Valuation- An Analytical Exercise

by | April 10, 2012

Our guest blog post this week comes from Mark Mitchel, Director of Valuation Services, Clothier & Head, PS.


A business valuation is an analytical exercise to determine the value of a business (or its individual assets), giving consideration to all of the factors that influence the operating performance of the business.

Key valuation concepts include the following:

  • Greater cash flows, earlier timing and lower risk increases value.
  • Operating forecasts should reflect an expected outcome, not pessimistic or optimistic outcomes.
  • Risk is accounted for in both the discount rate (or the rate of return required by an investor) and the cash flow forecast.
  • Some risks affect all asset prices (macro-economic factors) = “systematic risk,” risk that is typically accounted for in the discount rate.
  • Other risks affect only individual business (loss of a key customer, “dry hole” risk) = “unsystematic, or specific, risk,” risk that is typically accounted for in the determination of expected cash flows.

There are three principal valuation methods:  income, market and cost

The income approach measures the present value of expected future net cash flows generated by the business.  Models can involve multiple periods, as in a discounted cash flow model, or a single period, as in a capitalization of earnings model.  Though dependent on numerous assumptions, the flexibility in a multi-period forecast provides the best framework for understanding value drivers.  The discount rate is a key variable.

The market approach determine value based on the amount paid for similar companies, with prices typically expressed as a multiple of certain measure(s) of operating performance, such as sales, earnings before interest, taxes, depreciation and amortization (EBITDA), earnings before interest and taxes (EBIT), pretax income, net income or book value.

EBITDA multiples are commonly used because interest expense and depreciation can cause distortions when comparing otherwise similar companies.  Sales multiples are highly correlated with margins (e.g., a business with 10% EBITDA margins and a value equal to 50% of sales, carries a value equal to 5x EBITDA; at 20% EBITDA margins, a 5x EBITDA multiple yields  a value equal to 100% of sales; relatively high sales multiples are inconsistent with low margin entities and conversely).

Data can involve transactions of entire companies or trades of minority interests in public companies.

The asset (or cost) approach can be thought of as a replacement cost analysis (that does not result in liquidation value if completed properly).

The approach is applicable to both tangible and intangible assets.

The general principle is to create a fair market value balance sheet.

Types of intangible assets:

  • Customer lists/relationships
  • Patents
  • Trademarks and trade names
  • Other intellectual property
  • Subscriber bases
  • Assembled work force
  • Avoided start-up costs
  • Other elements of goodwill

All value enhancing activities should focus on the creation and sustainability of intangible asset value.  Economic value added is a key measurement tool when thinking about intangible asset value.  It is important to consider the cost of invested capital in the context of return on invested capital.  Excess returns indicate the creation of value, while deficient returns indicate the destruction of value.

Factors to consider when contemplating a business transaction include the following:

  • For certain transactions, negotiations of non-competition agreements and/or employment agreement are key factors in total deal value.  The effective transfer of certain elements of personal goodwill is often necessary for a seller to secure maximum value.
  • Buyer’s negotiate from a starting point roughly equivalent to book value (under the assumption that downside is virtually eliminated) and make additional payments contingent on forward performance.


  • Earn-outs may be necessary for a seller to secure full value.  The participation of the seller(s) in business management during the period covered by the earn-out will often influence negotiations on this aspect of the transaction.  Earn-outs represent one path for a seller to secure additional value if the seller believes that forward performance carries less execution risk than the seller.
  • Unexpected changes in profitability, either positive or negative, will often lead to changes in transaction terms, delays or cancellation of transactions.
  • Sellers preparing for a sale should focus on improving operating performance.  Negative or static trends may limit the quality and quantity of buyers and reduce multiples.
  • Synergistic buyers may be able to pay higher multiples than financial buyers; however, multiple buyers, of whatever class, are likely to lead to richer valuations than would be the case with a single buyer.  Financial buyers may be limited by credit constraints in some environments.
  • Sellers should be aware of working capital deficiencies, remedial capital expenditures and contingent liabilities.