“There are two things in the world you never want to let people see how you make ‘em – laws and sausages.”
-Leo McGarry, Chief of Staff – Bartlet Administration
I was reminded of this quote during a recent conversation with a client who asked me how we address the issue of divergent values when performing a business valuation. At the time, I responded with an off-the-cuff, “it’s a bit like making sausage.” But as I reflected on the question, it occurred to me that readers of our work product may not fully understand the process by which we reconcile varying indications of value.
In a typical valuation engagement, the valuator will consider the three approaches to determining a value: the asset approach, the income approach, and the market approach. While there are different methods that can be employed under each approach, the issue for today’s article is how the valuator handles the scenario when the three approaches suggest vastly different values. For example, let’s assume that valuator determined that the business was worth $6 million under the asset approach, $15 million under the income approach, and $20 million under the market approach. It is unlikely that a client would be satisfied with a “conclusion” stating that the business is worth somewhere in the range of $6 million to $20 million.
In this case, many valuators would take the position that the value indicated under the asset approach is deemed the company’s “floor value.” Under the adjusted net asset method, the valuator is able to establish a value based on the amount of money that would be realized upon a sale of a company’s assets and satisfaction of its liabilities.
Because the income and market approaches in this example indicated values higher than the company’s “floor value” under the asset approach, it is evident that the value of the company is better represented by its cash flows than its net assets. Therefore, the valuator can disregard the value indicated by the asset approach and focus on the income approach ($15 million) and market approach ($20 million) values. Depending on the nature of the engagement, the level of dispersion in values, and other factors, the valuator might consider the following steps to reach a reconciled conclusion of value:
- The first, and simplest, way to reconcile the two values would be through a weighting exercise. In other words, the valuator may simply split the difference by giving equal weight to the two values, ultimately arriving at a $17.5 million conclusion of value. Alternatively, the valuator may give more weight to either the income or market approach values if he believes that one is based on better data or provides a more reliable value than the other. However, valuation guidance from the IRS and other relevant bodies generally discourage the use of simplistic, unsupported weighting techniques, especially in cases where valuation indications are so different. On the other hand, if there is a reasonable basis for placing heavier reliance on one approach over another, the valuation community generally accepts weighting techniques. As always in valuation, it is imperative that the valuator provide his rationale for his conclusions in this regard.
- Another alternative that the valuator may consider would be to revisit certain assumptions embedded in the income and market approaches. It is at this relatively late juncture in the valuation process where the valuator has an opportunity to step back and re-evaluate the analysis holistically. Because the valuator now has a deep understanding of the business, its value drivers, and unique risk profile, he also might have a new perspective of many of the key judgment calls that were made throughout the process. These factors may include the discount rate used in the income approach; the benefit stream(s) used both in the income and market approaches; or the comparable transactions and resultant multiples used in the market approach. Relatively minor adjustments to any of these assumptions could result in a change in value under the income or market approach (or both), bringing the two indicated values more closely in line with one other. It is through this iterative process that the valuator can continually groom the analysis to reach a value that is supported by both the income and market approach conclusions.
Arriving at a well-reasoned conclusion of value is more complex than just applying asset, income and market-based approaches. Professional judgment, honed through years of valuation experience, is critical in reconciling values so that the final concluded value is supportable. As you can see, the process of reconciling values is far more involved than just throwing a set of values into a grinder and churning out a final conclusion.
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10 Common Errors in Valuations FREE Speaker Series event presented by Robert Ranallo, CPA/ABV, JD, CVA, CFF and Sean Saari, CPA/ABV, CVA, MBA. Thursday, June 26 beginning at 11:30a.m. Click for details; An RSVP is required as seating is limited. Earn CPE and CLE credit: This course has been approved by the Supreme Court of Ohio Commission on Continuing Legal Education for 1.00 total CLE hour(s) instruction and by NASBA for 1.00 total CPE hour instruction.