Business owners frequently find themselves in position where they need to value their business: succession planning; buy/sell agreements; estate and gift tax requirements; sales, mergers and acquisitions; shareholder or partnership buyouts; tax reporting; insurance purposes; obtaining financing – to name but a few. Despite the frequency of this requirement, most business owners don’t put much thought into the method they use. This article provides explanations of some of the more popular methods, and some benefits and drawbacks of each. There are three basic approaches with many variations of each.
THE MARKET APPROACH
The market approach looks at comparable companies to provide a relative valuation. Comparable companies are selected based on similarities in size and industry. The market approach, or Comps, is the most widely-used valuation technique in practice because of the relative ease in finding financial data. It is not always the best method, as company values can be skewed to temporary market conditions, and it may difficult to find truly comparable companies.
THE DISCOUNTED CASH FLOW APPROACH
The discounted cash flow (DCF) method estimates the value of the company based upon expected future cash flows, discounted to account for the time value of money. Use of this method is best for companies that have steady cash flows, and is favored by many as the most accurate estimate of the true value of the business. The disadvantage of the DCF method is that it can be difficult to accurately forecast future cash flows, and therefore it’s highly sensitive to the assumptions created to forecast such flows. Because the DCF method relies on estimations of future cash flows it could prove to be quite inaccurate.
THE COST APPROACH
The cost approach, perhaps the least commonly used method in corporate finance, assesses the actual costs to build or replace the business. It is generally considered less reliable than the comparable or income-based methods described above because it fails to accurately measure intangibles, or take into account prospective earnings.
Takeaway
A number of factors will impact which equity valuation model you choose. No one model is ideal for every company and for every purpose. The market method requires comparable peers to make comparisons, and the availability of data on those peers to make those comparisons. The DCF model requires accurate assumptions on future cash flows to create accurate results. Finally, the cost approach, while perhaps the easiest to calculate, may not provide a true measure of the business’s value. If you need assistance in drafting your business’s transitional documents, Contact CASHMAN LAW today for a free consultation to see how we might help you with your business’s contracts.
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