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What You Need To Know About Business Valuations

Article

The Business Advisor

May 2018

By: Ed Wilusz, ASA, CFA, Managing Director of Value Management Inc.

A business valuation is sometimes a necessity in a bankruptcy involving a cramdown, asbestos, or other situation. Presented below is a brief overview of the business valuation process.

Data Gathering
The initial stage of the valuation process requires gathering information that is both company and industry specific. Here, the appraiser requests and receives certain documents (financial and other) from the company. An important part of this stage is meeting with the company to discuss both its history and current operations. The questions asked are those that a potential buyer would ask about daily operations, marketing, competition, administration, financial performance (past and present), company expectations, and industry. After obtaining company information, independent research is undertaken to assemble industry and market specific information. This leads us to the second part of the process, the analysis.

Analysis
In this stage of the process, a qualitative and quantitative analysis of the company is performed. A comparison may be made between the performance of the subject company to that of other similar companies and/or to the industry in general. The purpose of the analysis is to understand what factors have impacted the company’s past performance and what may influence its future. Also, it is to identify what factors contribute or detract most to value. Upon completion of the analysis part of the process, the appraiser moves to the next stage, the application of valuation approaches.

Application of Valuation Approaches
The third stage of the process is the application of various valuation approaches. Generally speaking, there are three basic approaches: (1) income approach; (2) market approach; and (3) asset or cost approach.

    • Income Approach: Income or cash flow is generally the most important valuation factor for a going concern. Under this approach, the buyer asks the question “what’s in it for me?” That is, what is the potential revenue, net income, and, most importantly, cash flow this business will generate in the future. The second part of this question is, what is the risk or the degree of uncertainty associated with obtaining the earnings or cash flow? If projections have been prepared, it is important to understand who prepared the projections, how they were prepared (involvement of the management team or by the CFO), how they compare and are related to the past, and what reasons they may deviate from prior years.
    • Market Approach: The purpose of the market approach is to identify transactions involving interests in the stock of companies that share similar investment characteristics with the subject company. Once identified, a comparison of the quantifiable and non-quantifiable factors is made. From this information, prevailing investor attitudes and expectations are developed. Differences are noted and adjustments are made to develop representative valuation multiples which, in turn, are applied to the company to develop value indications.
  • Asset or Cost Approach: The asset or cost approach to value is an examination of the approximate realizable value of the company’s assets. While this approach is generally given little weight in the valuation of a profitable, going concern, it may be the controlling approach in a bankruptcy situation.

Valuation Conclusion
The weight given to the various approaches depends on the facts and circumstances. Sometimes significant or all weight may be given to one approach and little or none to others.