Valuing Privately Held Companies
By Andre Pontoni | August 31, 2004
What is your company really worth and how can that worth be determined? As a qualified and experienced business valuator I prepare valuation reports for privately held companies. The valuation process is based on valuation theory and it also involves a significant amount of judgement.
Valuation: the overall picture
The definition under which privately held companies are valued assumes the "highest price available in an open unrestricted market, under no compulsion to act expressed in terms of cash". Simply put, a valuation is the highest cash purchase price assuming both parties have sufficient time to search for all available options. Both parties would have sufficient time to do due diligence and are not restricted in any manner.
When most people think of a business valuation, their perception is that the valuator will give an appraised value of the property, plant, and equipment. While this is true to some extent, it is not a complete picture. The purpose of a business valuation is to assess the intangible part of a business, namely the goodwill.
Goodwill is that component of value associated with a company's earning potential, which is not supported by tangible assets such as land, and building. Essentially, goodwill is what you would be paying for a company's good reputation with customers, suppliers, employees and an in place infrastructure required to generate the company's profits.
A valuation is designed to provide the user with the highest price a company is worth in the market place at a particular point in time. A valuation conclusion is expressed in cash terms and includes both the tangible assets of a company and the intangible components as well.
Gathering relevant information
Each valuation assignment requires the assessment of a number of variables. The valuator must assess:
- The maintainable income stream of the business and the ability of management to deliver. This is important because the key driver behind any valuation is directly related to the present value of a company's income stream. The higher the income stream the higher the value.
- The growth potential of a business and the risks associated with achieving certain targets. Again, this is important as the higher the income potential the higher the value. In addition, the higher the risks in achieving the income potential the lower the value, risk and value have an inverse relationship.
- A reasonable and defendable capitalization rate. The capitalization rate is essentially trys to capture the required rate of return an investor might see in a particular business. It typically includes a risk free rate of return and a premium for both internal and external risk factors inherent in a company. Issues such as economic dependence on customers and employees among other factors are included in the rate of return analysis. This is important as the riskier the company, the higher the capitalization rate, and the lower the value.
Selecting the best valuation approach
There are several accepted valuation methods. An experienced valuator will selected the best method based on the company's earning potential, asset base and its financial position.
A manufacturing company and a dot.com company may still use similar approaches depending on the earning potential of each and its asset base. A manufacturing company with low earnings may at times be valued using an asset-based approach. A dot.com company with low earnings and asset base may still be valued using an earnings approach, as this value may still be higher than an asset base approach.
If the business is not earning a sufficient return, the valuator may determine that a company is best valued using a liquidation approach which includes the liquidation value of assets less any amounts owing to third parties. That is, if a company is breaking even, a valuator may determine that the shareholders can take the proceeds from liquidating a company's assets and reinvesting them in alternative investments which will earn them a better income stream than if they were used in the operations.
Experience and know-how important valuation skills
An experienced valuator brings to bear a number of skills, which are of value to any business. Professional training, the ability to assess risks, the ability to uncover hidden value and losses, determining a suitable valuation approach and reconciling alternative approaches, coupled with a strong in-depth financial background are some of the ingredients required in a seasoned business valuator.
Different factors influence public sector valuations
Public companies are valued on the open market whereas privately held companies are not. In assessing value determined by the open market, careful consideration needs to be given to the market climate, and issues such as earnings reports, monetary policy and political issues, to name a few.
The above comments provide a general understanding of the issues involved with a valuation. The process is very specialized and requires the appropriate amount of training and experience. In understanding a company's worth today, you can better plan the future.