Business valuation, or the synonymous term, business appraisal, is all about determining “the value” of businesses. The ASA Business Valuation Standards use a string of terms. Business appraisers value “businesses, business ownership interests, securities and intangible assets.”
I put “the value” in quotations because there is no such thing as “the value” of a business. We value businesses for particular purposes at particular points in time. The purpose of a valuation may impose required standards of value and what I refer to as “levels of value.”
Standards of value include fair market value, fair value (accounting), fair value (statutory), investment value, and others. Levels of value refer to placement on the conceptual levels of value charts used by business appraisers, including strategic control, financial control, marketable minority, and nonmarketable minority levels of value.
The particular point in time of a valuation is the valuation date (or appraisal date). This date determines the availability of information for consideration, conditions in the national economy, the industry, the public securities markets, and so on that are relevant for consideration by appraisers in reaching valuation conclusions.
So what is the value of a business? Let me offer the following definition, which is one that few have objected to over the years:
The value of a business, today, is the present value of all expected future benefits to be derived from the business, discounted to the present at a discount rate reflective of the risks associated with the expected future cash flows.
Appraisers call the valuation method defined by the above as the discounted cash flow model (or DCF method). The DCF model (or method) and the definition suggest that value is a function of expected cash flows and risk, which is true. Professor Gordon showed us that the DCF method can be reduced, under simplifying assumptions, to the following equation:
Value = Expected Cash Flow / (Risk – Expected Growth), or,
Value = CF1 / (r – g)
Given the formula expression of the Gordon Model, we see that the two variables of the DCF model, i.e., expected cash flow and risk, can be described as three variables. The three “valuation variables” are expected cash flow, expected growth of those cash flows, and expected risk. The “valuation variables” are brought to present value by the use of present value concepts.
What I have learned over the past 30+ years in this emerging valuation profession is that it is almost always (I never say always) a good idea to look at valuation questions, issues, and facts in terms of the implications for expected cash flows, expected growth of the cash flows, and the risks associated with the expected cash flows. It is certainly almost always a good idea to examine valuation in light of present value concepts.
When appraisers forget to do these seemingly simple things, or take shortcuts along the way to doing so, illogical valuation inferences, judgments, and conclusions can result.
This blog is ValuationSpeak. As we begin our discussion of valuation and value, we will continually look at valuation questions, issues and facts in light of expected cash flow, expected growth, and risk. And, of course, we will look at those questions, issues, and facts in light of the present value concepts that convert future cash flow expectations into value for particular purposes as of particular valuation dates, whether present, past or future.