How to Read a Valuation Report

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The first inclination when picking up a valuation report is to turn to the page expressing the value. This shortcuts the benefit of the report and creates an assumption of value to the user without an explanation of how or why the valuator arrived at such an amount.

Besides a conclusion of value, a valuation report should provide the purpose, standard(s) followed, assumptions utilized, approaches considered, and methods incorporated.

Valuation reports are used in buying and selling businesses, planning for transitions, settling disputes, estate planning, divorce (business or domestic) and various other reasons. Valuation reports are typically produced based on standards as established by the American Institute of Certified Public Accountants (AICPA), Uniform Standards of Professional Appraisal Practice (USPAP) or other governing organizations.

All reports are not created equal. The report may be detailed, in summary, a calculation or even oral. The level of detail may be important to the user based on his or her level of knowledge of the particular business being valued or purpose of the report.

The purpose of the report should be stated since this restricts how it is to be used and prepared. The purpose also sets the context in which it should be understood. For example, the purpose of a report produced to establish a selling price to a strategic buyer may be materially different than one for use in estate planning.

With the purpose understood, one should then consider the assumptions under which the report has been produced. Is the value based on fair market value, fair value, liquidation value or another basis? Fair market value (FMV) is defined as the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts. Fair market value assumes a cash purchase with no financing provided by the seller. The buyer is unknown, hypothetical as is the seller. If the purpose of the valuation is to sell to a particular buyer (strategic or synergistic) the reader should be aware that different assumptions may be used in the final estimate of value of the business.

Fair value (FV) typically assumes there is not a willing buyer or seller, the seller is under compulsion to sell, a concept of fairness to the seller is considered and there is no assumption as to equal knowledge of the parties. Fair value is typically used in dissenting and oppressed owner disputes.

Both FMV and FV assume the business will continue to operate as a going concern.

Liquidation value estimates the net value remaining after the entity ceases to operate.

The definition of terms used in a valution report should not be overlooked by the user. Detailed and summary reports will typically contain a glossary of business valution terms. These definitions will distinguish their use for purposes of valuation as opposed to the same word’s use in another context.

The value of a business is typically considered using three approaches: asset, income, and market. One of those approaches is then chosen as the most appropriate when arriving at a conclusion of value.  All of the approaches may be compared within the report.  The asset-based approach considers the value of the assets owned by the business less liabilities to determine a value. This approach may be used when real estate is owned by the entity and its value is different than the depreciated cost on the balance sheet. The income approach considers the value of the business by converting anticipated economic benefits (cash flow) into a present single amount. The market approach considers the value of the business by comparing the business to similar entities, ownership interests, securities, or intangible assets that have been sold.

Once the historical financial results are reviewed, forecasts of future operations considered, then the potential buyer must assess the risk associated with the purchase. That consideration can be compared to other investment opportunities. That comparison can be between “risk less” returns on government bonds to equity investments in large, middle, or small publicly traded securities all the way to closely held startups.  The end result being, what return on my purchase is acceptable to me as the buyer? Is it 10%, 20%, or more?  The return sought by the buyer is typically called the cost of capital. The valuation report will address the cost of capital and most likely express that as a discount or capitalization rate which may be utilized as a multiple of earnings or cash flow. For example, a 20% cost of capital equates to a multiple of five (100/20).

The purpose of the report will define the percentage of value being determined in the business, whether 100% or less. Ownership of over 50% is usually associated with a controlling interest (depending on governance documents) while 50% or less are seen as non-controlling.  If the business is not readily marketable as in a sale which may be concluded in a few days (publicly traded securities) the interest is described as non-marketable. This is not to say non-saleable but rather to point out there is less liquidity (ability to convert to cash) with the interest being valued.

A non-marketable, non-controlling ownership interest will be subject to a majority of owner(s).  With less control over the decision making within a business, the non-controlling owner will be at the “mercy” of those in control.  The lack of control is typically estimated by applying a discount for lack of control to the interest being valued. Likewise, a discount for lack of marketability will be applied to estimate the cost of selling, time period involved and other factors.

Finally, the reader reaches the conclusion or estimate of value in the report. At this point the purpose of the report, assumptions made, historical results and, perhaps, forecasts considered as affecting the approaches to value are understood by the reader.  That understanding is then considered as to the risk involved, possible return on the investment and nature of the interest be it minority (non-controlling) or majority (controlling).

A user of the report will almost always additionally benefit from inquiring of the author or other experts in the field of valuation as to terminology, considerations, and reasoning behind the conclusion(s) of value.

Price CPAs has extensive experience in valuations of all types. If you are in, or expect to be in a position where a valuation is needed, please contact us at 615/385-0686, through our website (www.pricecpas.com), or via email at shayna@pricecpas.com.

Tom Price
Partner, CPA, ABV, CFF, CVA