The Basics of Business Valuation: What Matters and Why

Before we dive into methods of business valuation, we should start with a basic discussion about what value means and why we can, or even want to, rely on business valuation methods. Once we are comfortable with what value is and why we should wonder about it, we will go over the mechanics of classic valuation approaches. We’ll focus on the ones that are typically used – with minor variation - by a variety of market participants, including corporations, banks, portfolio managers and venture capitalists, buyers or sellers alike. 

What’s Value Anyway?

Not surprisingly, value can mean different things to different people, depending on the circumstances, interpretations and role played in a transaction. For example, value means different things when we buy an asset versus when we sell it. It’s simply human nature to assign a higher value to what belongs to us, when we try to sell an asset, than when we purchase the same exact asset.[1] Research also shows that people tend to assign more value to something earned rather than to something gained. As a result, we are much more likely to assign less value to the million dollars won in Vegas (and spend it less wisely), than the same amount of money in our IRA after a lifetime of savings and sacrifices. It makes sense. Or does it?

Based on our everyday experience, we also notice the difference between price and value. If we are trying to buy a Modigliani masterpiece at a Sotheby’s auction, we can assume that there is a lot of uncertainty as to whether or not the price, or winning bid, reflects the actual value. As the highest bidder, there is the possibility that we overpaid for the Modigliani and we will remain doubtful until we sell it in the next auction.[2] Only then will we be able to see if it resells for at least the same amount. Conversely, if we buy stock of a blue chip company with over 500 thousands shares traded every day,[3] it’s almost certain that we can resell it immediately for a similar. In this case, price is more likely to be “fair” and reflective of the true value of the asset (unless we are, of course, in the middle of a market bubble). This is because, quite simply, many more people are involved, information is widely available and exchanges of shares happen on a daily basis, helping to correct pricing inefficiencies almost immediately. All of these factors should lend themselves to a more rational outcome.

More similar to the example of the Modigliani masterpiece, the price of a privately held company can be established only after a lengthy process (typically an auction), when the counterparties shake hands and the negotiated total consideration is wired to the bank account of the seller.[4] However, once the ink dries and ownership is transferred, price will be left to range freely, until it can be corralled in another auction process. In this case, despite its inherent limitations, business valuation can help us estimate the price that would be paid in a live transaction without actually having to sell a company.

So let’s break down some of the common value terms, particularly those related to business valuation techniques:

-          Fair market value: the price at which a business would change hands between a willing buyer and a willing seller  when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts;[5]

-          Investment value: the value of a business in the hands of a particular buyer based on its own specific attributes.

Taking some liberties with the interpretation, we can think of Fair Market Value as the going concern of a business that either continues to be operated by its current management or is sold to a new owner who will continue to manage the business efficiently, without any substantial changes.[6] In other words, the buyer is an average market participant, therefore value is not dependent on who operates the company, but on the uniqueness of the assets. Conversely, Investment Value assumes the combination of the subject company with one or more businesses and this creates synergies that are peculiar to every single potential acquiror. The motivation and/or special characteristics of the buyer will translate into different types of value (value follows the buyer).