HOW MUCH IS THIS BUSINESS WORTH?

business valuations

TYPES OF VALUATION ENGAGEMENTS

  • Valuation Engagements 
  • Calculation Engagements 

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History of Business Valuation

Historically, the valuation of a closely held company was more of an art than a science; there was some guidance provided by the IRS and minimal reporting standards. Accordingly, many in the business valuation professionals served as advocates for the client, rather than as an expert (or advocate for the conclusion of value). The growth and diversity within the valuation profession, improvement in software, growing sophistication of the judiciary and availability of data through the Internet has transformed the profession and practice. There is now less guesswork and more scrutiny.

The single most important piece of valuation literature is widely regarded to be the 1959 I.R.S. Revenue Ruling 59–60. This outlined methods and factors to be used in valuing closely held businesses. The ruling provided for a series of valuation formulas or methods. The various formulas are not alternatives to one another; all of its methods should at least be considered. Many formulas are tied to “earnings” rather than “excess earnings” which are multiplied or capitalized by certain industry factors or “public” company comparable factors. 

The first question we ask when approached about a business valuation is “why are you needing a valuation?” This determines the type of engagement we will enter into. There are two types of engagements:

Valuation Engagements

A valuation engagement and report results in a conclusion of value. It is governed by the professional and reporting standards of several professional valuation organizations. Each require a high level of research and analysis to reach the conclusion of value. A business interest typically will be viewed from all approaches.
Because of the stringent requirements in place by professional organization reporting standards, valuation engagements and reports meeting these requirements are accepted by the IRS and most courts. Accordingly, valuation engagements and reports are most appropriate for estate and gift tax filings, litigation, divorce proceedings, and when a higher level of assurance is required. The Small Business Administration also requires this type of report if the size of financing requires a valuation.  


Calculation Engagements

A calculation engagement and report results in a calculation of value. The valuation analyst normally qualifies the calculated value by stating that a calculation of value does not include all of the procedures required for a full valuation. We may further qualify the calculated value by disclaiming that had a valuation engagement been performed instead, the results might have been different.

Most valuations will examine the entity from three different "approaches"


Market Approach

The market approach to business valuation involves valuing a company by reference to what other similar companies or interests in companies have sold (similar to buying a house, a database of market comps is consulted) relative to some fundamental variable in the subject company, such as sales, net income, EBITDA (earnings before interest, taxes, depreciation and amortization), EBIT (earnings before interest and taxes), etc. 
 

Income Approach

The income approach to business valuation values a company by estimating some measure of its earning power in the future and converting that measure to a present value based on an investor’s required rate of return on the investment considering the risk of the investment.
 

Asset Approach

The asset approach to business valuation values a company by adjusting its assets (what the business owns) and liabilities (what the business owes) to fair market value and the difference represents the “net asset value” of the company. The procedure is to adjust each asset and liability item on the balance sheet to its fair market value. This approach is usually not applicable to a profitable going concern because in that case the value lies largely in the earning power of the business. 
 

Business Valuation Manufacture