The art of business valuation.

• Author: Cassiere, George G.

Discounted cash flows, comparisons and more

Business valuation truly is an art--an art that is predicated on well-defined financial theory.

The willing buyer and the seller consider two primary factors when negotiating the price: the future benefits from ownership, normally in the form of cash disbursements (termed dividend capacity), and the nature and level of the risk of the investment.

Since the value of the company is primarily from future cash flows that the company will generate for the equity investor, the most direct method of valuing a business is by discounting forecasted future cash flows to present value at a reasonable rate of return to the equity investor. While being the most theoretically correct, the method also can be the most sensitive to minor changes in assumptions. Many business-valuation professionals consider this method to be the most subjective, and therefore look to other "relative" valuation methods.

For example, a common measure of relative value for a company is the price-earnings ratio, or P/E. If reasonably comparable publicly traded companies can be found, the value of a privately held company can be predicated on the P/E ratios of those particular companies. A good analogy is buying a home. The final negotiated price of a home in a particular neighborhood will be greatly influenced by recent sales in the neighborhood. This method of basing the value of a subject company on the price of comparable companies is termed the market-valuation approach.

There are times when the value of the business is best determined by the underlying value of its assets and liabilities. There are cases when the sale of assets minus the settlement of liabilities is worth more than the value of the business as a going concern. Methods in this category are appropriately termed asset or modified book-value methods. Liquidation value would fall into this genre. When appropriate, the valuation professional will perform a liquidation analysis to determine a "floor" value for the subject company.

In the world of mergers, acquisitions and takeovers, the going-concern methods are often combined with an asset method to arrive at an offering price for a...