Value is the foundation of every investment. Whether a valuation is performed to support the sale to an employee stock ownership plan (ESOP) or to a third party, understanding the factors underpinning a valuation is critical. But what exactly is meant by “value” or valuation?
There are many definitions of value that differ depending on context. For example, a valuation supporting a sale to a strategic buyer might be focused on investment value, whereas ESOP valuations, in accordance with Employee Retirement Income Security Act of 1974 (ERISA) Section 3(18)(B), are focused on fair market value.
Value Definitions
Several business organizations have agreed upon certain definitions of value. They include:
- Intrinsic Value:1 This defines the value that an investor considers, on the basis of an evaluation or available facts, to be the “true” or “real” value that will become the market value when other investors reach the same conclusion. When the term applies to options, it is the difference between the exercise price and the strike price of an option and the market value of the underlying security.
- Investment Value:2 This pertains to the value of a particular investor based on individual investment requirements and expectations.
- Fair Market Value (FMV):3 The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market (when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts).
The IRS further defines FMV as the price at which the property 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.4 Court decisions frequently state in addition that the hypothetical buyer and seller are assumed to be able, as well as willing, to trade and to be well informed about the property and concerning the market for such property.5
One of the key components of the definitions of FMV is the focus on a hypothetical willing buyer and willing seller. At times, investors may be motivated to pay a premium to secure benefits, also known as synergies, that they believe can be derived from an acquisition. Under the FMV standard, these buyer-specific synergies are generally not captured in the valuation. On the other hand, investment value is focused on a specific buyer and typically does account for these expected synergies.
Additional Factors to Consider in a Business Valuation
After determining what standard of value is applicable, there are many factors that need to be considered in determining the value of a business. Revenue Ruling 59-60 provides a good starting point and outlines key factors that valuation professionals need to consider when valuing a company.6
- Nature of the business and history
- Economic outlook and industry conditions
- Book value and financial condition
- Earning capacity of the company
- Dividend-paying (distribution) capacity of the company
- Goodwill or other intangible value
- Sales of the stock and the interest to be valued
- Market price of comparable stock
These factors provide a consistent framework for valuation professionals. However, each company and valuation is unique, thus the impact of such factors will differ based on the specific facts and circumstances of the respective valuation.
Below is a breakdown of the first four factors outlined in Revenue Ruling 59-60 and what they mean for a company’s valuation.
1. Nature of the Business & History
Understanding the company’s business and history is a key step in ascertaining value. The nature of the business can help a valuation professional understand the strengths and weaknesses of the business and ultimately understand the riskiness of the business. Risk is an influential component of every valuation, often captured in the form of a discount rate. In general, increased risk decreases value.
2. Economic Outlook & Industry Conditions
The general economic environment, as well as industry conditions, has an impact on a company’s value. For example, a company operating in a highly competitive industry may experience pricing pressure compared to a business with little direct competition. High inflation and rising interest rates can compress profit margins and increase borrowing costs, which have a direct impact on value.
3. Book Value & Financial Condition
This factor focuses on a company’s balance sheet. Is the company highly leveraged? If so, why? Some businesses operate in asset-intensive industries that require a significant amount of fixed assets to generate revenue. A company’s debt level and liquidity are important considerations in a valuation.
4. Earning Capacity of the Company
The earning capacity of a company is arguably one of the most important factors to consider. Understanding the company’s historical earnings, as well as future earning capacity, is a vital part of the valuation process for operating businesses.
At its core, valuation is based on expectations for the future. Investors buy and sell based on their future expectations of a company’s performance. Have the company’s earnings been growing or shrinking and is that expected to continue? Has the company’s performance been erratic or stable? For some businesses, historical performance may not be indicative of future performance. Analyzing the past in relation to future expectations can help determine the riskiness of the company.
Putting It All Together
The above factors all work together, with varying degrees of impact, to reveal the value of a business. These factors are interwoven and influence each other. The economic outlook and industry conditions may impact the earning capacity of a business. In addition, the nature of the business has an impact on the financial condition of the company.
Examining the factors outlined in Revenue Ruling 59-60 is a great starting point for determining the value of a business, though that is only the beginning of the journey. Each company is different, meaning each valuation will need to be customized based on unique business facts and circumstances.
How Forvis Mazars Can Help
Our Valuation team can assist with independent, technically sound valuations tailored to help meet your unique needs. We bring experience, led by skilled professionals who prioritize excellence and deliver an Unmatched Client Experience®. For more information on ESOP valuations and more, please reach out to a professional at Forvis Mazars.