Three Approaches to Business Valuation
The three commonly accepted approaches to business valuation are the asset (or cost) approach, the income approach, and the market approach. The asset approach uses the fair market value of a company's assets less its outstanding liabilities to determine the value of the business. The income approach (often referred to as the discounted cash flow, or DCF, approach) uses the company's expected future cash flows discounted to present value to determine the value of the business. The benefit of the income approach is that it can vary the specific factors that influence investors' cash flow expectations for the company and isolate the impact of an event on those expectations. The market approach uses publicly traded guideline companies or historical sales transactions for similar companies to determine the value of a business. Although the market approach can adjust for the impact of an event, it can be viewed by some as inherently more subjective. Therefore, valuations using this approach must be must be appropriately applied and supported.
The Market Approach
A market approach to business valuation uses actual market transaction data in determining the value of the company. There are generally two methods to valuing the company using the market approach. The guideline public company method uses stock prices for publicly traded companies similar to the company being valued, and the guideline company transactions method uses historical sales transactions for similar companies. Under both methods, relevant financial measures such as revenue, earnings, or assets are used to develop valuation multiples for each guideline company (e.g., the ratio of guideline company stock price to guideline company earnings). A representative multiple is then determined and applied to the relevant financial measure of the company to determine its value.
For example, a valuation expert may determine that the most relevant financial measure for valuing a bank is earnings. Assuming a mean guideline company price to earnings ratio of 10, the value of a bank with similar prospects and risks to the average guideline company could be determined as 10 times its earnings.
Key Considerations in the Application of the Market Approach
On the surface, the use of real transactions and stock prices appears to be a way to determine the value of a company that is practical and easy to explain to judges and juries. However, there are several critical steps in applying the market approach that will lead to unreliable results if they are not performed properly. Understanding the answers to some of the following questions will give you a sense of the reliability of the valuation based on the market approach.
How were the guideline companies selected? There needs to be a clear process for selecting guideline companies. The goal of the selection process is to choose companies that are most comparable to the subject company. One process could start with similar Standard Industrial Classification (SIC) or North American Industry Classification System (NAICS) codes to the company being valued. Next, other criteria such as size, geography, growth rates, and similarity of products could be used to eliminate non-comparable companies or transactions. When using guideline company transactions, it is imperative to understand changes in the industry or economic climate that could render the data point less relevant to the company being valued. Transactions occurring considerably farther away in time from the valuation date generally will be less relevant due to changes in market conditions. The process should result in a sufficient number of companies and transactions so that the valuation is not materially distorted by one data point. A process with clearly defined selection rules will be more defensible than a subjective process in which the expert could be accused of cherry-picking guideline companies or transactions to achieve a desired valuation result.
Were the financial statements of the selected guideline companies adjusted to ensure comparability? Failure to control for accounting policy differences and non-recurring and non-operating items can lead to distortive results when applying the market approach. If the guideline companies and the company subject to valuation have different accounting policies (e.g., inventory, depreciation, or leases), adjustments are required to put the financial statements on a consistent basis. Further, non-recurring and non-operating items should be isolated and addressed independently of a company's operating value.
What valuation multiples were used to determine the value of the company, and how were they selected? Knowledge of the industry and market conditions is required to understand how buyers in the industry enter into transactions. For example, certain industries tend to rely more heavily on earnings multiples to value potential target companies, while others place more emphasis on revenue multiples. As discussed earlier, valuation multiples can be based on revenues, earnings or assets. Understanding the reasons why certain multiples were used and how the relative weighting for each multiple was determined can provide important information on the reliability of the valuation. The relative weight given to each valuation multiple should be based on the relevance of the underlying financial measure to potential buyers of the company.
Is the underlying data used in the market approach being properly adjusted for transaction-specific items that might not be relevant to the company being valued? Data sources containing underlying purchase information may include transaction-specific provisions that may not be applicable to the company that is being valued. The purchase prices for certain historical transactions can contain earn-out provisions or strategic buyer premiums. It is important to understand how an expert controlled for these provisions and premiums if they were contained in the underlying data used in the market approach.
Is the valuation based on the market approach supported by the valuation based on one of the other business valuation approaches? Some courts have excluded valuation testimony in part because the expert failed to use the income approach and relied solely on the market approach using comparable companies. These rulings concluded that there was no way to assess whether the business valuation using the market approach was a reliable measure of the company's value because the income approach was not used. In light of this, it is necessary to demonstrate that the results of the market approach are supported by one of the other business valuation approaches or, at a minimum, that the differences in values between the approaches can be properly explained.
It is critical that the approach and underlying assumptions in a damages claim are consistent with the facts and circumstances in the case. A market approach may be the most appropriate way to quantify damages, however, the opinion of the expert can be subject to exclusion under a Daubert challenge if not applied correctly and appropriately supported. Greater familiarity with the major assumptions that influence the output from these approaches will allow for a better assessment as to whether the applied business valuation results in a reliable damage claim.
Keywords: litigation, expert witnesses, business valuation, market approach, damage claims, Daubert, guideline companies, financial statements
Brian P. Sullivan is a director in the Philadelphia, Pennsylvania, office of Navigant Consulting and a chartered financial analyst.
Navigant Consulting, Inc. is a sponsor of the Section of Litigation, and this article appears in connection with the Section's sponsorship agreement with Navigant Consulting, Inc. Neither the ABA nor ABA sections endorse non-ABA products or services.