Posts Tagged ‘Asset’
Capital Asset Pricing Model (“CAPM”) The Capital Asset Pricing Model (CAPM) is one method of determining the appropriate discount rate in business valuations. The CAPM method originated from the Nobel Prize winning studies of Harry Markowitz, James Tobin and William Sharpe. The CAPM method derives the discount rate by adding a risk premium to the risk-free rate. In this instance, however, the risk premium is derived by multiplying the equity risk premium times “beta,” which is a measure of stock price volatility. Beta is published by various sources for particular industries and companies. Beta is associated with the systematic risks of an investment. One of the criticisms of the CAPM method is that beta is derived from the volatility of prices of publicly-traded companies, which are likely to differ from private companies in their capital structures, diversification of products and markets, access to credit markets, size, management depth, and many other respects. Where private companies can be shown to be sufficiently similar to public companies, however, the CAPM method may be appropriate.
How much your business is worth depends on many factors, from the current state of the economy through your business’s balance sheet. Let me say up front that I do not believe that business owners should do their own business valuation. This is too much like asking a mother how talented her child is. Neither the business owner nor the mother has the necessary distance to step back and answer the question objectively.
So to ensure that you set and get the best price when you’re selling a business, I recommend getting a business valuation done by a professional, such as a Chartered Business Valuator (CBV). In Canada, you can find Business Valuators through the yellow pages or through the website of the Canadian Institute of Chartered Business Valuators.
A Business Valuator (or anyone valuating your business) will use a variety of business valuation methods to determine a fair price for your business, such as:
1) Asset-based approaches
Basically these business valuation methods total up all the investments in the business. Asset-based business valuations can be done on a going concern or on a liquidation basis.
A going concern asset-based approach lists the business net balance sheet value of its assets and subtracts the value of its liabilities.
A liquidation asset-based approach determines the net cash that would be received if all assets were sold and liabilities paid off.
2) Earning value approaches
These business valuation methods are predicated on the idea that a business’s true value lies in its ability to produce wealth in the future. The most common earning value approach is Capitalizing Past Earning.
With this approach, a valuator determines an expected level of cash flow for the company using a company’s record of past earnings, normalizes them for unusual revenue or expenses, and multiplies the expected normalized cash flows by a capitalization factor. The capitalization factor is a reflection of what rate of return a reasonable purchaser would expect on the investment, as well as a measure of the risk that the expected earnings will not be achieved.
Discounted Future Earnings is another earning value approach to business valuation where instead of an average of past earnings, an average of the trend of predicted future earnings is used and divided by the capitalization factor.
Standard and premise of value
Before the value of a business can be measured, the valuation assignment must specify the reason for and circumstances surrounding the business valuation. These are formally known as the business value standard and premise of value.[1] The standard of value is the hypothetical conditions under which the business will be valued. The premise of value relates to the assumptions, such as assuming that the business will continue forever in its current form (going concern), or that the value of the business lies in the proceeds from the sale of all of its assets minus the related debt (sum of the parts or assemblage of business assets).
Business valuation results can vary considerably depending upon the choice of both the standard and premise of value. In an actual business sale, it would be expected that the buyer and seller, each with an incentive to achieve an optimal outcome, would determine the fair market value of a business asset that would compete in the market for such an acquisition. If the synergies are specific to the company being valued, they may not be considered. Fair value also does not incorporate discounts for lack of control or marketability.
Note, however, that it is possible to achieve the fair market value for a business asset that is being liquidated in its secondary market. This underscores the difference between the standard and premise of value.
These assumptions might not, and probably do not, reflect the actual conditions of the market in which the subject business might be sold. However, these conditions are assumed because they yield a uniform standard of value, after applying generally-accepted valuation techniques, which allows meaningful comparison between businesses which are similarly situated.
Income, asset and market approaches
Three different approaches are commonly used in business valuation: the income approach, the asset-based approach, and the market approach[2]. Within each of these approaches, there are various techniques for determining the value of a business using the definition of value appropriate for the appraisal assignment. Generally, the income approaches determine value by calculating the net present value of the benefit stream generated by the business (discounted cash flow); the asset-based approaches determine value by adding the sum of the parts of the business (net asset value); and the market approaches determine value by comparing the subject company to other companies in the same industry, of the same size, and/or within the same region.
A number of business valuation models can be constructed that utilize various methods under the three business valuation approaches. Venture Capitalists and Private Equity professionals have long used the First chicago method which essentially combines the income approach with the market approach.
In determining which of these approaches to use, the valuation professional must exercise discretion. Each technique has advantages and drawbacks, which must be considered when applying those techniques to a particular subject company. Most treatises and court decisions encourage the valuator to consider more than one technique, which must be reconciled with each other to arrive at a value conclusion. A measure of common sense and a good grasp of mathematics is helpful.