THE VALUATION PROCESS
The valuation process, carried out by experienced professionals, consists of a rigorous financial and economic analysis of the business. A careful review of historical financial statements, detailed information on the company’s products or services, plus our own preliminary independent research ensures a more productive due diligence meeting with the company’s management team. Our objective in the early stages of our engagement is to learn as much as possible about your company and its industry and outlook in order to assess ongoing earnings power and the risks associated with its business.
Three valuation approaches are commonly considered for use in valuing closely-held companies: the Cost Approach, the Income Approach and the Market Approach.
Cost Approach
The Cost Approach is based on the notion that a prospective buyer of a business would not pay appreciably more than it would cost to recreate the productive assets of the subject business. This method involves the discreet valuation of all of the subject company’s tangible and intangible assets and liabilities. In general, this valuation approach is used in cases where the subject entity is an investment or holding type entity, or where earnings power is not sufficient to warrant a “going concern” value in excess of the aggregate value of the entity’s discreet assets (particularly when a controlling interest is being valued).
Income Approach
The Income Approach involves the capitalization of historical measures of earnings or the discounting of projected future income at a rate that reflects the risk inherent in the subject company. There are variations of this approach, including the discounted cash flow method (DCF). The DCF approach to valuation embodies the most fundamental proposition in finance, which is that the value of any income-producing asset is the discounted or present value of all future cash flows that can be expected from the investment.
The DCF analysis consists of two basic steps: the projection of “free cash flows” and the selection and application of an appropriate discount rate to those expected free cash flows. The projection of free cash flows forces the analyst to explicitly consider expected growth rates, cash expenses and reinvestment requirements in arriving at an estimate of the subject company’s value. The selection of an appropriate discount rate forces a careful consideration of the risk that is inherent in an investment in the subject company, i.e. the risk that actual cash flows will not be as favorable as those projected.
Market Approach
The Market Approach typically involves the selection of public companies with investment attributes as similar as possible to the subject company. This information is used to derive meaningful standards of value that can be applied to the subject company (the Guideline Company Approach). Alternatively, the analyst can identify transactions involving the sale of companies, private or public, with similar investment characteristics to the subject company; if sufficient information regarding these transactions is available, then useful valuation standards can be formulated.
Use of the Market Approach for the valuation of business interests recognizes the reality of the marketplace for securities, which is that investment decisions are not made in a vacuum. The marketplace contains a wide variety of investment choices with different risk and return characteristics. Investors are constantly striving to achieve the highest return for a given level of perceived risk, or to incur the lowest degree of risk for a given return. This process is by its very nature comparative.
The documentation of our analysis and conclusions depends on the client’s needs. Documentation can consist of a formal detailed report with supporting charts, tables and exhibits, or it can be as brief as a short letter. In all cases, we strive to present our findings in a manner that is technically accurate and as jargon-free as possible. In many cases, a well written valuation report will help stakeholders achieve their goals, whether it be tax compliance or transparent financial reporting.