Understanding business valuation for divorce litigation (part II of III)

The commonly used methods of valuation are categorized into three primary approaches. The three approaches are the asset, income and market approaches. Each method uses its own theoretical basis and mathematics. The independent results of each method can produces sometimes significantly different valuation results.

Asset Approach

The asset approach looks at the market value of the assets of the company and subtracts the market debt to produce a net realizable value of the business entity. This approach looks to obtain the economic worth of the tangible, intangible and other assets of the entity in excess of the outstanding debts. Using this approach, there are two common methods for determining the economic worth of the entity; they are the book value method and the adjusted net asset value method.

Book Value Method

The book value method is primary based upon the accounting concept of historical value. When you purchase a physical, hard asset, it is placed on the books or balance sheet at its purchase price amount. Depreciation is generally applied as a deduction from value over the useful life of the asset. For example, a depreciable manufacturing machine purchased and installed may represent an expensive transaction from an accounting perspective. Generally, external costs such as interest, installation and outside contractor fees are added to the asset value and depreciated over time. These costs are considered to be book value (or commonly accounting value). "Book value" references the way accountants traditionally record items on the balance sheet, at its historical cost. The same asset's value to an independent third party however, may be minimal.

Most liabilities are recorded at their face or present value at the time the liability is incurred. As the debt principle is paid, the balance of what is owed is reduced. Unlike most assets, the book and market value of debt is usually the same as what is stated on the balance sheet.

In accordance with Generally Accepted Accounting Principles (GAAP), soft or internally developed intangible assets such as trademarks, trade names, logos, patents and goodwill are not recognized as assets. Rather, internal costs are expensed as they incur. These costs do not necessarily have anything in common with the current market value of the asset to an independent purchaser.

Book value is frequently irrelevant beyond a historical yard marker and in specific circumstances. For example, book value determines capital gains for sale purposes and S Corp conversions. It is also referenced in many buy/sell agreements. In banking, the carrying book value of most loans has already been subjected to market principles. Therefore, in the context of banking industry, book value is more prevalent as a primary consideration of value (because the loans are at market). In most cases, book value does not reflect the current market value of assets. Value is a market concept, not a historical cost.

Adjusted Net Asset Methods

The adjusted net asset method is based on the current market value of the business's assets and liabilities. Using this approach, assets and debts are adjusted from book value to their current fair market value. Unlike the book value method, fixed assets, patents, logos, trademarks and other goodwill items are listed at their current fair market value as of the date of the valuation irrespective of their historical cost. For example, real estate would be listed at its current fair market value.

There are two premises to the adjusted net asset method: going concern value and liquidation value. As a going concern assets are generally valued as a cohesive unit in production. In liquidation value, assets are assumed to be broken up and sold in pieces. The proceeds thereon are netted against selling costs such as auctioneer fees, brokerage fees, sale preparation costs, advertising, etc.

Liquidation value has two forms, forced liquidation and orderly liquidation. An orderly liquidation assumes the sale of the assets will be conducted in a manner that maximizes value. In other words you would not want to liquidate a Christmas decorations supplier in the summer; you would wait until winter to sell the assets. An orderly liquidation will yield a higher value than a forced liquidation. Many times, lenders look at liquidation values as hedges against loaned proceeds. This presents the lender with the "worst case" scenario in which they would be forced to foreclose and subsequently sell pledged assets at a discount.

The asset method does not address business earnings. Rather, it considers only the market value of jettisoning the current assets to a real or hypothetical buyer. This methodology is prevalent in asset intensive businesses such as real estate holding companies, mineral or raw resource companies, or companies with sustained operating losses. Companies which experience sustained losses deteriorate the underlying asset value by causing the entity to acquire more capital or sell assets in order to sustain ongoing cash losses. Therefore, these companies may be worth more at break up than as a going concern.

Income Approach

The income approach considers the economic earning capacity of the business. Assets are placed into useful production whether they are real or intangible, human capital or fixed machinery in order to produce a return to the business owners and investors. The return to investors and owners is quantified as either cash or net income over a period of time. The perceived value and risk of the future cash flows is what gives a business value at a given point in time. The underlying theory of the income approach is that the value of the business is the sum of the present value of its future cash flows.

This is the same way income instruments are valued. For example, assume a $1,000,000 certificate of deposit pays 5% interest annually. The cash flow from this instrument is therefore, ($1,000,000 x 5%) $50,000 every year. In this example, we knew the principle amount, $1,000,000 and the interest rate, 5%. The annual payment by multiplying the principle by the interest rate to produce the yearly cash flow of $50,000.

Valuing a business with the income approach is similar to this calculation. Using the above example, if the cash flow is $50,000 per year and the risk associated with receiving $50,000 is 5%, the principal is derived by dividing the cash flow by the risk rate. $50,000 divided by 5% equals $1,000,000. In other words, we would pay $1,000,000 to safely receive $50,000 annually.

Income approaches in business valuation are determined by the benefit stream expressed as either cash flow or net income. Next, the risk rate associated with earning the benefit stream is determined. Using these two factors, an entity's gross value (like the principal value determined above) can be calculated by dividing the benefit stream by the risk rate.

Business value has an inverse relationship to business risk. As business risk increases, the value of the business decreases. Using the above example with a $50,000 annual cash flow, instead of a bank paying 5% assume that the company's investment risk is determined to be 20%. The calculated value of this investment is $50,000 divided by 20% or $250,000. For the same right to earn $50,000, the investment in the company is valued at $250,000 while the bank investment instrument is worth $1,000,000. In this example, there is a greater chance of losing some or all of the invested capital by investing in a risky business rather than investing in the security of a bank CD. Therefore, the rate of return required to invest in a business is higher than the rate of return paid by a bank.

There are several methods to determine business value within the income approach. The methods include single period capitalization, multiple period capitalization, excess earnings, and discounted future cash flows to name a few. Irrespective of the method, there are fundamentally two underlying factors at play, the benefit stream and the risk rate of realizing that particular benefit stream.

Basics of Risk Rate Components

Risk rate models are comprised of individual components added together to produce the overall investment risk of a particular business entity. The risk components are subdivided into two categories: systematic risk and nonsystematic risk. Systematic risk is the risk inherit with investing in the publicly traded stock market. Systematic risks are further quantified into subparts as follows: the risk free rate, the equity risk premium, and the size premium.

The risk free rate is based on the yields of U.S. Treasury bills. This return is considered "risk free" because the United States has never defaulted on an obligation (yet..!). The "equity risk premium" is the difference between large-cap stock total returns and U.S. Treasury bill total returns.

The size premium is based on the observation that publicly traded small companies tend to have higher rates of return associated with them compared to publicly traded large companies. Smaller firms do not possess the array of resources larger firms have available. For example, larger firms are better able to weather a downturn in business, can generally spend more on research and development, have a greater access to financial capital, and are able to attract human capital more easily compared to smaller firms. As a consequence, investments in smaller companies are riskier, (thus the greater rate of return). This incremental risk distinction between large companies and small companies is quantified as the "size premium."

Non-systematic risks in business valuation is comprised of the industry risks in which the company operates and the risk associated specifically with this company. Industry risk is the incremental risk associated with the performance of a particular industry. Certain sectors of the economy outperform other sectors of the economy. Industry risks vary based on the performance of the overall economy at any given point in time. If the outlook is positive, the industry risk will be less than if the outlook is negative.

Company specific risk is determined by the business valuer. Company risk is based on several factors such as the financial strength, depth of management, diversity of clients/products, business continuity planning, geographic region, etc. Business valuer's use subjective judgment to calculate a company's specific incremental risk.

Adding these incremental risks produces the overall risk associated with investing in a particular company. The process of adding incremental risks is commonly known as the "buildup method." To calculate a business's value, long term growth is subtracted from the overall company risk. This formula is expressed as: business value = case flow / (risk rate - growth).

Market Approach

The market approach is based on data collected regarding the sales of similarly situated companies. The market approach assumes the risks inherent in the observations are similar to the risks inherent in the subject company. This is analogous to the real estate appraiser's approach to value which compares the value of neighborhood houses to the subject house.

A comparative scale, similar to the price per square foot common in real estate, associates the valuation subject to the market observations. For example, publicly traded stocks are commonly quoted relative to their price-to-earnings ratio. In other words, at what price does a stock trade relative to its earnings? For a company that trades at 10 times its earnings per share, earnings of $12 per share produces a stock price of (10 x $12) $120. Therefore, if our subject company earns $8 per share, multiplying the observed ratio of 10 times earnings per share, by the subject company's $8 of earnings per share produces a stock value of $80 per share. Once the share price is determined, the market value of equity can be derived by multiplying the total number of shares by the price per share.

Dealing with Competing Methodologies and Results

Which approach is the most appropriate? Each approach produces a unique business value. Each approach is best under certain valuation circumstances. For example, the asset approach is generally best for real estate holding companies or stock investment companies. In operating companies, the asset approach serves as a floor to value. If the operating assets are worth more broken up and sold in the market rather than assembled in the production of income, then the asset approach may be the best indicator of value. For example, in companies that lose money, value can be preserved by selling the assets rather than absorbing additional losses. Therefore, if the income approach yields a value that is less than the asset approach, the company is worth more broken up than held together.

Market approaches are useful for franchises and frequently traded business interests. In operating companies, the market approach tends to be a ceiling to value. This is because an upward bias in the reported sales of companies may be present. Many times, firms buy other firms for synergistic reasons. As a result, the price paid for a synergistic purpose inflates the multiples used to value the subject company. Experts should screen the comparable company data for this effect.

The income approach analyzes the overall economic earning capacity of the subject entity and applies a specific risk rate to the business. Business valuers typically have reasonable access to detailed company data and financial statements. This allows the business valuer the opportunity to develop an informed understanding of the environment in which the company competes. As a result, business valuers often prefer the income approach.

As shown in Table 1, business valuers can use the results from all three approaches or use the result from a single approach.

When using all three approaches, a weighting is applied to each approach. The resulting valuation conclusion is a combination of the business valuer's reliance on each approach. This issue with this approach is that the weighting assigned by the business valuer is subjective. IRS Rulng 59-60 discourages this practice "No useful purpose is served by taking an average of several factors ... and basing the valuation on the result." 