Business valuation

A business valuation is an estimate of the fair MARKET VALUE of a closely held business. There is no distinction between a valuation and an appraisal, but usually the term valuation is applied to estimating the value of a business and an appraisal is used to refer to estimating the value of a spe­cific ASSET, such as real estate, jewelry, antiques, or art. Fair market value, an important term in business valuation, means what a willing buyer and seller would agree upon if neither had a particular compulsion to buy or sell and both had reasonable knowledge of all the facts.

Valuations are done for many reasons. The most obvi­ous is the valuation done to assist in a genuine transac­tion, when, for example, a prospective buyer or seller hires a valuation expert to assist them in the process. But valuations are also done for other reasons. The estate tax levies a certain amount of tax on the value of property transferred to an heir, and so an estate must have a valua­tion of any family business that is inherited by the next generation. Sometimes the valuation of a family business is important in divorces. When the assets are being divided by the spouses, it is a relatively easy matter to establish a value for such things as cars and houses, but the value of the family plumbing business is a different matter. A valuation expert is important to guide the courts in the division of the assets.

In general there are three approaches used in estimating the value of a business: asset approach, INCOME approach, and the market approach. The asset approach is the easiest to understand: The company’s individual are valued, then its debts are subtracted to find an overall fair market value.

The income approach estimates the company’s future income and then uses DISCOUNTING techniques to estimate its current value. The difficulties with this approach include estimating the future income and determining an appropriate DISCOUNT RATE.

The market approach is theoretically very appealing. It compares certain characteristics of the company being val ued to companies that have been sold recently; the person doing the valuation tries to find a comparable company in the same industry, with about the same assets and income size. The difficulty with this method is both in finding a comparable company and understanding the elements of the comparable transaction, which may include other con­siderations besides the company being sold. For example, the CONTRACT to sell a comparable company may include a certain amount of work to be done by the previous owner or some special financing provision. Such things have to be stripped from the comparable transaction before it is used as a basis for valuing the business. Finding a compa­rable company and understanding the transaction makes the market approach most difficult to apply.

The American Society of Appraisers and the AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS have specialty designations or valuation credentials that they confer on members who accomplish certain prescribed training and testing and have pertinent experience.