Steps in the Business Valuation Process
INNP Consulting > Insights > The Asset, Income, and Market Approaches to Value a Business
March 17, 2020
What are the Steps in the Business Valuation Process?
BY ANASTASIA BOURGEOIS
A typical valuation engagement includes the following steps:
1. Defining the Valuation Engagement. A business appraiser identifies the ownership interest to be valued, the valuation date on 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 necessary information is available. After sufficiently understanding the details for the valuation engagement a valuation professional issues a written engagement letter that documents the above mentioned 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 signs 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. Documents that need to be produced by the owner or management of a closely-held or privately-owned business may include historical and projected financial statements (balance sheets and income statements), tax returns, a corporation’s articles of incorporation, an LLC’s operating agreement, a partnership agreement, other private arrangements agreed to among stakeholders, a buy-sell agreement, and contracts, such as franchise agreements, leases and loan covenants.
3. Analysis of Economic Conditions and Industry Data. A valuation expert assesses the overall economic outlook (national, regional, local, and, if needed, international), and the condition and outlook of the relevant industry.
4. Review and Analysis of Financial Performance of the Company. To perform a meaningful and thorough business valuation, a business appraiser should gain an understanding of the nature, history and financial condition of the closely-held or privately-owned company being valued. This process usually includes reviewing historical financial statements, including balance sheets and income statements, identifying trends, and comparing the company’s financial performance to industry averages.
5. Normalization of Earnings. Before applying any valuation approach, the company’s historical financial statements are adjusted or “normalized” to better represent a 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 projections and forecasts, and better compare the subject company’s financial performance and position to its peers and industry averages. When normalizing financial statements a business appraiser may remove excessive owner’s compensation, non-recurring revenue and expenses, non-operating assets and liabilities and their related earnings and/or expenses, and make adjustments to inventory accounting and depreciation accounting methods, and for GAAP compliance.
6. Valuation Analysis. In this step of the valuation process, the goal of a business appraiser is to determine how much a closely-held or privately-owned 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.
According to the business valuation professional standards, business appraisers are required to consider all three main valuation approaches in every valuation engagement - the asset, market and income approaches (click here to read more about the Three Main Approaches to Value a Business). A business appraiser usually relies on one or two 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 control premium, a discount for lack of control, or a discount for lack of marketability.
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. After a thorough quality control review to check for any errors or miscalculations, a draft report is prepared and may be reviewed by 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 or calculation 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.
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 (2015). Professional Standards. Retrieved from: http://web.nacva.com/TL-Website/PDF/NACVA_Professional_Standards_Incl_Review_Stnds_Effective_8-1-15_Final.pdf