Valuation Methodologies

A complete business valuation often provides an objective starting point for both buyers and
sellers of businesses. Without a professional valuation, the seller may be ill prepared to meet with
buyers, especially if the buyers have a more accurate idea of the value of the business. In short,
without a comprehensive business valuation you may be leaving money on the table, and not even
know it!
Strictly speaking, a company's fair market value is the price at which the business would change
hands between a willing buyer and a willing seller when neither is under any compulsion to buy or
sell, and both parties have knowledge of relevant facts. This is a somewhat circuitous statement
because it begs the question, "How do buyers and sellers arrive at this value?"
Arriving at the transaction price requires that a value be placed on the company for sale. The
process of arriving at this value should include a detailed, comprehensive analysis which takes into
account a range of factors including the past, present, and most importantly, the future earnings and
prospects of the company.
Valuing a business is not an exact science. The valuation process involves comparing several
different approaches and selecting the best method, or a combination of methods, based on the
analyst's knowledge and experience. Generally, there are several different methodologies that
practitioners use to value businesses. These are:
1. Asset-based valuation;
2. Comparable transactions analysis;
3. Comparable public company method; and
4. Discounted cash flow.
In applying these methodologies to determine the value of a business, one or more of the following
factors are generally reviewed and analyzed:
1. The nature of the business and its operating history;
2. The industry and economic outlook;
3. The book value and financial condition of the company;
4. The company's earnings and dividend paying capacity;
5. The value of the company's intangible assets;
6. Market prices of public companies engaged in similar lines of business; and
7. Transaction prices of other companies engaged in similar lines of business.
Throughout the valuation process, it is important that the purpose of the valuation be kept in mind.
Although a valuation can serve many purposes, if the aim is to sell the business, then the valuation
should objectively determine the fair market value of the business. This objective market valuation
should also take into account the synergies and fit that the business may have with potential buyers.
In addition to valuing a business for an impending sale, a business valuation can also be required
for legal proceedings, estate planning, shareholder disputes and for capital raising.

Although commonly used "rules of thumb" may be a good starting point to obtain a rough idea of
the valuation of a business, a comprehensive business valuation is ultimately what is required.
Rules of thumb often provide a useful "back of the envelope" test of value that is based on
empirically available data. This empirically available data includes industry benchmarks or
historical transaction multiples. Although a rule of thumb can give a quick answer to a difficult
question, they do not take into account business-specific information that may significantly impact
the value of a business above and beyond industry benchmarks. In fact, the IRS weighs in on this
very issue, and states in everyone's favorite IRS Revenue Ruling 59-60 - that, "a determination of
fair market value, being a question of fact, will depend upon the circumstances in each case." The
Rule continues, "No formula can be devised that will be generally applicable to the multitude of
different valuation issues."
Asset Based Valuation
This valuation method is based on the premise that the value of a business can best be determined
by adding the value of all the assets of the company and subtracting the liabilities, leaving a net
asset valuation. An asset-based valuation can be further segmented into four approaches: (1) book
value, (2) replacement cost, (3) appraised value, and (4) excess earnings. Asset-based valuation
methods ignore the importance of a company's earnings and cash flow. For this reason, this
valuation approach is generally not used to determine the market value of a company - especially in
the context of an acquisition.
Book Value - The book value of a company is obtained from the balance sheet by taking the
adjusted historical cost of the company's assets and subtracting the liabilities. Tangible book value
is calculated the same way as finding regular book value, except that intangible assets (like
goodwill) are excluded in the calculation. Using book value does not provide a true indication of a
company's value, nor does it take into account the cash flow that can be generated by the company's
assets.
Replacement Cost - Replacement cost reflects the expenditures required to replicate the operations
of the company. Figuring replacement cost is essentially a make or buy decision.
Appraised Value of Assets - The difference between the appraised value of assets, and the
appraised value of liabilities is the net appraised value of the firm. This approach may be most
commonly used in a liquidation analysis because it reflects the divestiture of the underlying assets
rather than the ongoing operations of the firm.
Excess Earnings - In order to obtain a value of the business using the excess earnings method, a
premium is added to the appraised value of net assets. This premium is calculated by comparing the
earnings of a business before a sale and the earnings after the sale, with the difference referred to as
excess earnings. Assuming that the business is run more efficiently after a sale, the total amount of
excess earnings is capitalized (e.g., the difference in earnings is divided by some expected rate of
return) and this result is then added to the appraised value of net assets to derive the value of the
business.

Comparable Transactions Analysis
Comparable transactions analysis involves obtaining financial and operating data from other,
similar transactions and applying it to the target company to obtain a predicted value. These
historical transactions involve companies that have similar lines of business as the company being
valued. In analyzing comparable transactions, valuation professionals will often divide deal price
by some industry standard metric, such as EBITDA, or number of subscribers. An average or the
median of the resulting multiples is then multiplied by the target company's metrics to obtain a
company valuation.
Depending upon the relative similarity or difference of the target company's characteristics to the
group of comparable transactions, analysts may apply a discount or premium to the multiple before
it is multiplied by the target company's metrics.
Although comparable transactions analysis can be an important valuation methodology, its
usefulness is dependent on the relevance, quality and timeliness of historical transactions data. In
addition, due to the fact that the overwhelming majority of acquisitions involve privately-held
companies, there is often a dearth of financial data available to track the financial characteristics of
these transactions.
Comparable Public Company Method
Public markets are generally considered efficient at valuing companies. Each day, stock prices
reflect the instantaneous and independent pricing decisions of buyers and sellers around the world.
Thus, using existing public companies as a benchmark to value similar private companies is a
viable valuation methodology.
The comparable public company method involves selecting a group of publicly traded companies
that, on average, are representative of the company that is to be valued. What is important is that
investors would view the comparable companies and the target company as similar. Each
comparable company's financial or operating data (like revenues, EBITDA or book value) is
compared to each company's total market capitalization to obtain a valuation multiple. An average
of these multiples is then applied to derive the company's value. If several metric multiples are
used, professionals will often weigh each metric based on the relative importance of the metric in
the valuation of the company.
Because the comparable public companies will have different characteristics than the firm
undergoing the valuation, premiums or discounts may be applied to the target company. These
valuation premiums or discounts are based on generally accepted research and empirical data and
involve such adjustments as discounts for lack of marketability or control premiums. Unlike public
companies, privately held firms do not have an actively traded market for their shares. This
significant factor, referred to as liquidity or marketability, will result in private companies almost
always being valued at a discount to their public company peers.

Discounted Cash Flow
As a methodology, discounted cash flow is often considered the preferred tool to value businesses.
What sets this approach apart from the other approaches is that it is based on projected, future
operating results rather than on historical operating results. As a result, companies can be valued
based on their future cash flows, which may be somewhat different from historical results,
especially if a potential buyer expects to operate some aspects of the business differently

Discounted cash flow analysis consists of projecting future cash flows, deriving a discount rate and
applying this discount rate to the future cash flows and terminal value. This detailed analysis
depends on accurate financial projections and discount rate assumptions. The resulting company
valuation is the sum of discounted future cash flows and the discounted terminal value.
Projecting Future Cash Flows - The first step in conducting a discounted cash flow analysis is to
project future operating cash flows over a projected holding period, generally five years. These
projections are generally done before debt (but after taxes) to obtain an accurate indication of future
free cash flow, without making any assumptions about the company's leverage. The future free cash
flow is the cash left over after operating the business and investing in necessary property, plant and
equipment, but before servicing debt or paying out any cash to owners.
Discount Rate - The second step in the discounted cash flow analysis is to develop a discount rate.
The discount rate is also referred to as the weighted average cost of capital (WACC) and is best
thought of as a percentage which represents the return expected by an owner of the company
commensurate with the risk associated with the investment. For example, a risky Internet start-up
with little in the way of a demonstrated track record, would receive a higher discount rate than a
company with a long history of growth and profitability and more obvious future prospects.
Discount rates are generally calculated by deriving the company's cost of equity capital and the
company's after-tax cost of debt (note that although the cash flows are projected on a debt free
basis, it is important to derive a WACC based in part on the company's expected cost of debt, since
this reflects the company's level of risk). These financing costs are weighted and result in a WACC
percentage, or discount rate. The cost of equity capital is generally determined using the capital
asset pricing model (CAPM), which is based on three inputs: (1) the risk free rate (the expected
return on long term government bonds - currently about 6%), (2) the beta, which is a measure of the
relative riskiness of the company (compared to the market), and (3) the equity risk premium (the
expected rate of return on common stocks in the long run - currently about 8%). The derived
discount rate is applied to the projected future cash flows to determine the present value of the
future cash flows.
Terminal Value - The next major step involves calculating a terminal, or residual value. A terminal
value calculation combines assumptions used to derive future projections and the discount rate to
obtain a current value for a company's long term future cash flows. The assumption underlying this
step is that a company is a going concern and that its value is imbedded in its ability to generate
value not just today, but well into the future. A terminal value is calculated by determining the cash
flow in the period beyond the last projected period. This predicted future cash flow is then
capitalized by a percentage (represented by the company's discount rate less the predicted long term
growth rate) and this capitalized figure is then discounted back to the present using the discount
rate.
Comprehensive Business Valuation
Together with an analysis of the company's operating history, business, industry and competitive
environment, the results from one or more of these valuation methodologies are combined to form
the basis of a comprehensive business valuation. To be accurate, this comprehensive business
valuation should take into account all aspects of the company's business, including factors which
may be difficult to value and that do not show up on financial statements. These factors include,
among other things, such value enhancers as proprietary technology, strong market position, an
extensive sales network and an experienced management, that in the case of a sale, is willing to
remain with the company.

Summary
There are four broad and generally accepted valuation methodologies. They are: (1) asset-based
valuation, (2) comparable transactions analysis, (3) comparable public company method and (4)
discounted cash flow analysis. Valuation experts will value a company with more than one of the
methodologies, comparing results among the different approaches to determine a correct valuation,
all the time keeping in mind the strengths and weaknesses inherent in each approach.