Three approaches to valuing a privately held company.

• Author: Peterson, Douglas
• Position: PRIVATE COMPANIES

The potential for rising taxes due to huge U.S. government budgetary deficits are prompting many owners of privately held companies to consider their options. Other owners have a need to value their businesses for the purpose of estate planning--potentially a target for tax code changes.

Before considering a transaction, it's helpful to have a clear understanding of the three common methodologies used to value private businesses.

* Income Approach values a business or asset based on its expected future cash flow. When determining the business enterprise value, expected future cash flow represents cash flow available to debt and equity holders.

Cash flow projections generally incorporate expectations of future revenue growth and operating profitability as well as capital expenditure needs, working capital requirements, taxes and depreciation estimates. Cash flow projections also consider a residual component or terminal value, which reflects the expected value of the business at the end of the projection period.

Cash flows expected in the future are worth less today because of the time value of money and the risks associated with achieving the projected cash flows in the future. Accordingly, their present value is calculated by means of discounting, using a rate of return or discount rate that reflects the time value of money and the appropriate degree of risk inherent in the underlying business.

* Market Approach is based on a comparison of the subject company to similar companies with quoted prices in actively traded markets, or which were involved in recent transactions for which meaningful data is available.

Using the market price quotation or the transaction price to estimate the market value of the comparable companies, multiples of value relative to significant financial variables (i.e., earnings, operating cash flow, assets, etc.) are developed for each of the comparable companies. Valuation multiples are adjusted for differences in growth and profitability prospects as well as risks applicable to the subject company versus each comparable.

* Cost Approach is based on the investment required to replace or reproduce the assets of a business using current prices for labor, materials and operating facilities--less depreciation for physical deterioration and functional and economic obsolescence. The cost approach requires estimation of the value of the subject company's net working capital, machinery and equipment, real estate and...