A company’s historical financial statements cannot be used by themselves to determine the value of a business. Financial statements are prepared according to generally accepted accounting principles (GAAP). GAAP relies on the historical cost of assets or the price paid for them at the time of acquisition. Additionally, depreciation, amortization, and some other expenses are applied based on accounting rules not on economic realities. Historical financial statements do not show any goodwill or other intangible asset value that may be in place due to the successful operation of the business over a number of years. Other intangible assets that may not be reflected on company financial statements include such things as proprietary lists, beneficial contracts, below market leases, patents and applications for patents, copyrights, trademarks and brand names, subscriptions and service contracts, franchise agreements, and in-house developed software.
When appraising a company, historical financial statements are used to help assess risk and to project likely future returns.
Valuation methods typically fall under one of three basic appraisal approaches: the asset approach, the market approach, or the income approach.
The asset approach uses appraisal methods that consist of a review of the individual assets of the company. The most commonly used asset approach method is called the adjusted book value method. In this method, assets and liabilities are adjusted to the standard of value, for example fair market value. The major weakness of this method is that the intangible asset value of a going-concern business is not measurable. Occasionally, an appraiser may use an asset approach method in combination with a hybrid-method, the excess earnings method, used to value the intangible assets of a company.
The market approach uses businesses in the same or similar industry to develop valuation multiples that can be used to determine a value for the business in question. Several methods may be used—some use information from the sale of private companies, others use the sale of public companies or the price of stock as of the date of valuation for comparable public companies in the same or similar industry.
The income approach consists of two primary methods: the capitalization of cash flow method and the discounted cash flow method. These two methods are mutually exclusive. The basic difference between the two is based on the stability or lack thereof of expected future income. The most difficult part of the income approach is the determination of the appropriate discount or capitalization rate to be used. A discount or capitalization rate measures the risk associated with achieving the projected income or cash flow.
Some formulas exist to give businesses in a particular industry an easy, quick way to estimate a value. These formulas are generally referred to as rules of thumb. Rules of thumb usually provide a range of values—often a wide range of possible values. They are best used as checks for reasonableness instead of appraisal methods.
The appraiser must reconcile the various values determined from each appraisal method to determine a final value for the company.