This blog post is from Edward C. Fowler, CFA, ASA, the President of Financial Valuation Services, LC. Mr. Fowler has 18 years of full time experience performing valuations of businesses, business interests, and intangible assets. He holds a Finance Degree from the University of Texas at Austin and a Master of Business Administration from Texas A&M University. He is designated as an Accredited Senior Appraiser (ASA) in Business Valuation by the American Society of Appraisers and as a Chartered Financial Analyst (CFA) by the CFA Institute. Mr. Fowler has provided testimony in both State and Federal Court. In addition, Mr. Fowler was appointed and served as Court Master for the 192nd District Court of Dallas County, Texas, regarding the value of a closely held business and interests therein.
Anyone owning an interest in a private company may face questions about its value. However, you can’t just look it up on the Internet or in the Wall Street Journal. So how do you determine the value of a privately-held business interest?
There are three generally accepted approaches used to determine the value of a business: the asset approach, the market approach, and the income approach.
When using the asset approach, one first determines the value of the assets owned by the company. Subtracting the value of its liabilities produces an indication of net asset value, or the value of the company’s equity.
The market approach entails valuing a company through the use of valuation yardsticks taken from either prior sales of the subject company’s stock, the prices at which the stock of similar public guideline companies trade, and/or transactions in which entire guideline companies changed hands in the merger and acquisition markets. A guideline company is one which is similar to the subject company in terms of products or services sold, size, markets, customers, suppliers, outlook, etc.
The income approach is used to determine the value of the future economic benefits derived from owning the business. Such economic benefits can include dividends, earnings, and cash flow. In applying the income approach, the amount and timing of the expected future economic benefits or earnings are first projected. Then, the projected earnings are capitalized or discounted back to present value using an appropriate required rate of return.
There are several definitions of value that can be applied in valuing a business. The most common definition of value used is fair market value. Fair market value is the cash or cash equivalent price settled on between a hypothetical willing buyer and a hypothetical willing seller, both knowledgeable of the relevant facts, and neither under compulsion to buy or sell. Depending on the approaches and methods used, certain adjustments may be needed to convert an indication of value into the fair market value. Two common adjustments are to reflect the marketability, or lack thereof, of the subject business interest and the subject business interest’s ability to control the company. The concept of marketability deals with the liquidity of the subject interest; that is, how quickly and certainly it can be converted to cash. The control issue relates to the subject interest’s ability to control the operations of the business.