Business Valuation

Theory and Practice

Marco Fazzini

• Publisher: Palgrave Macmillan
• Year: 2018
• ISBN:
  9783319894942
• Topic: Business
• Subtopic: Finanza d'impresa
• Index: Business

This book provides an applied theoretical approach to modern day business valuation. It combines elements from both finance and accounting to help practitioners identify the most suitable method for analysis, showing when and how methods can be applied in different contexts and under specific constraints. It describes how business valuation techniques can be applied to calculate value in case of transactions, litigation, IPOs, and the fair value under an IFRS framework.
The purpose of this book is to offer a guideline for the application of an integrated approach, thereby avoiding "copy and paste" valuations, based on pre-packaged parameters and the uncritical use of models. Specifically, an Integrated Valuation Approach (IVA) should be adopted that encompasses, within any specific method, a wide range of elements reflecting the characteristics and specificities of the firm to be valued.
The book is based on the International Valuation Standards issued by the International Valuation Standards Council. Valuation standards allow for an alignment of both the methods and their application, providing a common basis for valuers.

© The Author(s) 2018

Marco FazziniBusiness Valuationhttps://doi.org/10.1007/978-3-319-89494-2_1

Begin Abstract

1. Value, Valuation, and Valuer

Marco Fazzini¹

(1)

European University of Rome, Rome, Italy

End Abstract

1.1 What Does Making a Valuation Mean?

In life we continuously make valuations. When we go shopping, for example, we make sure that the proposed price reflects quality; when we book a room, we make sure that the rate is in line with the hotel features and the services it offers; when we choose a school for our kids, we assess the quality of the programs and the teachers’ standing; when we buy a house, we make sure that the value is in line with that of other houses in the neighborhood.

In short, valuations are part of our daily experience; generally, they consist of two components: an objective one, which regards the intrinsic value, and a subjective one, linked to the valuer’s perception of the object to be valued. Separating these two components is difficult, as our choice is never entirely based on either the subjective or the objective component, but on a mix of both. For example, when buying a house, we do not choose the house with the best price per square foot, regardless of its characteristics; nor do we solely rely on our aesthetic perceptions, neglecting the price. Not surprisingly, we make choices based on a trade-off between objective circumstances (price) and subjective perceptions (location, finishes, interior design, etc.).

This mechanism is easy to find in contemporary art auctions. Given an objective value, based on previous auctions, expert judgment, quality of the work, and so on, the results may differ significantly, reaching amounts that have little to do with the characteristics of the work or with the prices attained in previous auctions.

Business valuations work in the same way. There is an objective component of value, based on valuations methods, and a subjective one, based on the valuer’s experience and ability to capture reality.

This means that two equally knowledgeable persons, with similar sensitivity, will hardly get the same result, although they start from the same assumptions and quantitative inputs. To make a comparison, think of two chefs who are given the same ingredients to prepare a certain dish. The result may appear similar, but the different combination of timing, cooking processes, doses, creativity, experience, and dish presentation will lead to different outcomes.

In this book, we will deal with the objective component, which is how we determine the value of a business based on generally accepted valuation methods.

What does it mean to value a business? We can respond that valuation is the act of estimating or setting the potential value of a business by considering both internal and external variables.

The internal variables look at the results a firm has achieved in the past; for example, the debt-to-equity ratio, EBITDA (earnings before interest, tax, depreciation, and amortization), revenues, and cash flow provide us with an understanding of what characterizes the business and constitute a basis for determining its value. The external variables look at the environment in which the company conducts its business and include, for example, market features, the company’s competitive positioning, distribution channels, or consumers’ tastes. In short, it is necessary to develop a comprehensive opinion that encompasses in one single model both the theoretical business value and the value that considers the environment where that business develops and performs its activity.

This is why the method presented in this volume is called integrated valuation approach (IVA). According to this approach, the evaluation process does not end with the application of a model, but requires considering the business as a whole.

1.2 The Business Valuation

Valuing a business is a complex exercise for various reasons.

First of all, the characteristics of the business change quickly. Over time, changes may occur that affect the value of the business, for example, a reduction in profit, higher investments, new debts, different revenues. Value, therefore, is neither constant nor immutable, but must refer to a specific date and situation. A valuer is like a photographer who has to take a picture of a moving object. To obtain a clear image he or she needs the right camera and the right setup and must have enough experience for this type of shot. Likewise, valuers must be able both to choose the model that better interprets the value and to apply it correctly.

Secondly, the value of a firm can be seen from different perspectives. As we will see further on, we can use methods that are based on expected cash flows (income methods, see Chap. 4), market values (market methods, see Chap. 5), and reproduction/replacement cost (cost method, see Chap. 6). Each of them considers some specific aspects of the firm and can lead to partially different results. As mentioned in IVS 105 (International Valuation Standard 105) “the goal in selecting valuation approaches and methods for an asset is to find the most appropriate method under particular circumstances. No one method is suitable in every possible situation.” Valuers must therefore apply their experience and judgment to identify the most suitable approach; it means that value depends not only on business characteristics but also on the model applied.

Furthermore, not all assets can be measured. The value drivers of a firm are often based on elements that can only be quantified through the output they produce. For example, the value of Facebook is linked to assets such as the number of users, competitive positioning compared to other social networks, the ability to innovate, and integration with other platforms such as Instagram and WhatsApp. Evaluating Facebook based on financial figures only could be an oversimplification.

As shown in Table 1.1, the market value of Facebook rose by 109.80% from 2013 to 2014, from $66.4 billion to $139.3 billion. Assuming there is no constant relationship between market value and financial data (otherwise we would now have the “safe” investment formula), none of the key figures have changed in the same way as market value. Expectations about the company’s value were evidently higher than the results achieved. Market value increased more than proportionally compared to key financial figures also from 2014 to 2015.

Table 1.1

Facebook financial key figures and market value (2013–2016)

Consolidated data ($/Mil)	2013	YoY growth (%)	2014	YoY growth (%)	2015	YoY growth (%)	2016
Revenues	$7872	58.36	$12,466	43.82	$17,928	54.16	$27,638
Income from operations	$2804	78.10	$4994	24.65	$6225	99.63	$12,427
Free cash flow	$3458	58.91	$5495	41.89	$7797	48.99	$11,617
Market value	$66,420	109.80	$139,350	56.39	$217,930	39.19	$303,330

It was only from 2015 to 2016 that the increase in market value was lower, probably due to investors’ perception of a stronger alignment between key financial figures and market value.

Hence, financial results do not perfectly reflect the value of a firm and, although they are the basis on which business valuation is built, there are other aspects that cannot be measured reliably.

Finally, there is a difference between price and value: in an ideal world they should coincide, but in practice they may differ, and the gap can be significant.

Price is the amount requested to purchase an asset. It is an empirical quantity that is influenced by supply and demand. Value, on the other hand, is the result of an estimate and may reflect a potential price in a transaction between two independent parties.

Here are some examples to help you better understand this price/value gap.

A cotton T-shirt made by an haute couture company, with a modest intrinsic value of a few dollars, is put on the market at a price of tens or hundreds of dollars. In this case, price is higher than the value of the good.

Here is another example: in a crisis situation, people may have to sell out some of their property (e.g. jewelry, buildings, art collections) for amounts lower than their intrinsic value. In this case, price is lower than value.

We face the same problem when valuing a company. How much is 2% of a small firm’s equity worth when another shareholder owns the other 98%? In theory, that stake is worth 2% of the total value of the company; in practice, the price may be impossible to define or close to zero, as there would be no buyer due to lack of marketability. Indeed, who would want to spend money to buy a minority interest that (a) is difficult to sell and (b) has absolutely no influence on the majority shareholder? In this case, again, price and value may have no correlation at all.

If we generalize the concept, value reflects a potentiality; price, on the other hand, reflects the here and now. The misalignment between value and price is sometimes significant, but no amount is “truer than another”. They can both be justified, depending on the characteristics of the good to be traded and the circumstances. Moreover, as Oscar Wilde once said, “nowadays people know the price of everything and the value of nothing”.

1.3 What Is Value?

“ Value” is not a concept that can be easily enclosed in a universally valid definition; there is no unique measure for it, not even from a quantitative standpoint, since, depending on the instruments used, the data taken as reference, and the interpretation proposed, we may obtain different results, all of them equally plausible and consistent.

Correctly applying a formula is not enough to reach the reasonable certainty that the result is the value of the entity, since it is highly unlikely that an equation can capture the complex set of conditions surrounding a firm.

A value is much more likely to be defined, in quantitative terms, through a range of plausible values, the breadth of which depends on methodological accuracy and the ability of the model to interpret the business specificities (Fig. 1.1).

Fig. 1.1

Range of plausible values

Value, therefore, is neither an absolute nor a unique concept. There is, actually, more than one configuration of value, depending on the purpose of the assignment and the characteristics of the business. This is precisely why referring to bases of value is more appropriate, as suggested by the IVSs.

According to IVS 104, “bases of value (sometimes called standards of value) describe the fundamental premises on which the reported values will be based”. The standard adds that “it is critical that the basis (or bases) of val...