What Determines the Value of My Company?
An Overview of the Valuation Process and the Sources of Value in Private Businesses, Partnerships, and Professional Practice
Introduction
Knowing what creates value and what your firm is worth is essential to making
wealth‐creating decisions. These decisions relate to everything from investing
decisions and financing choices to distribution polices and appropriate prices in
control transactions and estate planning. This paper is intended to be a primer on
the conceptual foundations of how value is measured and what can increase or
decrease the value of your firm. For some, the expectation is that valuation is a
science or a precise process. For others, the view is that valuation is art where
appraisers manipulate numbers to arrive at pre‐determined values. The truth of the
matter is that the valuation process is both art and science – meant to be effected
while resisting the lingering temptation to manipulate valuation outcomes.
It is helpful to view the firm from many perspectives to gain a greater understanding
of value. This is especially true for owner/managers who often find it very difficult
to accept that a potential buyer have a justifiably different opinion on value of the
firm without being overly pessimistic regarding its prospects. With this in mind we
start the discussion by building a framework of the valuation process from the
perspective that the firm is nothing more that a nexus of contracts.
The Firm as a Nexus of Contracts
The value of the firm is the central focus of all of its stakeholders, not just the
shareholders. When addressing the question of value, it is important to consider the
non‐shareholder’s interests because the firm is at its core, a nexus of contracts. As
such, the business owner needs to be aware of the potential impact of these other
claims on the value of his or her business. Furthermore, this “contracts perspective”
properly aligns the expectations of the owner who is a residual claimant. That is,
the owner gets whatever remains of the accounting profits after all the other claims
have been satisfied. Or in the case of a sale of the business, the owner gets whatever
is left of the proceeds of the sale after all the other claims are satisfied. Nowhere is
the sting of the residual claim felt more strongly than in bankruptcy, where owners
typically walk away empty handed because there is nothing left for the residual
claimant. Incidentally, the bankruptcy process is often described as a re‐contracting
process.
Generally, the firm is contracting with four broad groups: labor, customers,
government and the suppliers of capital. Each group has a unique relationship with
the firm; therefore each negotiates and contracts with the firm to address the
concerns and expectations that are important to it. It is these contracts, and the
nature and characteristics of the groups contracting, which determine their added
value to the firm. The contracts or characteristics may also result in value
diminution – especially for a new owner following a control transaction.
For example, labor contracts may create relatively stable wages with predictable
increases, which are often desirable characteristics for the manager of a company or
for a potential investor. However, if the contracts lack the flexibility for the new
owner to respond to labor market dynamics, then they may reduce the value of an
enterprise saddled with potentially unsustainable labor costs. Another
consideration related to the value of labor contracts relates to the ability for these
contracts to induce and facilitate employee “investment in the firm.” That is, the
owner of the firm prefers labor to investment its time and energy into developing
firm‐specific knowledge and skills, presumably to make the company more efficient
and profitable.
Likewise, an owner will also prefer employees to develop relationships with other
stakeholders, such as suppliers and customers, which are value‐creative for the
enterprise. Finally, the question of labor mobility must be considered. A potential
purchaser of your business will want to try to determine how mobile your labor is,
and how likely it is to move if there is a control transfer. These are just some of the
labor related issues that a potential buyer will consider when estimating the value
of your enterprise. Hand‐shake agreements, implicit understandings, and trust
between you and your employees that has been nurtured over many years may have
great value to you as the current owner, but less value or little value to your buyer in
a control transaction because of the uncertainty related to retention.
Similarly, you and your enterprise most likely have implicit agreements and
relationships and explicit contracts with your customers. Your implicit contracts
and relationships may produce repeat business and referrals for your enterprise,
while your explicit contracts are likely to contain guarantees and warranties on
your products and services. Presumably you have developed these relationships
and put these agreements and contracts in place to create value. However, a
potential buyer may see less value in the agreements and may actually view the
contracts in place as constraints or even liabilities, rather than assets. Taken
together, the contracts in place with labor, suppliers and customers may have very
different value for a prospective buyer than they have for you.
Another “partnership” that requires a great deal of attention and care is your
partnership with the government. It may be unusual to think of federal, state, and
local governments as your partners, but they are – they consistently take pieces of
your profits through taxation. Governments also place legal, regulatory and
environmental constraints on your company. These constraints may create
potential liabilities for the prospective buyer, especially when the regulatory
standards themselves, or the degree of enforcement of those standards, continually
change. There are also times when these constraints may actually be beneficial to a
business. For example, regulation may create barriers to entry for potential
competitors, thereby creating a protected environment in which your firm can
operate. However, the profit potential in these industries (e.g. utilities) is often
restricted by the same regulations that create the favorable competitive
environment.
Finally, a potential investor will consider your financing choices and how they might
promote or diminish value. For example, is the firm locked into high cost debt? The
cost of debt isn’t the only consideration. Because the firm obtains debt financing
voluntarily, it assumes all of the constraints contained in the debt contract(s). These
constraints, or covenants, may reduce the financing flexibility of the firm in the
future. Furthermore, the covenants may make what is otherwise attractive
assumable debt less attractive and thus reduce the value obtainable in a control
transaction. The amount of debt may also be a concern. Overleveraged firms tend
to be growth‐constrained, they tend to be riskier investments so new investors will
seek discounted share prices, and too much leverage is often an indication of future
dilution. That is, because the only financing option left for over‐leveraged firms is
more equity, the new equity financing will dilute existing shareholders.
Potential problems for investors may also take the form of outstanding options and
warrants, dual‐class capital structures, and preferred shares. The existence of these
securities raise issues related to dilution and control, voting rights and control, and
distribution preference, respectively.
In sum, the existing contracts of the firm may allow a seller to transfer more value to
a buyer and thus receive a higher selling price all else equal. Alternatively, existing
contracts, and potential legal, regulatory, or environmental issues may greatly
reduce the value a seller may receive in a control transaction.
Foundations of Value, the Valuation Process & Wealth Creation
The valuation process is full of potential pitfalls and problems. It requires one to
determine the purpose of the valuation that will initially create the proper
framework for the valuation process and related outcomes. In general, the process
requires the definition of value, the proper perspective to set guidelines and
expectations, the quantification of expectations, and some refinement before
arriving at a reasonable estimate of value for your firm.
Intrinsic Value is Unobservable
Any discussion about value requires the definition of value. This may sound
elementary but in reality we have book values, market values, present values, option
values, replacement values, and liquidation values. We also have specific guidelines
given by the IRS to determine something called “fair value”.1
Therefore, when we are discussing value we need to know exactly what it is we are
considering (e.g. a single tangible or intangible asset, a liability, a firm, an option)
and the purpose of the valuation (e.g. going‐concern, buy/sell transaction, estate tax
planning, liquidation, etc.). When it comes to valuing a firm, what we are really
attempting to do is determine its intrinsic value. That is, intrinsic value is a value
that everyone would agree on if we all had the same set of information and
expectations about the firm. Obviously, this isn’t the case, so the job of an appraiser
is to estimate the value of your company. To do that, the appraiser needs to take an
objective look at your enterprise.
It is also useful to note here that the existence of intangible assets makes the job of
enterprise appraisal much more difficult and increases the likelihood that the
perception of value can differ dramatically between the seller and the buyer, or
between the owner and the IRS. Therefore, owners of companies whose assets are
largely intangible may find it particularly difficult to determine the value of the
companies with a great degree of certainty. That is, any valuation estimate
produced for such a firm is likely to be bounded by very wide ranges of value.
A widely accepted standard for valuing a closely held business is fair market value as defined by
Treasury Regulations §25.5212‐1. All federal and state tax matters (estate taxes, gift taxes, income
taxes, etc.) require the standard of fair market value. Revenue Ruling 59‐60 defines fair market value
as: …the price at which the property would change hands between a willing buyer and a willing seller
when the former is not under any compulsion to buy and the latter is not under any compulsion to
sell, both parties having a reasonable knowledge of relevant facts. Court decisions frequently state in
addition that the hypothetical buyer and seller are assumed to be able, as well as willing, to trade and
be well informed about the property and concerning the market for such property.
Thinking like an Investor
When considering the value of an enterprise, and asset, or a liability, one should
focus on the size of the related future cash flows, the timing of those future cash
flows, and the uncertainty associated with those cash flows. The risk helps
investors determine appropriate expected returns from investment.
Rational investors engage in investments that are expected to create wealth. Wealth
is created when realized returns exceed expected returns. This basic concept is
fundamental to successful investing. So, what does this mean for the value of your
firm? It means that in order to understand a potential buyer’s perspective you need
consider the buyer’s returns expectations. You may be perfectly content to earn a
10% percent return on your equity capital, but other investors in the industry, or
related industries, may consider a 10% return insufficient for the level of risk in
your business. Therefore, for investment purposes they will expect higher rates of
return. In order to have a realistic chance at earning those higher returns the
potential buyers or investors will place a lower value on your business than you do.
Investors want to be paid for the risk they are taking. You should too. All else equal,
higher perceived risk results in higher expected returns, which in turn, result in
lower valuations.2
It is also important to realize that there are value drivers that are common to almost
every firm. These value drivers include the growth rate in revenues and earnings,
return on assets, return on invested capital, and most particularly return on equity.
If your firm is able to consistently produce relatively high rates for most or all of
these variables you already know that your firm is creating wealth for you and that
you can and should expect relatively high offer prices if you ever decide to sell.
Alternatively, if your firm is producing at modest or poor rates, expect modest or
poor prices and fewer offers.
Embrace Estimation and Forecasting
Recall that when we are thinking like investors we are considering the size, timing,
and uncertainty of future cash flows. Because every acceptable valuation method
relies on expectations of the future, they are necessarily dependent on estimation
and forecasting. But which valuation methods and estimators should we consider?
The following list contains those that are frequently used:
A. Book value of equity (accounting estimate of value)
B. Market value per share (market estimate of value)
A simple example illustrates this point. Consider an investor facing an investment opportunity that
costs $1,000 and has an expected payoff of $1,100. Such an opportunity is offering a 10% return. If
the investor is satisfied with this expected return then he or she will comfortably and willingly invest
$1,000. However, if the investor was expecting a higher rate of return, say 15%, then he or she
would be willing to invest no more than $956.52. At this price the expected return one the same
investment opportunity is 15%.
C. Discounted cash flows (theoretical estimate of value)
D. Option values (theoretical estimate of value)
E. Replacement values (market estimate of value of similar assets)
F. Liquidation values (market‐based estimate of value of similar assets)
G. Guideline company multiples (market estimate of value of similar firms)
H. Guideline transactions multiples (acquirer’s estimate of value of similar
firms)
At this point it’s natural to stop and ask: Why are there so many different methods
and estimators? The answer is straight‐forward – each method or estimator has
strengths and weaknesses. Each can be rationally applied to the valuation process
but each is subject to biases. Therefore, when an appraiser goes through the
valuation processes he or she should provide at least two or three valuation
methods to the exercise and triangulate a value range (e.g. for negotiations) or a
specific value (e.g. for estate tax purposes) for your company. This brings us to the
valuation process itself.
It’s all about the Process
An acceptable valuation is defined by adherence to the rules of the valuation
methods employed, and not by some desired outcome. The process requires that
the appraiser apply judgment and careful attention through out the valuation
exercise. Careful attention to the mechanical processes of valuation methodologies
alone is likely to render a less useful value. Even worse, if one quickly and
thoughtlessly inserts accounting data a valuation model without much thought, the
best one can hope for is a useless value. It is more likely that this approach will
render an inaccurate and misleading value. Ultimately, a reasonable valuation is
obtained from the application of knowledge, experience and wisdom to the data
gathered, estimated, and included in the valuation model or methodology.
It is also noteworthy to understand that business appraisers are typically not
industry specialists, but rather valuation specialists. While some appraisers
specialize in certain industries (e.g. real estate), it is more common for an appraiser
to rely on business owners for the industry specific knowledge necessary to
complete a valuation analysis. This isn’t to say that generalists won’t have other
resources to use in analyzing your firm and the related industry. They do. However,
because each industry operates in unique ways, your knowledge and experience will
allow a generalist to capture all the essential nuances related to the value of your
firm. As firm size increases and business activities become more complex, it makes
sense for owners to consider using more expensive industry specialists. At this level
the specialist may have access to data, knowledge, or an understanding of the
industry that you haven’t yet acquired. He or she can bring these into the valuation
analysis to make it more complete. However, for most privately held firms the
trade‐off between cost and additional insights isn’t justified. The lower cost
generalist will be able to provide an accurate estimate of value with your firm.
Think Critically
Once the base case assumptions have been determined, they have to be tested. That
is, the valuation process should include scenario testing and sensitivity testing to
scrutinize the assumptions used therein. In reality, it is easy to select variable
values in isolation, only to learn later that the variables and their associated values
interact in unexpected ways. Thus, the valuation process is an iterative one,
requiring feedback and refinement. Ultimately, the valuation process requires
critical thinking about the inputs and the outputs to ensure the integrity of the
process and the reasonableness of the valuation outcomes.
Some Other Considerations
Other considerations beyond the contracts perspective, value drivers and the
valuation process include the application of premiums and discounts, and
identifying pitfalls in the valuation process. These are addressed briefly below.
Control Premiums and Related Discounts
In addition to valuing your firm as a going concern, some other firm characteristics
may require adjustments to that value. For example, if there is a control position
(e.g. a single investor can determine or influence the outcome of major company
decisions, or in many cases, all of the companies decisions), then any other
shareholders are necessarily in minority positions. Minority positions are less
valuable than control positions and are therefore subject to discounts. There are
also discounts for lack of marketability (think private firms where no market for its
shares exists) and discounts for the lack of liquidity (e.g. shares that are
contractually prohibited from sale for any period of time). These adjustments to
value can have a profound effect on the value of shares in private companies and the
value of minority shares.
What Valuation is Not
It is tempting for owners to find quick and inexpensive ways to estimate the values
of their companies. For example, an owner may have an accountant or another
trusted professional advise them on the going rate for firms like their own. The
advice may take a form such as “just use one times revenues to find the value of your
company” or some other rule of thumb. This approach, while inexpensive and easy
to use and understand, has little hope of helping an owner arrive at a fair or
reasonable value for his or her company. Moreover, the IRS will not accept valued
derived such methodologies. In addition to the value drivers already mentioned,
firm characteristics such as expected growth rates, profit margins, distribution
policies, capital structure, off‐balance sheet financing, the ratio of tangible assets to
total assets, and the cost and availability of capital might cause the value of firms to
vary dramatically. There is little chance that your firm is sufficiently similar to
another firm that just sold that you would want to use that firm’s valuation
multiples without some serious comparisons and analysis.
It is also tempting to borrow valuation multiples (e.g. price‐earnings multiples) from
publicly traded firms and apply them to your own firm to arrive at a fair value. This
method is also incorrect for the previously mentioned reasons. In addition, the
powerful influences of control premiums, minority discounts, and other discounts
may create additional material biases in the resulting value.
Finally, as mentioned previously, the valuation process is not intended to arrive at
some pre‐determined value through manipulation of the methods and estimators
that are employed. Rather, the process is intended to guide an appraiser through
the application of valuation theory, reasonable estimators and assumptions, and
judgment and experience in order to arrive at a reasonable and credible valuation
outcome.
Summary
The valuation process is complex and requires the tools of valuation theory as well
as the judgment, knowledge, and skill possessed by an experienced appraiser. As a
business owner, there are many things you can do to add value to your firm, and
create wealth for yourself and your family. Ultimately, whatever those actions are,
they need to facilitate relatively high and sustainable growth in revenues and
earnings, while minimizing the amount of invested capital. The resulting high
returns on invested capital and even higher returns to equity will make your
company more valuable and more attractive to any potential buyer.
References
Bruner, Robert F, Applied Mergers and Acquisitions, 3rd ed., John Wiley & Sons, 2004.
Damodaran, Aswath, Damodaran on Valuation, 2nd ed., John Wiley & Sons, 2006.
Koller, Tim, Marc Goedhart and David Wessels, Valuation: Measuring and Managing
the Value of Companies, 5th ed., John Wiley & Sons, 2010.
Goedhart, Marc, Timothy Koller and David Wessels, The Right Role for Multiples in
Valuation, McKinsey on Finance, Number 15, Spring 2005.