3 things about Livingstone s Guide to Business Valuation
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1 Book Information 3 things about Livingstone s Guide to Business Valuation 1. Designed to provide an introduction for students not experienced with the subject 2. Also serves as a refresher for those familiar with valuations 3. A short (50 pages) affordable primer,; includes progress tests with answers! See following pages for Table of Contents and Introduction.
2 Guide to Business Valuation Les Livingstone MBA, Ph.D., CPA University of Maryland University College
3 GUIDE TO BUSINESS VALUATION Les Livingstone, Ph.D., CPA (NY and TX)
4 Contents Introduction 1 Learning Objectives 1 Reasons for Valuing Businesses 1 Events Providing a Need for Business Valuation 2 The Business Interest to be Valued 2 The Standard of Value 3 The Premise of Value 4 The Premise of Value: An Example 5 The Standard of Value and the Premise of Value 5 PROGRESS TEST #1 7 Valuation Approaches 9 Approaches to Business Valuation 9 The Market Approach 10 Comparable Businesses 11 PROGRESS TEST #2 17 Approaches to Business Valuation 19 The Income Approach to Valuation 19 Determining Risk-Based Rates of Return 27 Summary of The Two Approaches to Business Valuation 34 PROGRESS TEST #3 37 Valuation Premiums and Discounts 39 PROGRESS TEST #4 43 Sanity Checks 46 Valuation Checklist for Completed Valuations 57 INDEX 49 iii
5 Introduction This guide covers the basics of business valuation, and serves as an introduction for those who are not experienced in this area. It also serves as a refresher for those who seek review and updating in business valuation. The guide covers the following key topics: What is value? What standards of value should be used in business valuations? What are the various valuation methods, and how are they applied? When to use the different methods of valuation? What is the impact when a majority or a minority interest in a business is being valued? How to allow for lack of marketability of the business interest being valued? How to pull it all together to finalize the valuation conclusion? Learning Objectives The learning objectives for this guide are as follows: Understanding the reasons for valuing businesses Specifying the business interest to be valued Establishing the: Standard of value Premise of value Learning the various categories of valuation methods Calculating value under each method of valuation Determining which methods of valuation apply in different situations Estimating: Capitalization rates Discount rates Reviewing, adjusting and analyzing the financial statements Performing the valuation by means of the selected valuation methods Determining the relevant premiums and/or discounts Finalizing the valuation conclusion Reasons for Valuing Businesses Companies whose stock is publicly traded in the financial marketplace are constantly being valued and revalued as their shares are bought and sold by investors. These valuations are reflected in the fluctuating prices of their stock. 1
6 2 Guide to Business Valuation But stock in closely held businesses is not publicly traded, and so there are no stock prices to reflect their valuations in the financial marketplace. If and when a need for a valuation arises, that valuation will have to be specifically performed. In fact, the need for a valuation of a closely held business usually does occur from time to time. The need for a valuation is often triggered by a particular event. The following is a list of events that typically create a need for a valuation of a closely held business. Events Providing a Need for Business Valuation The following events are likely to require a valuation of a closely held business: Buying or selling a full or partial interest in a business A business merger or acquisition Admission or retirement of a partner in a business Property division in a divorce, when marital property includes an interest in a business Payment of estate or inheritance taxes involving an interest in a business Estate planning Preparing personal financial statements including an interest in a business Employee Stock Ownership Plans (ESOPS) require valuation of employer securities upon their acquisition by an ESOP, and at least annually thereafter, under the Employee Retirement Income Security Act of 1974 (ERISA) and the Internal Revenue Code Dispute resolution in cases where damages must be determined for lost value of a business, such as breach of contract, patent infringement, franchise disputes, antitrust suits, eminent domain, lender liability, and dissenting stockholder suits. The Business Interest to Be Valued In some cases, the valuation involves a 100% interest in the subject business. In other cases, only a fractional interest may be the subject of valuation. It is most important that the nature and extent of the business interest to be valued be clearly determined at the start of the valuation engagement. The valuation may involve a 100% interest, a majority interest less than 100%, a minority interest, or possibly a 50% interest which is neither a majority nor a minority interest. 2
7 Guide to Business Valuation 3 Usually a valuation is made of the business as a whole. Then this valuation is adjusted to the fractional interest involved. For example, if the fractional interest involved is 50%, the valuation of the business as a whole would be multiplied by 50%. This result may then require another adjustment, such as the application of a premium or a discount. In the case of a majority interest, it may be necessary to include a control premium in the valuation, and in the case of minority interest, a minority discount may need to be deducted from the valuation. Further, in the valuation of a business interest that does not consist of marketable securities, a discount for lack of marketability may need to be taken into account. The valuation methods to be used may be affected by the use of a control premium or discounts for a minority interest or a lack of marketability. Therefore it is important to be absolutely clear at the beginning of the valuation engagement about the nature and extent of the business interest to be valued. The Standard of Value The term valuation and the term appraisal are usually considered to be synonyms, and will be so treated in this guide. For our purposes, an appraisal is a valuation. But what actually does value mean? There are several different standards of value, including the following: 1. Book value is the amount reflected in the financial statements for owner equity (assets less liabilities). The assets are usually stated at historic cost, reduced by appropriate allowances for: a. depreciation or amortization (in the case of depreciable fixed assets), b. spoilage, shrinkage or obsolescence (in the case of inventories) c. uncollectible amounts (in the case of accounts receivable) 2. Investment value or strategic value is value to a specific individual investor, as opposed to an objective impersonal market value to investors at large. For instance, a uranium mine is probably worth more to a purchaser who has access to nuclear technology than to a purchaser who lacks such access. A steel plant that emits excessive pollution is probably worth more in a region that has no anti-pollution restrictions than in a region with strict environmental laws. The concept of investment value is value-in-use, rather than value-inexchange, which is market value. 3. Fair value this term means whatever it is defined to mean by the relevant case or statute law, or industry trade practice or some other source. 4. Fair market value this is defined in the Business Valuation Standards of the American Society of Appraisers as the price at which a willing seller would sell a business to a willing buyer, when neither party is under compulsion and 3
8 4 Guide to Business Valuation both parties have reasonable knowledge of the relevant facts. A similar definition is contained in the Internal Revenue Code and in Revenue Ruling These definitions assume an arms-length transaction between unrelated parties, with each party acting in its own best interests, and based on a cash price unaffected by creative financing or other side issues. In brief, fair market value represents a genuine free market price. Fair market value is the most widely accepted standard of value used in business valuations. It is the legal standard in virtually all business valuations for federal and state tax purposes, and it is the standard for most other types of business valuations, except in cases where a different standard is expressly agreed upon or imposed by some legal requirement. For example, a partnership agreement may specify that newly entering partners must acquire, and that retiring partners must sell their partnership interests at book value, based on Generally Accepted Accounting Principles (GAAP). In that case, all sales of individual partnership interests between incoming and departing partners will take place at GAAP book value. However, if the entire partnership as a whole were to be sold (say to a larger firm), the partnership agreement would probably not apply, and the sale would probably be based on fair market value. This shows how important it is to determine the standard of value before performing any business valuation. Fair market value will usually be the standard, but that should never be taken for granted. In every case, it is necessary to determine the relevant standard expressly, and not automatically assume that fair market value will apply simply by default. The Premise of Value It is essential to understand that the value of a business depends to some extent on the manner in which it is sold. A business may be sold as a whole, or broken up and sold piecemeal. In either case, the sale may be made on an orderly basis, or as a forced liquidation. A forced liquidation may take place at all deliberate speed, or more rapidly, perhaps by auction. Normally, in the case of a controlling interest, the manner of sale will be based upon the highest and best use of the combined assets of the subject business. The manner of sale is known as the premise of value. The premise of value can be visualized as shown in Table 1. Table 1 Premise of Value A. As a Whole B. Broken Up 1. Orderly basis i. Going concern, or Piecemeal: Orderly ii. In combination 2. Forced liquidation i. Going concern, or Piecemeal: Forced ii. In combination 4
9 Guide to Business Valuation 5 The Going Concern basis is value-in-use, and the In Combination basis is value-in-place. The two Piecemeal bases represent value-in-exchange, either of an Orderly or Forced nature. It is clearly important to determine the premise of value before performing any business valuation. Going Concern value will often be the standard, but that should never be taken for granted. In every case, it is necessary to determine the relevant premise of value expressly, and not automatically assume that Going Concern value will apply by default. The Premise of Value: An Example The Breakers in Palm Beach, Florida, is a famous, luxury resort hotel. It has operated successfully for many years, and continues to be a vigorous going concern. However, if asked to value a 100% interest in The Breakers, it would not necessarily be appropriate to adopt a going concern premise of value. The prices of real estate in Palm Beach have escalated significantly in recent years, and conceivably The Breakers could be worth more than its hotel going concern value if its rooms were to be converted into condominiums, and sold off unit by unit. In that event, the appropriate premise of value would not be as a going concern, but rather as a piecemeal sale on an orderly basis. As a matter of fact, some former hotels in Palm Beach have in the past undergone condominium conversions. Therefore the alternative of condominium conversion is a premise of value that should not to be overlooked when considering a valuation of The Breakers. The Standard of Value and the Premise of Value Whatever the premise of value may be, it can still involve the fair market value standard with its willing buyer(s) and willing seller(s). Willing buyers and sellers can agree on transactions that are composite or piecemeal, and on an orderly or forced liquidation basis. Therefore the standard of value is not to be confused with the premise of value. Despite some similarity in name, the standard of value is separate and distinct from the premise of value. In order to keep these two important concepts apart in our minds, it may be helpful to review the following summary: 1. The standard of value is the type of value involved, for example: a. book value, b. investment or strategic value, or c. fair market value. 5
10 6 Guide to Business Valuation 2. The premise of value is the manner of sale, for example: a. as a whole, b. broken up, c. orderly sale, or d. forced sale. 6
11 Guide to Business Valuation 7 Progress Test 1 Test yourself by answering the following questions. Try to answer without looking back. 1. Which events usually create a need for a business valuation? a. Dispute resolution involving lost profits damages b. Liquidation of an insolvent business c. Inheritance of publicly traded securities d. A business merger or acquisition e. A divorce dispute over alimony 2. Where applicable, business valuations should take into consideration: a. A minority interest premium b. A control discount c. A discount for lack of marketability 3. The Standard of Value: a. Is usually, but not always, a going concern b. Is occasionally based on a forced sale c. May be as a whole or broken up d. Is normally fair market value 4. Name a valid basis for the Premise of Value: a. Book value b. Fair value c. Orderly sale d. Investor value 5. The Going Concern basis is: a. Value-in-place b. Value-in-use c. Value-in-exchange d. Value-in-combination 7
12 8 Guide to Business Valuation Answers for Progress Test #1 1. Which events usually create a need for a business valuation? a. Dispute resolution involving lost profits damages b Liquidation of an insolvent business c. Inheritance of publicly traded securities d. A business merger or acquisition e. A divorce dispute over alimony 2. Where applicable, business valuations should take into consideration: a. A minority interest premium? b. A control discount? c. A discount for lack of marketability? 3. The Standard of Value: a. Is usually, but not always, a going concern? b. Is occasionally based on a forced sale? c. May be as a whole or broken up? d. Is normally fair market value? 4. Name a valid basis for the Premise of Value: a. Book value? b. Fair value? c. Orderly sale? d. Investor value? 5. The Going Concern basis is: a. Value-in-place? b. Value-in-use? c. Value-in-exchange? d. Value-in-combination? If you answered almost all questions correctly, congratulations and move on. If not, it would be wise to review and retest before continuing. 8
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