More to Business Valuation than Meets the Eye

Most business owners and attorneys know the basics of the business valuation process. For example, you might know that there are three approaches to value: the cost, market and income approaches. You might even know some of the methods that fall under these approaches, including the:

• Adjusted book value,
• Excess earnings,
• Guideline public company,
• Guideline transaction (merger and acquisition),
• Capitalization of earnings, and
• Discounted cash flow.

But experienced laypeople also understand that the process of valuing a business is not simply a matter of plugging numbers into these "black boxes" and having the answer spit out the other end. Instead, the valuation analyst uses professional judgment to arrive at a reasonable conclusion of value.

Factors to Consider

Arriving at a reliable value starts with the subject company's financial information, including tax returns and financial statements from the last three to five years. Valuators also consider forecasts, projections and business plans.

But a comprehensive valuation goes beyond the numbers. It includes site visits, management interviews and an evaluation of the nonfinancial factors that impact value.

Valuators rely on various professional standards and publications to guide them through this part of the valuation process. These tools help appraisers know what information to request and what questions to ask.

For example, the AICPA Statement on Standards for Valuation Services No. 1 suggests the following nonfinancial information to consider when valuing a business:

• Nature, background and history of the subject company,
• Facilities,
• Organizational structure,
• Management team (which may include officers, directors and key employees),
• Classes of equity ownership interests and rights attached thereto,
• Products or services (or both),
• Geographic markets,
• Industry markets,
• Key customers and suppliers,
• Competition,
• Business risks,
• Strategy and future plans, and
• Governmental or regulatory environment.

This list is similar to what's included in IRS Revenue Ruling 59-60, which addresses the valuation of closely-held stock for tax purposes. This ruling is also commonly referenced for nontax valuations.

Beyond These Four Walls

Many of the items valuators consider relate specifically to the subject company. However, valuation analysts also consider external factors that impact value. These factors affect every business differently, requiring appraisers to make subjective judgment calls. To illustrate, consider these four examples:

1. Market conditions. An appraiser's conclusion is only valid as of a specific point in time. Suppose the subject company is a restaurant located in a small, rural community that recently lost its major employer. Here, the restaurant's value would likely be adversely affected by its current market conditions.

On the other hand, if the restaurant were located in a town with a prosperous economy—despite a weak national economy—the local market conditions might increase the value of the restaurant. In some cases, a severe, ongoing economic situation, like during the COVID-19 pandemic, can have a dampening effect on almost every business no matter where it's located.

2. Regulatory environment. Government regulations can also impact the value of a company. For example, the Affordable Care Act (ACA) could increase overhead costs and, therefore, decrease future cash flows for companies with 50 or more full-time equivalent employees.
3. Competition. A company that operates in an industry with low barriers to entry—such as a product promotion firm—faces ongoing, often unforeseeable, competition. Anyone with a computer, inexpensive design software, the ability to sell and a creative mind can run this type of operation. The valuation analyst needs to determine the competitive situation, including how such a practice differentiates itself from the competitors, when determining value.

Conversely, a business that operates in an industry with high barriers to entry might not be as concerned about new competitors entering the marketplace. For instance, a manufacturer of products made from tungsten, an expensive and volatile commoditized metal, might find itself in a good competitive position because handling tungsten requires specialized facilities and training.

4. Industry outlook. The state of the company's industry also impacts value. For example, a company that operates in a declining industry—such as direct mail—may not be worth much more than its liquidation value, even if it has years of positive operating cash flows. Conversely, companies in emerging growth markets—such as technology service providers—may be worth more than their historic financial performance might suggest. The value of these firms may, instead, be based on speculative future earnings estimates.

Putting the Pieces Together

It's often said that valuation is an art as much as a science. Valuation analysts piece together various types of internal and external data to get a complete picture of how much a business is worth. The process requires more than dropping numbers into a black box. Like a trained artist, valuators use their professional tools, accepted methods and business experience to finesse the data into reliable value conclusions. Attorneys and business owners who understand what happens behind the scenes can facilitate the valuation process.