Answers to Attorney FAQs on Preferred Business Valuation Methods
By Alina Niculita, ASA, CFA, MBA and Paul Heidt, ASA
At a recent Oregon State Bar CLE webinar, we spoke to 80+ attorneys who wanted to learn more about business valuation. A few common questions came up. We are sharing these with a broader audience since it’s likely that others have the very same questions.
QUESTION #1: Which business valuation methods are generally preferred by buyers, sellers, and the court, and why? I would imagine sellers 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. As a trial attorney, I would greatly prefer the most stable and conservative valuation method to likely be adopted by the court. Also, which methods are preferred for different business types?
ANSWER:
In business valuation, we have three approaches to valuation: the income approach, the market approach and the asset approach. Each approach has one or more methods that falls under it. It is common practice in a business valuation to apply two or more valuation methods and obtain 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 to the methods. These include:
- adjustments that are made to the earnings before the application of the various 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; what liabilities are subtracted, including contingent liabilities
- whether the business had excess cash or non-operating assets, or a working capital deficiency, and other factors
Theoretically, all valuation methods are applicable to value any business. That being said, based on business valuation practice, certain business valuation methods may be a better fit for different types of businesses. For instance, asset-light businesses such as service businesses are typically valued by methods under the income and market approach. These methods include the capitalization method and the discounted cash flow method under the income approach and the transaction method and the public guideline company method under the market approach. More asset-intensive businesses benefit from the application of the asset approach in addition to the income and market approaches. Similarly, the income and market approaches are preferred and given more weight for operating businesses, and the asset approach is given more weight for asset-holding companies, such as real estate holding companies. These are broad rules, and every business is examined on a case-by-case basis.
Similarly, there are business valuation methods that are preferred in a certain jurisdiction and for certain purposes that are driven by case law that would need to be studied. For example, the market approach is considered in valuations for tax purposes because it represents real-life evidence of fair market value, as discussed in Revenue Ruling 59-60. The discounted cash flow method is preferred in Delaware courts. Family courts have preferred methods based on case law in the particular jurisdiction.
QUESTION #2: What method would you use for a professional company such as medical or law?
ANSWER:
We use income approach methods, including capitalization of earnings and discounted cash flow methods for both. We also use the market approach to value medical practices, but do not usually use it to value law firms, as there is typically no financial data available on transactions of law firms. For a medical practice with significant fixed assets, we would also use an asset approach and may enlist the help of an equipment appraiser.
To learn more, contact Alina Niculita or Paul Heidt. See our business valuation resources here:
- 3 Ways Personal Goodwill Can Help Business Owners Save Money
- Impacts on Business Value Vary by Industry During the Pandemic
- Using Comparable Businesses to Value Your Own Company
- Myths and Truths About Business Valuation
