Corporate business valuation in Toronto and Canada is based on the concept of fair market value. Fair market value is defined as:
Highest price available, in an open and unrestricted market, between informed parties acting at arm’s length, under no compulsion to act expressed in terms of money or cash equivalents.
Fair market value is determined using several valuation principles:
- Value is point-in-time specific
- Value is prospective (that is based on future earnings)
- The more liquid the business, the more higher the value
- The higher the net tangible assets of the business, the higher the value
Corporate business valuators use the above principles to estimate value, and then must choose the best valuation approach. There are three general valuation approaches for businesses that are going concerns:
- Asset approach
- Market Approach
- Income Approach
The asset approach to business valuation is based on the assumption that no rational buyer would pay more for the assets of a business than the cost to replicate those assets.
Advantages to the asset approach to corporate business valuation include factual data and actual money spent. Disadvantages include the fact that the transaction does not reflect any value-added.
The market approach to corporate business valuation uses precedent transactions in the market place and public company multiples as a benchmark to value the subject business.
In the precedent transaction approach, multiples are derived from open-market transactions of similar businesses. These multiples provide important information about the marketplace and whether there are competing companies in the same industry buying their competitors.
Unfortunately, there are limitations to the market approach. If the subject company is private, it may be difficult to find information about other similar sized private companies.
Further, the actual size of the businesses may not be comparable, and the available information may also be only for minority stake transactions and not for the business on the whole. Multiples used to purchase minority stakes are likely at a discount than the purchase of an entire company.
The amount of information available will help to determine if the market approach is best used as a primary or secondary business valuation method.
The income approach to corporate business valuation utilizes the financial data of the subject company in order to estimate the fair market value.
The type of income approach to be used can be influenced by a number of factors. For example, a start-up business in the early stages of its life must be valued based on the discounted cash flow approach, as the business has no historical earnings to base a value on. A company having been in operation for several years will have a history of earnings and may be valued based on its maintainable after-tax earnings.
There are many advantages to using the income approach. The valuation will be based on specific factors related to the subject company, and not just a multiplier based on industry averages. The possible future growth of the subject company is considered, rather than applying a multiple that has been used in historical transactions.
Implied Goodwill and Intangible Value
The corporate business value of a company is comprised of the following elements:
- Net tangible assets (eg. inventory, cash on hand, land, building)
- Identifiable intangibles (eg. customer lists, trademarks, copyrights)
- Redundant assets (eg. Additional cash on hand not required to run the business, residential property owned by the company)
Once an estimate of value has been reached by the market or income approaches, it is important to perform an assessment of the reasonability of tangible value. Two basic valuation metrics are used:
- Price to Book Value: this ratio divides the equity by the net book value of the assets, with a ratio of over 1.0 implying positive goodwill and intangible asset value. As with the market approach, the ratios of public companies can be used as a benchmark to compare the subject company’s implied goodwill value
- Number of Years of Goodwill: Another measure of goodwill is to determine the number of years to payback the purchase price of goodwill. This is calculated by dividing the goodwill and intangible value by the maintainable earnings level considered (cash flow, EBITDA, etc.). This ratio should generally be in the range of 1-10 years of payback. The higher the number of years required to payback the goodwill, the higher the risk involved. Most recently, the acquisitions of tech companies like twitter and whatsapp have placed an extremely high value on intangible value component of their valuation. Therefore, the ratio of goodwill to maintainable earnings may well be in the 100+ year range.