Business Valuation Considerations

by Steven Rayson

 

value considerationsA business is typically valued using one or more of the following valuation methodologies, or business valuation considerations, as the title of the article states:

  • Asset approach – which adjusts the reported net book value of the net assets of a company to their respective fair market values.
  • Income approach – which is based on the future income generating ability of an entity adjusted by the risks inherent in achieving the future income streams.
  • Market approach – which ascribes a value to the company based on pricing parameters implied by comparable publicly traded companies or transactions of comparable companies[1].

The most common valuation methodology utilized by valuation practitioners is the income approach, especially where the subject company has a history of profitability with a consistent earnings stream.

The capitalized earnings[2] approach is an income approach based on the maintainable after-tax earnings a business is expected to generate. This involves a consideration of the business’ historical results and future prospects. The maintainable after-tax earnings is then capitalized by a multiplier, which serves as a measure of the rate of return required by a prospective investor of the business reflecting, among other factors, the risk inherent in achieving the determined level of maintainable earnings.

The risk factors that typically influence the selection of a multiplier include:

Favourable: Higher multiple:

  • Long lasting customer relationships, contractual/recurring, diversified
  • Historical pattern of consistent, sustained earnings, growth
  • Strong management team, capable of meeting forecasts
  • Pipeline (e.g. innovation, contracts)
  • Diversity (geographic, product)
  • Barriers to entry (brand, market share, regulatory, investment)
  • Healthy balance sheet, size of business
  • Growth potential

Unfavourable: Lower multiple:

  • Customer concentration (overreliance on key customers), non-contractual
  • Volatile or declining earnings, hockey stick forecast
  • Over-reliance on owner relationships (personal/non-transferable goodwill)
  • Poor industry outlook
  • Out of date processes, systems, equipment, infrastructure
  • Generic product/brand/service
  • Supply/distribution/operation issues
  • Product in tail end of life cycle, lower growth potential

The selection of an appropriate multiplier after considering the appropriate inherent risks will ultimately affect the fair market value of the business. Therefore, the stakeholders of an entity must be cognizant of, and manage to their best abilities, these valuation risk factors in order to maximize the value of their business.

[1] Given the difficulties in finding truly comparable companies, this approach is most often used a secondary approach to corroborate valuation conclusions derived using the asset or income approaches.
[2] The capitalized cash flow approach may also be used with cash flows being a proxy for the future income-generating ability of the entity.

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