Pursuant to the Statement on Standards for Valuation Services #1 issued by the American Institute of Certified Public Accountants (AICPA), the Internal Revenue Service Revenue Ruling 59-60, 1959-1 CB 237, and Miller v. Miller, 705 S.E.2d 839 (2010) “In developing the valuation, the valuation analyst should consider the three most common valuation approaches:
- Income (Income-based) approach
- Asset (Asset-based) approach or cost approach
- Market (Market-based) approach.” 1
“Although the asset approach can be used in almost any valuation, it is seldom used in the valuation of operating companies…The value of all tangible and intangible assets is captured, in aggregate, in the proper application of the income and market approaches.” 2
Although the market approach must be considered in every valuation assignment, there is often limited information regarding prior transactions, unless of course there was a recent prior sale of an interest in the subject entity. In addition to the limited information of sales of similar entities in the same industry, the date, location, form of entity (corporation v. partnership v. limited liability company v. sole proprietorship), form of sale (asset purchase/sale v. stock purchase/sale), and financing of the sale (amount of down payment, seller v. bank v. other financing, installment sale, consulting agreement for the owner-operator-seller) often limit the applicability of the market approach.
“Perhaps the most widely recognized approach to valuing an interest in a privately held enterprise is the income approach.” 3 “When someone buys a company or an interest in a company, what is that person really buying? Management? Markets? Technological skills? Products? Although each of these factors may be involved in the investment decision, what is actually being bought is the stream of prospective economic income.
The focus of this paper will be the income approach and how to challenge or support the expert’s conclusion of value with a more in-depth analysis of the underlying assumptions made in the calculation or conclusion of value derived under the income approach.
Let’s assume we own a $10,000 bank account. Let’s next assume that the bank is paying us a 6% interest. (Obviously not a current example). We would earn $600 of interest income from that bank account in one year ($10,000 x 6% interest rate equals $600). What if we knew the amount of interest income earned, the interest rate being paid to us by the bank, but did not know the value/amount of the bank account. Couldn’t we determine the value of the account by dividing the amount of the interest income ($600) by the interest rate (6%) and derive a bank account value of $10,000? ($600 divided by 6% equals $10,000)?
This is the basic analogy underlying the income approach. It helps the valuation analyst determine the value of a closely held entity. The sustainable after-tax cash flow is divided by the interest rate (better known as the capitalization rate) to calculate the value of the entity.
Sustainable After-Tax Cash Flows = Value of the Entity
There are additional considerations such as working capital requirements, capital expenditures, minority interests, etc., however this is the basic formula underlying the income approach. Since the basic formula to determine value consists of two items, a numerator (sustainable after tax cash flows) and a denominator (capitalization rate), a close analysis of these two items will help us support or challenge the conclusion of value prepared by the financial expert.
Next part will discuss strategies for your client.
1Statements on Standards for Valuation Services #1 (Valuation of a Business, Business Ownership Interest, Security, or Intangible Asset), para. 31, Valuation Approaches and Methods
2Financial Valuation-Application and Models, Third Edition, James Hitchner, James Wiley & Sons, Inc., 2011, p. 312
3Financial Valuation-Application and Models, supra, p. 121
4Valuing a Business-The Analysis and Appraisal of Closely Held Companies, Fifth Edition, Shannon P. Pratt, The McGraw-Hill Companies, Inc. 2008, p. 175
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