An Introduction to Business Valuation

June 13, 2021


Kevin Valley

There are two fundamental approaches to the valuation of a business — the liquidation approach and the going concern approach...

There are three types of Valuation Reports (Comprehensive, Estimate, Calculation) which are distinguished by the valuator’s scope of review, the amount of disclosure provided, as well as the level of assurance being provided in the conclusion.

Comprehensive Valuation Report

A Comprehensive Valuation Report contains a conclusion as to the value of a specific business interest that is based on a comprehensive review and analysis of the business, its industry and all other relevant factors, adequately corroborated and generally set out in a detailed Valuation Report.

Estimate Valuation Report

An Estimate Valuation Report contains a conclusion as to the value of a specific business interest that is based on limited review, analysis and corroboration of relevant information and is set out in a less detailed Valuation Report.

Calculation Valuation Report

A Calculation Valuation Report contains a conclusion as to the value of specific business interest that is based on minimal review and analysis economic and little or no corroboration of relevant information, and generally set out in a brief Valuation Report.

The type of valuation report selected will depend on the level of assurance required from the client. For instance, a valuation report prepared for financial reporting purposes may only require a report with a low level of assurance (e.g., a Calculation Valuation Report).

However, if the potential exists that a valuation report may be entered as expert evidence into Court (e.g., in a shareholder dispute or divorce matter), the assurance required in the valuation report would be higher, and therefore an Estimate or Calculation Valuation Report would be more appropriate.

Business Valuation Approaches

In valuing a business, the first factor that we consider is whether the business is still a going concern or if the business is not expected to continue operating profitably in the foreseeable future.

Thus, there are two fundamental approaches to the valuation of a business — the liquidation approach and the going concern approach. The approach which yields the higher value is the approach that must be chosen. This is consistent with the definition of fair market value, which incorporates the concept of the “highest” value.

The liquidation basis is used where the business is determined to not be viable as a going concern, or the return on the assets on a going concern basis is not adequate. This value is generally the net realizable value on an orderly disposition of assets made in a manner that would minimize the losses or taxes thereon.

The going concern basis assumes a business enterprise which is expected to continue to generate positive return on investments into the foreseeable future. Where the business has commercial value as a going concern, three approaches to valuation can be employed as discussed below:

  • Income approach;
  • Market approach; and
  • Cost/Asset approach.

Income Approach

The income approach measures the value of an asset by the present value of its future net economic benefits to be enjoyed over the life of the asset. These benefits may include earnings, cost savings, tax deductions, and proceeds from disposition.

The steps followed in applying this approach include estimating the expected cash flows attributable to the asset over its life and converting these cash flows to present value through discounting. The discount rate selected incorporates an appropriate return for time value of money, the expected rate of inflation, and any specific risks associated with the particular asset and the net economic benefit generated thereby.

Market Approach

The market approach measures the value of an asset based on what other purchasers in the marketplace have paid for companies which can be considered reasonably similar to those being valued. When the market approach is applied, data on comparable companiesare collected, including the prices paid for, and financial and operational information related to the reasonably comparable companies. Considerations and adjustments are made to the comparable companies, as necessary, to compensate for differences in financial condition, operating performance, economic, environmental, and political factors.

Asset Approach

The asset approach is based on the premise that a prudent third-party purchaser would pay no more for an asset than the cost to replace it with an identical or similar asset of equivalent utility - its replacement cost. To the extent that the assets being valued provide less utility than a newly constructed asset, the reproduction or replacement cost would be adjusted to reflect appropriate physical deterioration, functional obsolescence, and economic obsolescence.

The asset approach includes the adjusted net assets method. Under this method, a valuation analysis is performed for a company’s identified fixed, financial, and other assets, and the liabilities. The individual values of these assets are then aggregated, and the values of the liabilities are deducted to determine the value of the entity.

The asset approach is thus most appropriate for investment or holding companies which do not have independent operations.

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