In the final part of this four part series, we explore the final key issue that must be considered when performing valuations on business entities.
Issues previously discussed were (1) basis of value, (2) selecting relevant financial components, and (3) avoiding common errors. In this final part, we’ll discuss the fourth issue to consider – reconciliation of results.
In a typical valuation engagement, an appraiser will consider as many approaches as possible to value the subject entity. The three commonly accepted approaches are the asset approach, market approach, and income approach. In fact, the professional standards of most business appraisal organizations require that, at a minimum, the appraiser consider those three approaches.
Under each approach, there may be various methodologies that could be applied to indicate a value for the subject entity. For instance, under the market approach, the appraiser could determine that there are similar companies on stock exchanges from which the value of the subject company could be estimated. This methodology is typically referred to as the Guideline Company Methodology. In that same appraisal, the appraiser could also determine that there are relevant market transactions of similar companies (i.e., sales of ownership in similar companies) from which another indication of value could be estimated. This methodology can be referred to as the Guideline Transaction Methodology. Both the Guideline Company Methodology and the Guideline Transaction Methodology are applications of the market approach, whereby market-derived information (using either publicly-traded shares on an exchange in the Guideline Company Methodology or ownership transactions of similar companies in the Guideline Transaction Methodology) can provide an indication of the value of the subject entity.
Because multiple methodologies and/or approaches can be used, an appraiser should take care when selecting the ones that he or she will rely on to value the subject entity. Such selection is based on many factors including the appraiser’s experience, the appraiser’s knowledge of the subject company and industry, and the relevance of the various methodologies/approaches in determining an indication of value of the subject entity.
The selected methodologies/approaches are typically then weighted to account for their relevance or significance. In the weighting process, an important step is to reconcile any differences between the indicated values from the various methodologies and/or approaches used. Some common errors in this reconciliation process include:
- Disparities – Failure to reconcile disparities between the methodologies/approaches. The methodologies/approaches may indicate similar or different values. Regardless of the size of the difference between the indicated values, the appraiser should explore reasons for such differences (if any) and be able to reasonably explain them.
- Logic – Were the different approaches given appropriate weighting?
- Reasoning – Do disparities reflect common sense? Do disparities have logical explanations?
In summary, when an appraiser considers multiple methodologies and/or approaches, he or she should reconcile the indicated values. Failing to do so could result in unreasonable, unsupportable conclusions in a business valuation. Check back for future posts related to valuation issues. In the meantime, if you have any questions about general business valuation concepts or more detailed questions about reconciling values from multiple approaches, please contact either Dan Branch or Mary Varon . How can we help?
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