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Step-by-Step to Business Valuation: Understanding the Process

PRACTICE AREAS

Determining the value of a business or a percentage of ownership in a business is a critical but often complex process. This article provides a step-by-step guide to understanding the key steps involved in business valuation, from defining the purpose and scope of the valuation to employing various methodologies and ultimately presenting a well-supported conclusion. Whether you are an entrepreneur, investor, or other stakeholder seeking to gain insight into a company's worth, this article aims to equip you with a clear and concise understanding of the business valuation process.

Published:

February 5, 2024

Key Contact:

Anastasia I. Bourgeois

Director

A typical business valuation engagement includes the following steps:

1.  Defining the Valuation Engagement.  A business appraiser identifies the ownership interest to be valued, the valuation date as of which the business interest is to be valued, the purpose of the valuation, the standard and premise of value on which the valuation is to be used, the type of engagement and type of a report that are needed, and if the necessary information is available. After sufficiently understanding the details for the valuation engagement, a valuation professional issues a written engagement letter that documents the specifics of the engagement, the scope of the services to be provided, and the terms of payment for the services to be rendered, as understood by the client and the valuation expert. The client and business valuator sign the engagement letter.

2.  Production of Required Documents.  A valuation professional provides an initial request for documents and information necessary to prepare an objective, well-founded, and supportable business valuation. Information and documents that need to be produced may include historical and projected financial statements, historical tax returns, corporate documents and any amendments in existence up to the valuation date, non-compete and confidentiality agreements, buy-sell agreements and any other restrictions or agreements among stakeholders, franchise contracts, leases, loan covenants, an organizational chart, information and documents related to prior ownership transactions, payroll, insurance policies, real estate and other assets owned by the company, historical or expected statutory or discretionary penalties or sanctions, any current, pending, or threatened litigation. 

​3.  Analysis of Economic Conditions and Industry Data.  A valuation expert assesses the overall economic outlook at the national, regional, local, and, if needed, international levels, as well as the prevailing condition and outlook for the relevant industry. Examining economic conditions sheds light on factors such as interest rates, inflation, and overall economic growth, all of which can significantly impact a company's future profitability. Delving into industry data reveals trends, competitive pressures, and regulatory changes that directly influence the company's performance and its future potential.

​4.  Review and Analysis of Financial Performance of the Company.  To perform a meaningful and thorough business valuation, a business appraiser gains an understanding of the nature, history and financial condition of the company being valued. This process usually includes reviewing historical tax returns and financial statements, including balance sheets and income statements, identifying historical operational and financial performance trends including profitability, efficiency, and solvency, and comparing the company’s performance to the industry average.

​5.  Normalization of Earnings.  Before applying any valuation approach, the company’s historical financial statements may need to be adjusted or “normalized” to better represent more economically realistic financial operating results and fair market values (FMV) of the company’s assets and liabilities. Normalized financial statements also allow a business valuation expert to make more meaningful financial projections and forecasts, and better compare the subject company’s financial performance and position to its industry peers. When normalizing financial statements, a business appraiser may remove excessive owner’s compensation, non-recurring revenue and expenses, non-operating assets and liabilities and related earnings and/or expenses, and make adjustments to inventory accounting and depreciation accounting methods.

​6.  Valuation Analysis.  In this step of the valuation process, the goal of a business appraiser is to determine how much a business or a percentage of ownership in a business is worth. According to the IRS Revenue Ruling 59-60, no general formula may be used to determine the value of a business that is applicable to all different circumstances and facts of business valuations. However, the general approach, methods, and factors which must be considered when performing a business valuation are defined by the IRS ruling 59-60. The following factors, although not all-inclusive, are fundamental and require careful analysis in each case:

1.    The nature of the business and the history of the enterprise from its inception.
2.    The economic outlook in general and the condition and outlook of the specific industry in particular.
3.    The book value of the stock and the financial condition of the business.
4.    The earning capacity of the company.
5.    The dividend-paying capacity.
6.    Whether or not the enterprise has goodwill or other intangible value. 
7.    Sales of the stock and the size of the block of stock to be valued.
8.    The market price of stocks of corporations engaged in the same or a similar line of business, having their stocks actively traded in a free and open market, either on an exchange or over-the-counter.

 

According to the Professional Standards of the National Association of Certified Valuation Analysts (NACVA), "valuation methods are commonly categorized into the asset-based, market, income, or a combination of these approaches. Professional judgment is used to select the approaches and the methods that best indicate the value". A business appraiser may rely on one or more of the valuation approaches and their underlying methodologies to arrive at the conclusion of value depending on the purpose and specifics of the valuation. The valuation report should explain why some valuation approaches and methods were selected and others were not in determining the value of a business. 

​7.  Application of Discounts and Premiums.  When deemed appropriate, a business valuation professional applies certain adjustments to the values derived using the three valuation approaches. Such adjustments may include a discount for lack of control, discount for lack of marketability, and control premium.

​8.  Reconciliation of Indicated Values.  Based on the appraiser’s informed judgement, reasonableness and common sense, a valuation professional reconciles the values indicated by the various valuation approaches to reach a final estimate of value after considering all relevant facts and fundamental considerations of the valuation. The value reconciliation process may be accomplished by assigning appropriate weightings to the values indicated by the various valuation approaches to assist clients in understanding an appraiser’s judgement related to the issue of greater and lesser relevance of the valuation approaches applied. When deemed appropriate, a business valuation professional may assign value to the non-operating assets and liabilities that were removed in Step 5 above and add this value to the final estimate of value.

​9.  Report Production and Presentation.  After a thorough quality control review to check for any errors or miscalculations, a draft report is prepared and may be presented to the client. If any revisions or corrections are identified, a revised final report is produced and sent to the client.

Typically, a final estimate of value contained in a valuation report is subject to a statement of assumptions and limiting conditions. Among other things, this statement communicates to the intended parties that a valuation expert has relied on the company’s financial statements, provided by the company’s owner or management, as being an accurate and fair representation of the financial position and operations of the company. The business appraiser has not audited, reviewed, or compiled the financial information provided and, accordingly, he or she expresses no audit opinion or any other form of assurance on this information. In addition, a business valuation is neither a legal nor a tax opinion.

Bibliography

 

Internal Revenue Service (1959). IRS Revenue Ruling 59-60. Valuation of Non-Traded Assets. See a link to full text (PDF).

National Association of Certified Valuators and Analyst, NACVA (2013). Professional Standards.  Retrieved from: https://www.nacva.com/Files/NACVA_Professional_Standards_Effective_06-01-23.pdf.

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