A business valuation determines the price that a hypothetical buyer would
pay for a business under a given set of circumstances.
The valuation of a business is a complex and time-consuming undertaking and
yet the volume of business valuations being performed each year is
increasing significantly. A leading cause of this growth in volume is the
increasing use of mergers and acquisitions as vehicles for corporate growth.
Business valuations are frequently used in setting the price for a business
that is being bought or sold. Another reason for the growth in the volume of
business valuations has been their increasing use in areas other than
supporting merger and acquisition transactions. For example, business
valuations are now being used by financial institutions to determine the
amount of credit that should be extended to a company, by courts in
determining litigation settlement amounts and by investors in evaluating the
performance of company management.
In most cases, a business valuation is completed by an appraiser or a
Certified Public Accountant (hereinafter, appraiser) using a combination of
judgment, experience and an understanding of generally accepted valuation
principles. The two primary types of business valuations that are widely
used an d accepted are income valuation and asset valuations. Market
valuations are also used in some cases but their use is restricted because
of the difficulty inherent in trying to compare two different companies.
Income valuations are based on the premise that the current value of a
business is a function of the future value that an investor can expect to
receive from purchasing all or part of the business. Income valuations are
the most widely used type of valuation. They are generally used for valuing
businesses that are expected to continue operating for the foreseeable
future. In these valuations the expected returns from investing in the
business and the risks associated with receiving the expected returns are
evaluated by the appraiser. The appraiser then determines the value whereby
a hypothetical buyer would receive a sufficient return on the investment to
compensate the buyer for the risk associated with receiving the expected
returns. Income valuation methods include the capitalization of earnings
method, the discounted future income method, the discounted cash flow
method, the economic income method and other formula methods. Asset
valuations consider the business to be a collection of assets which have an
intrinsic value to a third party in an asset sale. Asset valuations are
typically used for businesses that are ceasing operation and for specific
type of businesses such as holding companies and investment companies. Asset
valuation methods include the book value method, the adjusted book value
method, the economic balance sheet method and the liquidation method.
Market valuations are used to place a value on one business by using
valuations that have been established for comparable businesses in either a
public stock market or a recent transaction. This method is difficult to use
properly because no two companies are exactly the same and no two
transactions are completed for the exact same reasons. Market valuation
methods include the price to earnings method, the comparable sales method,
industry valuation methods and the comparable investment method.
When performing a business valuation, the appraiser is generally free to
select the valuation type and method (or some combination of the methods) in
determining the business value. Under the current procedures, there is no
correct answer, there is only the best possible informed guess for any given
business valuation. There are several difficulties inherent in this
approach. First, the reliance on informed guessing places a heavy reliance
on the knowledge and experience of the appraiser. The recent increase in the
need for business valuations has strained the capacity of existing appraisal
organizations. As a result, the average experience level of those performing
the valuations has decreased. The situation is even worse for many segments
of the American economy where experienced appraisers don't exist because the
industries are too new. Another drawback of the current procedures for
completing a valuation is that the appraiser is typically retained and paid
by a party to a proposed transaction. It is difficult in this situation to
be certain that the valuation opinion is unbiased and fair. Given the
appraiser's wide latitude for selecting the method, the large variability of
experience levels in the industry and the high likelihood of appraiser bias,
it is not surprising that it is generally very difficult to compare the
valuations of two different appraisers--even for the same business. These
limitations in turn serve to seriously diminish the usefulness of business
valuations to business managers, business owners and financial institutions.
The usefulness of business valuations to business owners and managers is
limited for another reason--valuations typically determine only the value of
the business as a whole. To provide information that would be useful in
improving the business, the valuation would have to furnish supporting
detail that would highlight the value of different elements of the business.
An operating manager would then be able to use a series of business
valuations to identify elements within a business that have been decreasing
in value. This information could also be used to identify corrective action
programs and to track the progress that these programs have made in
increasing business value. This same information could also be used to
identify elements that are contributing to an increase in business value.
This information could be used to identify elements where increased levels
of investment would have a significant favorable impact on the overall
health of the business.
Another limitation of the current methodology is that financial statements
and accounting records have traditionally provided the basis for most
business valuations. Appraisers generally spend a great deal of time
extracting, aggregating, verifying and interpreting the information from
accounting systems as part of the valuation process. Accounting records do
have the advantage of being prepared in a generally unbiased manner using
the consistent framework of Generally Accepted Accounting Principles
(hereinafter, GAAP). Unfortunately, these accounting statements have proved
to be increasingly inadequate for use in evaluating the financial
performance of modem companies.
Many have noted that traditional accounting systems are driving
information-age managers to make the wrong decisions and the wrong
investments. Accounting systems are "wrong" for one simple reason, they
track tangible assets while ignoring intangible assets. Intangible assets
such as the skills of the workers, intellectual property, business
infrastructure, databases, and relationships with customers and suppliers
are not measured with current accounting systems. This oversight is critical
because in the present economy the success of an enterprise is determined
more by its ability to use its intangible assets than by its ability to
amass and control the physical ones that are tracked by traditional
The recent experience of several of the most important companies in the U.S.
economy, IBM, General Motors and DEC, illustrates the problems that can
arise when intangible asset information is omitted from corporate financial
statements. All three were all showing large profits using current
accounting systems while their businesses were falling apart If they had
been forced to take write-offs when the declines in intangible assets were
occurring, the problems would have been visible to the market and management
would have been forced to act on them much sooner. These deficiencies of
traditional accounting systems are particularly noticeable in high
technology companies that are highly valued for their intangible assets and
their options to enter new markets rather than their tangible assets.
The accounting profession itself recognizes the limitations of traditional
accounting systems. A group of senior financial executives, educators and
consultants that had been asked to map the future of financial management by
the American Institute of Certified Public Accountants (AICPA) recently
a) Operating managers will continue to lose confidence in traditional
financial reporting systems,
b) The motto of CFOs in the future will likely be "close enough is good
c) The traditional financial report will never again be used as the
exclusive basis for any business decisions.
The deficiency of traditional accounting systems is also one of the root
causes of the short term focus of many American firms. Because traditional
accounting methods ignore intangible assets, expenditures that develop a
market or expand the capabilities of an organization are generally shown as
expenses that only decrease the current period profit. For example, an
expenditure for technical training which increases the value of an employee
to an enterprise is an expense while an expenditure to refurbish a piece of
furniture is capitalized as an asset.
The dependence on accounting records for valuing business enterprises has to
some extent been a matter of simple convenience. Because corporations are
required to maintain financial records for tax purposes, accounting
statements are available for virtually every company. At the same time, the
high cost of data storage has until recently prevented the more detailed
information required for valuing intangibles from being readily available.
In a similar manner, the absence of integrated corporate databases within
corporations and the home-grown nature of most corporate systems has until
recently made it difficult to compare similar data from different firms.
The lack of a consistent, well accepted, realistic method for measuring all
the elements of business value also prevents some firms from receiving the
financing they need to grow. Most banks and lending institutions focus on
book value when evaluating the credit worthiness of a business seeking
funds. As stated previously, the value of many high technology firms lies
primarily in intangible assets and growth options that aren't visible under
traditional definitions of accounting book value. As a result, these
businesses generally aren't eligible to receive capital from traditional
lending sources, even though their financial prospects are generally far
superior to those of companies with much higher tangible book values.
In light of the preceding discussion, it is clear that it would be
advantageous to have an automated financial system that measured the
financial performance of all the elements of business value for a given
enterprise. Ideally, this system would be capable of generating detailed
valuations for businesses in new industries.