Building Value Is a Process
Part One of a three part series.
The process of building value in a company starts with a basic understanding of how value is determined.
There are three appraisal principles that constitute the foundation of valuation theory. These principles are (1) the principle of alternatives, (2) the principle of substitution, and (3) the principle of future benefits.
The principle of alternatives states that in any contemplated transaction both buyer and seller have choices and do not necessarily need to enter or proceed with a proposed transaction.
The principle of substitution states that value tends to be determined by the cost of an equally desirable substitute. In other words, if two items are identical, except for price, a willing buyer will gravitate to the item with the lower price. Or, in terms of an investment, if two investments have equal risk an investor will invest in the item that provides the greatest return.
Finally, the principle of future benefits tells us that economic value reflects anticipated future benefits. Basically, there are three reasons that investors will invest in a certain stock: (1) dividends (future cash flows to the investor), (2) capital appreciation (future cash flows to the investor upon sale), or (3) a combination of the two.
Since there is no ready market for closely held stock, an experienced valuator, keeping in mind the three principles above, will analyze and examine a vast array of information before selecting an appropriate valuation method or methods. The valuation method selected will fall within three general approaches:
In the asset approach emphasis is placed on the current value of the assets less liabilities. It is typically used for companies with volatile or low earnings, holding companies, companies that will soon be liquidated and capital intensive operations. It does not provide a value for goodwill which must be computed separately if it exists.
The market approach employs the valuation principle of substitution. The substitution theory states that similar assets have similar values. Therefore, by comparing the subject company to other comparable companies a reasonable estimation of value is obtained. The market method is a highly regarded method for valuing a going concern because value is derived directly from the marketplace. However, finding suitable comparable companies is extremely difficult and often time consuming.
For profitable, non-public companies, the Income Approach is often favored. The income approach measures value based on the principle that the value of a business is equal to the present value of the future benefits of ownership. The benefits of ownership are most often expressed in terms of net cash flow. The present value factor is usually referred to as a capitalization or discount rate and is generally considered to be a measurement of investor risk expressed as a percentage.
The income approach employs a simple formula to determine value:
Value = Benefit/Risk
Therefore, maximizing value is a function of increasing net cash flow, decreasing risk or a combination of both.
Next month, in Part Two of this article, we will discuss ways to increase cash flow and minimize investor risk.
Thomas G Stevenson, CPA, CVA