This article is intended to provide a conceptual introduction of business valuation for attorneys who seek a confirmation of the fundamentals, disabuse from common misleading notions, or practical tips to assess the quality of valuation reports encountered in their practices. Business valuation is a broad and technically challenging discipline. It would be impossible to introduce all the aspects of business valuation in this article. The author's approach has been to present several key concepts with the perspective of attorneys in mind to expedite their understanding while minimizing repetition of the ordinary material presented in the ordinary way.
In gaining understanding of any new field, it is very helpful to first identify its fundamental postulate. Once known, the postulate becomes the stable orientation point around which subsequent information and inevitable complexities can be aligned and understood. For example, Chinese general Sun Tzu wrote in 500 B.C., "All warfare is based on deception."1 This provided the student of warfare with a reference point to orient further study.
How To Facilitate the Study of a New Field
One of the earliest expositions on business valuation was published in 1959 by the Internal Revenue Service in Revenue Ruling 59-60.2 Today, 45 years later, it continues to offer refreshing clarity to business appraisers. Perhaps the most frequently quoted section lists the eight factors which must be considered in a full valuation report. These eight factors are central to the valuation process:
The Significance of Revenue Ruling 59-60
Attorneys should consider this the first reference on business valuation they read.
- The nature of the business and the history of the enterprise from its inception.
- The economic outlook in general and the condition and outlook of the specific industry in particular.
- The book value of the stock and financial condition of the business.
- The earning capacity of the company.
- The dividend-paying capacity.
- Whether or not the enterprise has goodwill or other intangible value.
- Sales of the stock and the size of the block of stock to be valued.
- The market price of stocks of corporations engaged in the same or a similar line of business having their stocks actively traded in a free and open market, either on an exchange or over-the-counter.3
It is from Rev. Rul. 59-60 that a workable fundamental postulate emerges:
The Fundamental Postulate of Business Valuation
Indeed, discounts, premiums and further calculations, assumptions and limiting conditions must be considered in arriving at the value conclusion. However, the basis of business valuation is conceptually grounded on the above postulate.
- Valuation is, in essence, a prophesy as to the future,4 thus
- For an operating going concern, value is based upon the risk-adjusted present value of the expected future benefit stream.5
The foundation of business valuation theory is governed by three fundamental principles:
Principles of Valuation
- Principle of Alternatives - Each party to the transaction has alternatives to fulfilling the transaction, for what price and with whom.6
- Principle of Substitution - Substitution acknowledges how parties to a transaction will behave regarding alternative choices among comparable properties when prices vary.
- A prudent investor will not pay more for one investment than another equally desirable substitute. Derived from investment theory, an investor will choose the higher return between two choices of equivalent risk.7
- Principle of Future Benefits - Valuation is based on the future outlook of the business in the form of capital appreciation or dividends, or both, all distributed in the form of cash flow. Investors do not buy historical earnings, but history is relevant in assessing achievability of projections and assessing the risk associated with realizing future economic benefits.8
Valuation methodology is organized into a hierarchy of three basic levels:
How the Body of Knowledge Is Organized
Thomas Kalajian, BS, CRTP, AVA, ABAR, President of Provident Valuation Professionals, specializes in Business Valuations, Appraisals and Accredited Business Appraisal Review. He provides litigation support services as a consulting expert, including reviews of FRCP 26(a)(2)(B) business valuation reports of privately-held, small-to-medium-sized businesses.
See Thomas Kalajian's Profile on Experts.com.
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