Information and data is widely available on the value of most investments, satisfying our expectations of instant information. Free-trading markets around the world provide up-to-date market prices for publicly-traded securities. As an owner of a closely held business or security, however, pricing information is not available. So how does the owner of a closely-held business, or the owner of closely-held securities, determine the value of their investments?
To value closely-held businesses/investments, often times a valuation firm is engaged. Valuation firms specialize in the development of value estimates for, among other things, closely-held businesses and securities. Business owners may ask for a “back of the envelope” value of their company or what are current multiples in my industry? Unfortunately, there is really no simple answer or all-encompassing “rule-of-thumb” – rather, value depends on many assumptions, variables, and methodologies. This article will highlight some of the key concepts that are considered when conducting a valuation of a closely-held company.
Purpose of Valuation: Depending on the purpose, each valuation approach could have a different value premise. A value might be necessary for an owner gauging the value of the investment. Other valuations may be driven by tax reporting purposes requiring a fair market value.
Valuation Approaches: More than one valuation approach is generally desirable because each provides a check on the other measures of value. In some cases, three approaches (income, asset or market-based approaches) are applicable. But normally, one or two approaches are utilized. The approach or combination of approaches applied will depend on the specific purpose, the subject business or industries, and the quality of information available.
The preferred method for most closely-held businesses is the income approach, as it takes into account the specifics of the operations that make it unique. The income analysis begins with expectations of revenues and cash flows based on financial analysis, industry and market trends, and management opinions encompassing a business cycle. Anticipated cash flows are adjusted for the time value of money and the risks inherent in the business (discount rate). Components of the risk characteristics are the accuracy of the sales forecasts, the income/expense relationships, and the amount and the timing of capital expenditures. To derive the true economic value of a closely-held company, it is often necessary to adjust assets, incomes and expenses (i) to reasonable economic levels; (ii) for unusual items; and (iii) for inconsistencies. It is also important to isolate assets which are not essential to the operations of the business and consider them separately. These non-operating assets often consist of real estate and non-essential working capital.
In most cases, there are no directly comparable public companies as each closely-held company is unique. A valuation expert will look beyond operating performance to also consider financial condition relative to those of publicly-traded companies operating in the same or similar lines of business.
Depending on the industry in which the closely-held company operates, one might consider sales, earnings, cash flow or earnings less capital expenditures.
Earnings multiples reflect expected earnings risk and growth. A company with low growth potential and a very uncertain future could have a lower earnings multiple than a company with high growth potential and a very stable future. Factors that affect earnings volatility include market recessions, size, financial and operating leverage, and product and customer mixes. External growth potential is predicated on market demand. Internal growth is related to asset utilization, debt utilization and relative profitability. A company that has an asset turn-over ratio that is below its long-term average level can often improve earnings or cash flows through better asset management. A company that has a low debt-to-equity ratio can grow faster than a highly leveraged firm because expansion plans can be financed with nondilutive debt rather than dilutive equity financing. Finally, a company that has a profit margin which is above industry levels is less likely to grow earnings through margin improvements than a company with below-normal profit margins.
Similar to the guideline company method, the guideline transaction method uses current (most recent available) financial results of operations as the basis for computing an indication of value. Price multiples are derived from publicly traded or acquired companies and applied to the Company’s earnings stream. The reliability of the methods depends upon the degree of comparability between the company and the comparison companies. The degree of comparability between the Company and the publicly-traded or the acquired companies is determined by comparison of business operations and recent financial results and prospects. Whereas the guideline company method considers comparable company multiple data, the guideline transaction method is based on actual market transactions of companies within the same or similar industries as the subject company.
The cost or asset-based approach includes the asset accumulation method which examines the company’s assets less its obligations. This approach recognizes that all of the economic value of a company has to come from its productive assets. In the case of a profitable company, an asset-based approach would not capture the future earning capacity of the company. Instead, a cost approach might be utilized for holding companies, marginally profitable companies, or industries where ownership of tangible assets is a key determinant of success.
Lastly, while beyond the scope of this article, one could also consider value adjustments for lack of control associated with a non-controlling interest and adjustments for lack of liquidity and marketability. These adjustments are guided by extensive analysis and need to be defensible in case of a challenge.
In the end, many factors of a business must be considered when answering the question “what is the value of my closely held business” The answer will likely be, “It depends…”