Business Valuation: Theory and Practice

By Marco Fazzini

This book provides an applied theoretical approach to modern day business valuation. It combines elements from both finance and accounting to help practitioners identify the most suitable method for analysis, showing when and how methods can be applied in different contexts and under specific constraints. It describes how business valuation techniques can be applied to calculate value in case of transactions, litigation, IPOs, and the fair value under an IFRS framework.
The purpose of this book is to offer a guideline for the application of an integrated approach, thereby avoiding "copy and paste" valuations, based on pre-packaged parameters and the uncritical use of models. Specifically, an Integrated Valuation Approach (IVA) should be adopted that encompasses, within any specific method, a wide range of elements reflecting the characteristics and specificities of the firm to be valued.
The book is based on the International Valuation Standards issued by the International Valuation Standards Council. Valuation standards allow for an alignment of both the methods and their application, providing a common basis for valuers.

• Language: English
• Publisher: Palgrave Macmillan
• Release date: Jun 6, 2018
• ISBN: 9783319894942

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© The Author(s) 2018

Marco FazziniBusiness Valuationhttps://doi.org/10.1007/978-3-319-89494-2_1

1. Value, Valuation, and Valuer

Marco Fazzini¹ 

(1)

European University of Rome, Rome, Italy

1.1 What Does Making a Valuation Mean?

In life we continuously make valuations. When we go shopping, for example, we make sure that the proposed price reflects quality; when we book a room, we make sure that the rate is in line with the hotel features and the services it offers; when we choose a school for our kids, we assess the quality of the programs and the teachers’ standing; when we buy a house, we make sure that the value is in line with that of other houses in the neighborhood.

In short, valuations are part of our daily experience; generally, they consist of two components: an objective one, which regards the intrinsic value, and a subjective one, linked to the valuer’s perception of the object to be valued. Separating these two components is difficult, as our choice is never entirely based on either the subjective or the objective component, but on a mix of both. For example, when buying a house, we do not choose the house with the best price per square foot, regardless of its characteristics; nor do we solely rely on our aesthetic perceptions, neglecting the price. Not surprisingly, we make choices based on a trade-off between objective circumstances (price) and subjective perceptions (location, finishes, interior design, etc.).

This mechanism is easy to find in contemporary art auctions. Given an objective value, based on previous auctions, expert judgment, quality of the work, and so on, the results may differ significantly, reaching amounts that have little to do with the characteristics of the work or with the prices attained in previous auctions.

Business valuations work in the same way. There is an objective component of value, based on valuations methods, and a subjective one, based on the valuer’s experience and ability to capture reality.

This means that two equally knowledgeable persons, with similar sensitivity, will hardly get the same result, although they start from the same assumptions and quantitative inputs. To make a comparison, think of two chefs who are given the same ingredients to prepare a certain dish. The result may appear similar, but the different combination of timing, cooking processes, doses, creativity, experience, and dish presentation will lead to different outcomes.

In this book, we will deal with the objective component, which is how we determine the value of a business based on generally accepted valuation methods.

What does it mean to value a business? We can respond that valuation is the act of estimating or setting the potential value of a business by considering both internal and external variables.

The internal variables look at the results a firm has achieved in the past; for example, the debt-to-equity ratio, EBITDA (earnings before interest, tax, depreciation, and amortization), revenues, and cash flow provide us with an understanding of what characterizes the business and constitute a basis for determining its value. The external variables look at the environment in which the company conducts its business and include, for example, market features, the company’s competitive positioning, distribution channels, or consumers’ tastes. In short, it is necessary to develop a comprehensive opinion that encompasses in one single model both the theoretical business value and the value that considers the environment where that business develops and performs its activity.

This is why the method presented in this volume is called integrated valuation approach (IVA). According to this approach, the evaluation process does not end with the application of a model, but requires considering the business as a whole.

1.2 The Business Valuation

Valuing a business is a complex exercise for various reasons.

First of all, the characteristics of the business change quickly. Over time, changes may occur that affect the value of the business, for example, a reduction in profit, higher investments, new debts, different revenues. Value, therefore, is neither constant nor immutable, but must refer to a specific date and situation. A valuer is like a photographer who has to take a picture of a moving object. To obtain a clear image he or she needs the right camera and the right setup and must have enough experience for this type of shot. Likewise, valuers must be able both to choose the model that better interprets the value and to apply it correctly.

Secondly, the value of a firm can be seen from different perspectives. As we will see further on, we can use methods that are based on expected cash flows (income methods, see Chap. 4), market values (market methods, see Chap. 5), and reproduction/replacement cost (cost method, see Chap. 6). Each of them considers some specific aspects of the firm and can lead to partially different results. As mentioned in IVS 105 (International Valuation Standard 105) the goal in selecting valuation approaches and methods for an asset is to find the most appropriate method under particular circumstances. No one method is suitable in every possible situation. Valuers must therefore apply their experience and judgment to identify the most suitable approach; it means that value depends not only on business characteristics but also on the model applied.

Furthermore, not all assets can be measured. The value drivers of a firm are often based on elements that can only be quantified through the output they produce. For example, the value of Facebook is linked to assets such as the number of users, competitive positioning compared to other social networks, the ability to innovate, and integration with other platforms such as Instagram and WhatsApp. Evaluating Facebook based on financial figures only could be an oversimplification.

As shown in Table 1.1, the market value of Facebook rose by 109.80% from 2013 to 2014, from $66.4 billion to $139.3 billion. Assuming there is no constant relationship between market value and financial data (otherwise we would now have the safe investment formula), none of the key figures have changed in the same way as market value. Expectations about the company’s value were evidently higher than the results achieved. Market value increased more than proportionally compared to key financial figures also from 2014 to 2015.

Table 1.1

Facebook financial key figures and market value (2013–2016)

It was only from 2015 to 2016 that the increase in market value was lower, probably due to investors’ perception of a stronger alignment between key financial figures and market value.

Hence, financial results do not perfectly reflect the value of a firm and, although they are the basis on which business valuation is built, there are other aspects that cannot be measured reliably.

Finally, there is a difference between price and value: in an ideal world they should coincide, but in practice they may differ, and the gap can be significant.

Price is the amount requested to purchase an asset. It is an empirical quantity that is influenced by supply and demand. Value, on the other hand, is the result of an estimate and may reflect a potential price in a transaction between two independent parties.

Here are some examples to help you better understand this price/value gap.

A cotton T-shirt made by an haute couture company, with a modest intrinsic value of a few dollars, is put on the market at a price of tens or hundreds of dollars. In this case, price is higher than the value of the good.

Here is another example: in a crisis situation, people may have to sell out some of their property (e.g. jewelry, buildings, art collections) for amounts lower than their intrinsic value. In this case, price is lower than value.

We face the same problem when valuing a company. How much is 2% of a small firm’s equity worth when another shareholder owns the other 98%? In theory, that stake is worth 2% of the total value of the company; in practice, the price may be impossible to define or close to zero, as there would be no buyer due to lack of marketability. Indeed, who would want to spend money to buy a minority interest that (a) is difficult to sell and (b) has absolutely no influence on the majority shareholder? In this case, again, price and value may have no correlation at all.

If we generalize the concept, value reflects a potentiality; price, on the other hand, reflects the here and now. The misalignment between value and price is sometimes significant, but no amount is truer than another. They can both be justified, depending on the characteristics of the good to be traded and the circumstances. Moreover, as Oscar Wilde once said, nowadays people know the price of everything and the value of nothing.

1.3 What Is Value?

Value is not a concept that can be easily enclosed in a universally valid definition; there is no unique measure for it, not even from a quantitative standpoint, since, depending on the instruments used, the data taken as reference, and the interpretation proposed, we may obtain different results, all of them equally plausible and consistent.

Correctly applying a formula is not enough to reach the reasonable certainty that the result is the value of the entity, since it is highly unlikely that an equation can capture the complex set of conditions surrounding a firm.

A value is much more likely to be defined, in quantitative terms, through a range of plausible values, the breadth of which depends on methodological accuracy and the ability of the model to interpret the business specificities (Fig. 1.1).

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Fig. 1.1

Range of plausible values

Value, therefore, is neither an absolute nor a unique concept. There is, actually, more than one configuration of value, depending on the purpose of the assignment and the characteristics of the business. This is precisely why referring to bases of value is more appropriate, as suggested by the IVSs.

According to IVS 104, bases of value (sometimes called standards of value) describe the fundamental premises on which the reported values will be based. The standard adds that it is critical that the basis (or bases) of value be appropriate to the terms and purpose of the valuation assignment, as a basis of value may influence or dictate a valuer’s selection of methods, inputs and assumptions, and the ultimate opinion of value.

1.3.1 Common Elements of the Bases of Value

As described in IVS 104, while there are different bases of value used in valuations, most have certain common elements:

1.

an assumed transaction;

2.

an assumed date of the transaction; and

3.

the assumed parties to the transaction.

1.3.1.1 Assumed Transaction

According to IVS 104, depending on the basis of value, the assumed transaction could take different forms:

(a)

a hypothetical transaction;

(b)

an actual transaction;

(c)

a purchase (or entry) transaction;

(d)

a sale (or exit) transaction; and/or

(e)

a transaction in a particular or hypothetical market with specified characteristics.

A transaction is hypothetical when the other party has not yet been identified or the time is not ripe to initiate a transaction. For example, a valuer could be appointed by the shareholders to evaluate a company in the event of a potential sale, in order to identify a range of plausible values to be used as reference for the deal.

A transaction is actual if both the asset to be valued and the parties are known, there being, however, no specific constraints regarding the type of transaction.

A purchase transaction or a sale transaction imposes greater constraints on valuers, as they may be required to consider the value of potential synergies or potential valuation discounts or premiums.

Finally, a transaction in a particular or hypothetical market with specified characteristics requires that the valuer examines and is familiar with some specific aspects. For example, in a transaction involving financial assets in a Middle Eastern country, a valuer should be familiar with the fundamentals of Islamic finance and be able to distinguish between legal (halal), non-risky (gharār), and non-speculative (maysīr) investments.

1.3.1.2 Assumed Date of the Transaction

The assumed date of a transaction influences what information and data a valuer has to consider in a valuation. Value is indeed a matter of timing and the assumed date is a relevant variable, especially in a dynamic context characterized by frequent changes.

1.3.1.3 Assumed Parties to the Transaction

Identifying the parties also plays an essential role in the valuation process, since, as noted in IVS 104, most bases of value reflect assumptions concerning the parties to a transaction and provide a certain level of description of the parties. IVS 104 underlines that in respect to these parties, they could include one or more actual or assumed characteristics, such as: hypothetical, known, or specific parties, members of an identified/described group of potential parties; whether the parties are subject to particular conditions or motivations at the assumed date (e.g. duress), and/ or: an assumed knowledge level.

1.3.2 Bases of Value

IVS defines to following bases of value:

1.

market value;

2.

market rent;

3.

equitable value;

4.

investment value/worth;

5.

synergistic value;

6.

liquidation value.

According to IVS 104, market value is the estimated amount for which an asset or liability should exchange on the valuation date between a willing buyer and a willing seller in an arm’s length transaction, after proper marketing and where the parties had each acted knowledgeably, prudently and without compulsion.

Market value, in accordance with the IVS conceptual framework, is the most probable price reasonably obtainable in the market on the valuation date. In other words, it is the best price reasonably obtainable by the seller and the most advantageous price reasonably obtainable by the buyer. The market value of an asset reflects its highest and best use, that is, the use of an asset that maximizes its potential and that is possible, legally permissible, and financially feasible.

According to IVS 104, market rent is the estimated amount for which an interest in real property should be leased on the valuation date between a willing lessor and a willing lessee at the same conditions of the market value.

According to IVS 104, equitable value is the estimated price for the transfer of an asset or liability between identified knowledgeable and willing parties that reflects the respective interests of those parties. The value in this case reflects the respective advantages or disadvantages that each part will gain from the transaction. This value is different from market value, which excludes any advantage that is not accessible to all the parties.

According to IVS 104, investment value is the value of an asset to a particular owner or prospective owner for individual investment or operational objectives. The value of an investment is linked both to the characteristics of the asset being valued and to those of the buyer and the seller. It may consider specific synergies or whether there are any advantages for a specific party.

According to IVS 104, synergistic value is the result of a combination of two or more assets or interests where the combined value is more than the sum of the separate values. In this book we mainly look at stand-alone valuations, that is, those that are independent of potential synergies. Synergistic value is often associated with the evaluations made by a potential buyer who estimates not only the value of the asset but also the contribution that an asset may bring to the other assets already held. It is therefore an internal evaluation that can only be appreciated by those who can determine the benefit from combining several assets together.

According to IVS 104, liquidation value is the amount that would be realised when an asset or group of assets are sold on a piecemeal basis. A business can be liquidated as a natural or forced process. A business would be naturally liquidated when it reaches the end of its life cycle and this condition is accepted by its shareholders. Forced liquidation occurs when the seller is forced to sell, which places the seller in a weak position with an obvious adverse impact on value .

1.3.3 Objective and Subjective Component of Value

Given these definitions, we can conclude that there are two dimensions of value : an objective dimension, which reflects the value of the asset per se, that is, the intrinsic value that is assigned to an asset in an efficient market, and a subjective dimension, linked to the characteristics of the parties to the transaction, each of whom seeks to maximize their own benefits.

In general, each valuation contains both an objective and a subjective element. A valuer should stick to the objective dimension as closely as possible, by making use of the generally accepted methods. Inevitably, however, the subjective element that is linked to our own perception and experience also plays a role in the valuation process; such element, however, should be nothing but a background noise that does not affect the stand-alone perspective.

The more the valuer can count on a complete set of information, the less is the risk associated with the subjective variable.

When asked to make a valuation based on limited information, valuers will tend to fill the information gap using their own experience and making analogies with similar cases they may have dealt with in the past. A valuer should therefore point out any lack of information, especially if it can influence the choice of the valuation method and the processing of data.

1.4 Valuation Methods at a Glance

Various business valuation methods have been developed over the years. Each of these reflects a very precise logic and no one method is better than another in absolute terms. Rather, there are methods that, in certain circumstances, are more appropriate than others in interpreting the value of a business.

According to valuation standards, the various methods can be grouped in three main areas: cost-based approach, income-based approach, and market-based approach.

If we compare them based on the assumption that evaluating a company is not so different from evaluating a used car, we can better understand the logic of these approaches: there is no single metric to establish a fair value, but multiple perspectives that we need to consider.

When you go to a dealer, you will first check the car and see if there are any scratches or dents on the bodywork, check the tire wear, the brake and engine operation, and any optional features such as air conditioning, safety devices, sunroof, and so on. In short, you will examine the car as is, adjusting the price accordingly.

Not unlike a car, a firm can have its scratches on the bodywork, which can reduce its book value, such as receivables that are difficult to recover, obsolete equipment, contingent liabilities, and so on; at the same time, there may be enhancing elements, such as trademarks and goodwill that give the firm a competitive advantage, although they are not necessarily recorded in the financial statement.

As for a car, it is possible to estimate the value of a firm as is, based on a reasoned examination of its assets and liabilities. To do this, we must examine the items in the financial statements and check whether their book value reflects their fair value; in case of discrepancies, if the book value is lower than the fair value, we should make an upward adjustment, and, vice versa, if the book value is higher than the fair value, a downward adjustment. The valuation method in