Business Value is in the Eye of the Beholder

By Charles L. Kern, CPA, CFA, AEP, ABV, CVA, CFF, FCPA

We have all heard the statement, “Beauty is in the eye of the beholder.” The same can be said for the value of a business, especially small, closely held businesses. The worth of any investment can be defined as the net present value of future cash flows that the investment will throw off to the owner for his or her role as the owner. For example, an owner might get a salary greater than a fair market salary because of their ownership status and not their employee status. A minority interest shareholder is usually less able to influence cash coming out of the business to them, than is a shareholder with a majority interest. Future cash flows may vary for different owners and, consequently, the value of the business may so vary.

There are many reasons why the value of any given closely held business may vary legitimately. One, in fact, will depend on the purpose of the valuation. For example, a valuation done for estate, gift, or income taxes may be different from that for debt security purposes; may be different from that for sale of business purposes; may be different for purposes of selling a minority interest to members of management; and so on. These and other purposes rely on different “standards of value.” Commonly incurred standards of value include, but are not limited to, fair value, fair market value, investment value, and liquidation value. Future cash flows will differ among buyers if the buyers have different sources or structures for funding the purchase. If one buyer has greater purchasing power relative to materials going into the end product, that buyer’s future cash flows will differ from those of a buyer without that purchasing power.

The fact that business value, like beauty, is in the eye of the beholder is a vital notion that the seller, the valuator, and the buyer must wrestle with. The following fundamental points need to be addressed and fully understood by all parties:

Standard of value is defined as the identification of the type of value being used in a specific valuation engagement. As found in the International Glossary of Business Valuation Terms, some of the commonly used standards of value include the following:

Two other frequently encountered standards of value are defined by other authoritative sources:

The most frequently encountered approaches to determining the value of a business include the market approach, the asset approach, and the income approach. The International Glossary of Business Valuation Terms defines the approaches as follows:

Commonly encountered subsets to the income approach include the capitalization of earnings method and the discounted cash flow method. Another subset is the excess earnings method, which is less frequently applied. The excess earnings method is of special and limited application, and is viewed by some as a combination (income and asset) method. I intuitively favor the discounted cash flow method, given how it coincides with the notion that a business’s value is the present value of future cash flows available to the owner in the role as owner. However, the difficulty of estimating the amounts and timing of cash flows well into the future for many closely held businesses often leads a valuator to the capitalization of earnings method.

All approaches and methods should be considered by the valuator to select the most appropriate, given the facts and circumstances. Whatever the approach and method used, it should be noted that all approaches and methods attempt to measure a value that can and will vary with the differing characteristics of different potential owners.