership taking place on a highly frequent level locally. Its applicable use is limited to a few industries. However, the market approach can also influence the overall evaluation of the company. Some industries have/get higher multiples and some industries have/get lower multiples. There are certain commonalities among the industries that get higher multiples; high barriers to entry, low overhead costs, contract clients or “guaranteed” clients. There are also other industries that get higher multiples even without the above mentioned, such as industries that are related to tourism and the software industry.

Combination of the valuation methods

When valuing according the ROI method, the central aspect is the earnings, which arguably is highly relevant. However, the material assets are not taken into account, which is to be seen as a disadvantage. PE numbers (Price/Earnings) is a term used mainly within public companies. Profit multiple is the equivalent term used for private companies. 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. This is why the ROI and DCF methods are common for external investors, as their primary interest is how much return the investment can generate.

When valuing according to the asset approach, or liquidation valuation method, the earnings/profits 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. The potential new owner of said small business, is likely very interested in how much sellable material assets he or she is receiving in the deal.

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. However, in almost all cases, this is not the case. Reading a listing that doesn’t mention whether or not the commercial property is leased or owned, nor mentions the profitability, doesn’t qualify. In fact, the market approach can only used properly when all the information about previous transactions are publicly available.

A financial key number analysis is indeed objective as it takes into account both profitability and assets. Objectivity is rarely negative and in business, as numbers dont lie. A financial key number analysis does however not take into account the industry that the company operates in (unlike the market valuation method). Subjectivity is missing in this valuation method.

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, in order to execute an overall evaluation of the business.

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 towards 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.

Fair value vs fair market value (United States only)

Fair value is not the same as fair market value. Fair value is defined by each state, and therefore differs. In the US, all our locations are affected by this (New York, California and Florida). Our valuations always come with both the fair value and the fair market value. Fair value is typically applied in marital dissolutions, and when buying out a business partner due to a dispute. Within fair value, one may typically not apply discount for lack of marketability, key person discount, nor minority ownership discount.

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.

Tell us how we can help you

We work with the same valuation methodology as the big4, yet we charge half the price, and provide better personal service. If you have a small store/restaurant/salon, or a business that does not yet have revenue, we instead recommend using a business broker for the valuation.

Christoffer Nielsen meets all clients in Texas personally. Cell # 737 232 0838