Business Valuation

August 21, 2020

The value of any business is the present value of its future cash flows. This sounds simple; however, a valuation is generally a complex endeavor. One must consider several approaches, methods, and factors in the valuation of closely held companies. No formula can be devised that will be generally applicable to the different valuation issues that arise.

Oddly enough, an IRS Revenue Ruling from 1959 (59-60) provides the foundation for modern valuation theory. The fundamental factors mentioned by 59-60 required for valuation analysis include:

The nature of the business and the history of the enterprise from its inception;
The economic outlook in general and for the specific industry in particular;
The book value of the stock and the financial condition of the business;
The earning capacity of the company;
The dividend-paying capacity;
Whether or not the enterprise has goodwill or other intangible value;
Sales of the stock and the size of the block to be valued; and
The market price of stocks of companies engaged in the same or a similar line of business having their stock actively traded in a free and open market, either on an exchange or over-the-counter.

Together with these factors, there are three general approaches or methods used in valuations of closely held companies:

Income Approach – The income approach is a general way of determining a value indication of a business, business ownership interest, security, or intangible asset using one or more methods that convert anticipated economic benefits into a present single amount;
Market Approach – The market approach is a general way of determining a value indication of a business, business ownership interest, security, or intangible asset by using one or more methods that compare the subject to similar businesses, business ownership interests, securities, or intangible assets that have been sold; and
Asset Approach – The asset or cost approach is a general way of determining a value indication of a business, business ownership interest, or security using one or more methods based on the value of the assets net of liabilities.

The approach given the most weight depends on the nature of the entity and the circumstances in each case. For example: earnings are given primary consideration when valuing stocks that sell products and services. Conversely, the adjusted net worth of an investment or real estate holding company should be given more weight than the earnings capacity.

In the application of the income approach, it is necessary to capitalize the estimated ongoing cash flows at some appropriate rate. A determination of the proper capitalization rate presents one of the more difficult problems in valuation. The capitalization rate for a given company depends on the nature of the business, the risk involved, and the stability or irregularity of earnings.

Finally, the percentage of ownership and the marketability of a company must be analyzed. A minority interest in an entity is generally worth less than a majority interest. Also, there is generally not a ready market for small closely held businesses. These facts necessitate the consideration of discounts for lack of control and discounts for lack of marketability.

There are many points in the life cycle of a business when valuation is important. For example: merger, acquisition, sale, marital dissolution, litigation, estate tax, gifts, buy/sell agreements, etc. all require business valuations. We are in a unique position to analyze the components of your business that produce value. If you need a business valuation, call Riney Hancock CPAs and allow our credentialed valuation professionals to assist you in determining your business’ worth.