In the context of a business valuation, the Valuer/Appraiser considers many factors, including the following:
- Financial attributes (sales and profitability trends, noncash expenses, capital expenditures, tangible and intangible assets and liabilities, contracts, contingent liabilities, and others)
- Marketing attributes (location, competition, barriers to entry, distributor and supplier relationships, current demand for products or services offered, likely future profit potential for the business)
- General condition of the business and its assets (including state of bookkeeping, equipment, facilities, work environment, etc.)
- General economic factors in industry which the business operates (regulatory environment, labor relations, interest rates, consumer confidence, the stock market, etc.).
Approaches to business valuation: Several different valuation approaches can be used to determine the value of a business. Some are better suited to certain business types than others, and as Lawrence Tuller noted in Getting out: A step-by-step guide to selling a business or professional practice, “everyone has his own theory about the most equitable and accurate method [of valuation]”. Tuller noted that each business interest naturally tends to favour the valuation method that best suits his own self-interests, for instance: Finance companies value a business at what the assets will bring at liquidation auction. Investment bankers and venture capitalists, interested in rapid appreciation and high returns on their investment, value a business at discounted future cash flow. Statisticians have devised complex deviation curves based on historical performance to project future earnings. Corporate America looks to the prevailing P/E ratios; unless the market is depressed in which case they use book value.
- Balance sheet methods of valuation. These methods of valuation are most often employed when the business under examination generates most of its earnings from its assets (rather than the contributions of its employees). It is also used, wrote John A. Johansen in How to Buy or Sell a Business, “when the cost of starting a business and getting revenues past the break-even point doesn’t greatly exceed the value of the business’s assets“.
- Liquidation approach: This method assesses the value of a business by gauging its value if were to cease operations and sell its individual assets. Under this approach, the business owner would receive no compensation for business ‘goodwill’ – non-tangible assets such as the company’s name, location, customer base, or accumulated experience. This method is further divided into forced liquidations (as in bankruptcies) and orderly liquidations. Values are typically figured higher in the latter instances. Asset-based lenders and banks tend to favor this method, because they view the liquidation value of a company’s tangible assets to be the only valuable collateral to the loan. But it is unpopular with most business owners because of the lack of consideration given to goodwill and other intangible assets.
- Asset value approach: This approach begins by examining the company’s book value. Under this method, items listed on a business’s balance sheet (at historical cost levels) are adjusted to bring them in line with current market values. In essence, this method calls for the adjustment of an asset’s book value to equal the cost of replacing that asset in its current condition. This method is most often used to determine the value of companies which feature a large percentage of commodity-type assets. The net asset value method also referred to as net worth or owner’s equity, is one of the most commonly employed of all valuation approaches. While flawed in some respects, the net asset value method is popular because this approach can be easily figured from existing financial records.
- Income statement methods of valuation: These valuation methods are perhaps the most frequently used of the myriad valuation approaches that exist.
i. Historical cash flow approach: This is the most commonly used of all valuation methods. Many buyers view this method as the most relevant of all valuation approaches for it tells them what the business has historically provided to its owners in terms of cash. As Tuller observed, “the value of assets might be interesting to know, but hardly anyone buys a business only for its balance sheet assets. The whole purpose is to make money, and most buyers feel that they should be able to generate at least as much cash in the future as the business yielded in the past.” This method typically takes financial data from the company’s previous three years in drawing its conclusions.
ii. Discounted cash flow (DCF) approach: When a financial analyst is required to conduct a financial valuation on the business or company being forecasted by the financial model, a commonly used valuation technique in a financial modelling exercise is the Discounted Cash Flow (DCF) method. This method uses projections of future cash flows from operating the business to determine company value. The DCF approach requires detailed assumptions about future operations, including volumes, pricing, costs, and other factors. DCF usually starts with forecast income, adding back non-cash expenses, deducting capital expenditures, and adjusting for working capital changes to arrive at expected cash flows. The future cash flow method also is notable for its recognition of industry reputation, popularity with customers, and other “goodwill” factors in its assessment of company value. Once the value of the business’s assets has been settled upon, the appropriate discount rate must be determined and used to bring the future cash flows back to their present value at the as-of date of the valuation. DCF in its single period form is known as capitalization of earnings, which usually involves “normalizing” a recent measure of income or cash flow to reflect a steady-state or going forward amount that can be capitalized at the appropriate multiple.
The DCF method uses a nine step process to value a business enterprise:
- Forecast Free Cash Flow (FCF)
- Estimate the Weighted Average Cost of Capital (WACC)
- Use WACC to discount FCF
- Estimate terminal value (as known as residue value)
- Use WACC to discount terminal value
- Estimate total present value of FCF
- Add value of non-operating assets
- Subtract value of liabilities assumed
- Calculate value of common stock
- Market comparable approach. This approach looks to comparable companies—in terms of industry, size, growth rates, capitalization, and other factors—for which a market value is known or observable (e.g., publicly traded companies) to establish a value for the company under examination. This approach, contended Johansen, is inherently flawed since “rarely if ever are two businesses truly comparable. However, businesses in the same industry do have some characteristics in common, and a careful contrasting may allow a conclusion to be drawn about a range of value“.
References
Encyclopedia of Small Business,
Answers.com, Wikipedia
Financialmodelingguide.com).
Real Estate Valuation
Real estate valuation method has traditionally been classified into five methods as follows:
a. Comparative method.
The comparison method attempts to determine value by focusing on the result of the market derived sales price. The method is based on the premises that a reliable indication of the probable market price of a subject property is given by the prices paid earlier in the same market for physically comparable market conditions, financing and sales terms. Under the Comparative method of valuation, the value is derived from the direct comparison of capital values of similar properties. That is, comparing the subject property with other “bench-mark” properties, which are near substitutes for one another. Such properties should be of similar size, shape, location and the data should also reflect recent transactions. This method takes into account of all general economic factors affecting the property market.
The comparison approach is applicable to any property for which there is available evidence of an adequate number of market transactions involving comparable properties. It therefore follows that the comparison method of valuation will not be applicable to these properties in a particular active market, if there is not enough market information to make a market comparison method appropriate. The conditions that need to be satisfied in applying this method are that:
- Properties used for comparison should be truly comparable.
- That there should be market derived sales data on at least three comparable properties, preferable, more.
Some of the problems associated with use of comparison method: The value estimate obtained from this method is unreliable when:
- Comparables may not be truly comparable to the subject property of valuation;
- Comparables may have been sold under a rapidly changing conditions such as economic, market, legal/political conditions; and
- There are limited numbers of comparables to the extent that there is may be no reliable or justifiable basis of making the desired comparison or for making essential adjustments.
b. Investment/income method.
For income producing real properties such as one on letting, productivity is measured by its income generating capacity. The productivity of non-income properties (e.g. owner-occupied) can also be estimated by means of comparison with the income producing similar properties in the neighborhood or through the comparative sales price.
The underlying theory in valuation using investment method is that, a potential real property owner is rational and a reasonable investor. No such person should therefore pay more for an income real property than the cost of acquiring an alternative property (or other investment type) capable of producing an income stream of the same size and with the same risk.
This method is based on the discounting concept of time value of money. It operates to derive market value by applying a multiplier to a stabilizer net income. In the language of the Valuer, the multiplier is known as Year’s Purchase (YP). The major two critical variables under this method are the rental value and the capitalization rate of yield. The equation is often expressed as:
Capital value (CV) = Net Income (NI) x Year’s Purchaser (YP)
The process involves the following:
- Ascertaining the current open market (gross rental) value per annum realizable from the property
- Determine the level of outgoing to arrive at the NI
- Determine the appropriate yield
- Capitalise the NI by YP generated from the yield
Investment/income method is used for most commercial (and residential) property that is producing future cash flows through the letting of the property. If the current Estimated Rental Value (ERV) and the passing income are known, as well as the market-determined equivalent yield, then the property value can be determined by means of a simple model. Note that this method is really a comparison method, since the main variables are determined in the market.
c. Accounts/profits method
This is primarily a method for determining the rental value of a property based on the profits earned from the business activity carried out in the premises. When there is no evidence of contractual rent passing on a business premises or evidence of rents on comparable properties, the method attempts to determine the economic rent that can be imputed to the property.
This method is based on the premises that the productivity of the business carried out in a property is partly due to the locational, legal and physical attributes of property. Therefore for certain kinds of properties, where the volume or the profitability of the business carried out in them is influenced by some attributes of the property, it is considered reasonable to relate the rent to be paid to the volume of profits made.
Application of the method: In principle, this method is applicable to all business premises for which there is no readily available rental evidence from comparable properties in the open market. This is as a result of the relatively small number, or total absence of similar properties due to statutory restrictions requiring such premises to obtain likenesses, by contract or choice as in a shopping center or mere chance. The end results is that such a property may enjoy a legal or factual monopoly which enables it generate a high volume of business transactions or profits relative to what it might have achieved in the event of more competition. In general, the method is applicable to landed properties like hotels, theatres, cinemas, certain retail shops and licensed premises. A three-year average of net income (derived from the profit and loss or income statement) is capitalised using an appropriate yield. Note that since the variables used are inherent in the property and are not market-derived, therefore unless appropriate adjustments are made, the resulting value will be value-in-use or investment value, and not market value.
The conditions under which the method is used are:
- When the method is the statutorily or contractually specified method, for example, the profits method may be the specified method for the valuation of cinema/theatres or hotels for rating purpose.
- It may also be the specified method subject to other conditions, for example, in the determination of the rental value of hotels or cinema houses.
- When the Valuer needs to determine the rent of a business premises for which there is no evidence of rent passing on comparable, the profit method will become appropriate if reliable accounting records of the business is available.
d. Development/residual method
The residual or development method is primarily used for the valuation of property that has latent value due to its development potential. This method is based on the premise that the value of a property with development potential is best indicated by considering its residual productivity in that use; that is, residual value of a property with development potential can be determined by subtracting the cost of developing the subject property in its ‘highest and best use’, from the present value of the proposed development. This is expressed by the relationship:
Residual value = Gross development value – Total cost of development
The residual method is primarily applicable to property that has the potential of being put into a higher and more profitable use than its present use. Examples of such properties are:
- Unused land or agricultural land on the fringes of built-up areas.
- Undeveloped parcels of land put to some lower uses within built-up areas
- Developed sites for which the existing development does not represent the highest and best use of the site.
Application of the residual method of valuation: The use of this method is considered when valuation by the direct comparison method cannot be applied due to lack of reliable market data on comparables. However, the use of this method will only yield a reliable indication of the market value of the site when the following conditions are satisfied:
i. It is reasonably believed that in the event of a sale transaction, the market price, as determined by market forces, will be based on the value of the subject property in its most probable potential use.
ii. The subject property has a potential for development in a use that is determinable (not obscure or personalised), such that a consensus can be reached among probable market participants about the following with respect to the subject property:
- the most profitable potential use of the subject property;
- the type and characteristics of the proposed development;
- the scale and scope of the proposed development;
- probable cost of development based on an effective, market oriented project design;
- the timing of the development;
- the amount of the realisable market prices for the proposed development on completion;
- the timing of cash receipts;
- the market-indicated discount rates for finding present values.
e. Contractor’s/cost method
The cost method of valuation is based on the premises that the potential purchaser of real property is well informed and such a purchaser will not pay more for a subject property than it will cost to produce (develop) a substitute property of equal utility. Therefore, cost method is based on the assumption that the value of the land and building will be equal to the cost of erecting the building plus the value of the site. Thus the model:
Value (of land & building) = cost of site + cost of building
This is usually an unsatisfactory basis for value is not determined by what a property cost to bring it to its present use, but by what purchasers in the open market are prepared to pay for it in relation to the price the seller is willing to take. The types of property for which cost method could be used are hospitals, town halls, churches, schools, libraries, police stations and other such public buildings and properties in the rural areas. These properties rarely changes hands, i.e. they are rarely sold in property market and thus there will be no market evidence for comparison. Similarly these unique properties are largely non-income producing and thus do not possess rental value on which to apply investment method (upon which investment valuation could be carried out).
Using this method, the Valuer is indeed in search of the replacement cost, that is, the cost of reconstructing the existing property as-it-is. The ‘as-it-is; cost is also known as the depreciated replacement cost (DRC). Here the cost required is not necessarily the cost of building the property a new, as it is obvious that there would be some wear and tear resulting from its previous use and there might also be a degree of obsolescence which has arisen since it was new; therefore, necessary deductions must be made for both depreciation and obsolescence of design.
The cost method lends itself readily to an undeveloped property market such as Nigeria’s in which the volume of sales and other transaction is very low. To compound it all, this method is being statutorily prescribed for valuation for such purposes as rating, compensation, and probation etc. A good example is the land Use Act 1978 that prescribed depreciated replacement cost (DRC) approach for valuation of unexhausted improvement on land for compensation purpose some states rating laws also dictates the use of cost method for rating purpose.
