Answers to 6 Common Questions from Attorneys on Business Valuation

By Paul Heidt, CPA, ASA, ABV and Alina Niculita, ASA, CFA, ARM-BV, MBA

Our team regularly presents business valuation CLEs to law firms and bar associations, which sparks questions from attorneys. We’ve compiled a few of the most common questions from attorneys over the years with answers below.

1. Why do appraisers typically request five years of the subject Company’s financial statements?

ANSWER: When gathering information at the outset of a business valuation, appraisers typically request five years of the subject Company’s financial statements. Other documents typically requested include management projections, operating agreements, a list of top suppliers and customers, the ownership structure, and compensation of the owners/officers.

Five years of financial statements are typically requested in order to observe trends in the Company’s revenue, expenses, earnings, assets, and liabilities. An extended period of historical financial data allows the appraiser to estimate a normalized level of revenue or earnings or to identify anomalies in the Company’s historical financial statements, such as a significant decrease in revenues due to the Covid-19 pandemic or a one-time increase in professional fees from a legal dispute. For some companies or industries, such as construction companies, more than five years of financial statements may be requested due to the cyclical nature of the industry.

2. Which business valuation approaches are generally preferred by buyers and sellers? I assume buyers would prefer a valuation method that results in a higher value, and sellers would prefer a business valuation method that results in a lower value.

ANSWER: We have three approaches to business valuation: Income, Market, and Asset Approaches. Each approach has one or more methods that fall under it. It is common practice in a business valuation to apply two or more valuation methods, resulting in two or more indications of value.

It is important to note that it is not typically the method itself that may lead to a lower or higher value, but the inputs used in the methods, which include:

Adjustments that are made to the earnings before applying valuation approaches and methods;
Forecasted future earnings and the discount and capitalization rates applied to them in the Income Approach;
Valuation multiples and the earnings base to which those are applied in the Market Approach;

Estimated values of the fixed assets and other assets in the Asset Approach and which liabilities are subtracted, including contingent liabilities; and
Whether the business had excess cash or non-operating assets, or a working capital deficiency.

3. Which business valuation methods are preferred for different types of businesses?

ANSWER: Theoretically, all valuation methods are applicable to value any type of business. That being said, certain business valuation methods may be a better fit for certain types of businesses. For instance, businesses with very few fixed assets, such as service businesses, are typically valued by methods under the Income and Market Approaches. These methods include the Capitalization Method under the Income Approach and the Guideline Transaction Method under the Market Approach. See Using Comparable Businesses to Value Your Own Company. When valuing more asset-intensive businesses, such as a machinery manufacturer, we would typically utilize the Asset Approach, in addition to the Income and Market Approaches. See our piece on Which Valuation Approach is Best for a Manufacturing Company.

Typically, the Income and Market Approaches are preferred and given more weight for operating businesses, while the Asset Approach is attributed more weight for an asset-holding company, such as an LLC holding real property. Note that these are broad rules, and every business is valued on a case-by-case basis.

4. What are typical business valuation discount rate ranges?

ANSWER: The discount rate is one of the two main inputs of the Income Approach to business valuation along with the expected future cash flows. The discount rate is used to calculate the present value of the expected future cash flows, which is the value of the business under the Income Approach. The discount rate is a function of the riskiness of the investment in the business.

A fundamental concept in business valuation is that the higher the risk, the higher the requested return to invest in that business. In business valuation, the riskier the business, the higher the discount rate. What makes a business riskier than others? One example of a business risk is size. Generally, smaller businesses are riskier than large businesses, because of factors such as a lack of diversification, thin management, lack of resources, reliance on key people, and others. As a result of the higher risk, smaller businesses will have generally higher discount rates.

Another fundamental concept in business valuation is that there is an inverse relationship between the discount rate and the value of the business. The higher the discount rate, the lower the value of the business. The lower the discount rate, the higher the value of the business.

That’s why it is important to spot discount rates that may be unreasonably low or unreasonably high. While the discount rate depends on the facts and circumstances of each case, reviewers of valuation reports should be alert of cost of equity rates for small to medium size profitable companies that are outside of a 15%-20% range. Special cases warrant discount rates that are outside this range, of course, but they would need to be explained and supported.

5. What is cash flow and how is it used in business valuation?

ANSWER: In short, cash flow means what an owner can put in his or her pocket at the end of the day. According to the International Glossary of Business Valuation Terms, equity net cash flow is defined as those cash flows available to pay out to equity holders (in the form of dividends) after funding operations of the business enterprise, making necessary capital investments, and increasing or decreasing debt financing.

In a business valuation, appraisers calculate the subject Company’s net cash flow, as it refers to the amount of cash that can be distributed to the owners. A normalized level of net cash flow is typically capitalized to determine value under the Income Approach.

6. Why is an EBITDA (“earnings before interest, taxes, depreciation, and amortization”) valuation multiple often preferred in the Market Approach as opposed to a net income multiple?

ANSWER: The Price-to-EBITDA valuation multiple, which is often cited in the financial press, is used extensively in business valuation, specifically in the Market Approach, due to its ability to compare across different businesses. EBITDA presents a pure measure of the company’s earnings before consideration of how the company is financed (interest), how the company might be taxed (C-Corporation or S-Corporation) or what capital improvements or intangible asset investments might be underway that consume cash (depreciation and amortization). A net income valuation multiple on the other hand would include interest expenses, taxes, and non-cash charges and make comparing companies less accurate.

See video clips from our Business Valuation Nuts & Bolts webinar.

Paul Heidt, CPA, ASA, ABV brings close to 25 years of specialized experience in financial analysis and research. He has performed 250+ business appraisals for litigation, gift and estate tax planning, marital dissolution, business transactions, reorganizations and succession planning.

503-906-1583 | [email protected]

Alina Niculita, ASA, CFA, ARM-BV, MBA is a testifying business valuation expert with 25+ years of experience. Alina has valuation and appraisal review certifications from the American Society of Appraisers. She has appraised hundreds of companies across diverse industries for purposes including litigation, estate and gift tax reporting, estate planning, marital dissolution, shareholder redemptions, reorganizations, and business transactions.