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: Return on investment (ROI)

The Return of investment valuation method 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.

Valuation method: Financial key number analysis

In a financial key number analysis, the key numbers are analyzed to evaluate the financial health and the potential of the company. This shouldn’t be confused with credit rating, which is primarily used for loan applications. If the company is assessed to have a potential beyond the ordinary, the “surplus” will fall into this category. In order for potential to become actual figures on a business valuation document, more than only vision is required. Extraordinary large purchase orders, letters of intent, main competitor in bankruptcy, recently increased profits are all examples of what can justify a higher than average potential and adjust of the value, according to this valuation method. Our valuation employ profit multiples conservatively, to then raise the immaterial value, if extraordinary potential has surfaced.

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.

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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.

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