The starting point for a business valuation is generally the subject company’s financial statements. Here’s an overview of how historical financial statements can serve as the basis for a valuation professional’s conclusion under the cost, income and market approaches.

Cost (or asset-based) approach

Because the balance sheet identifies a company’s assets and liabilities, it can be a reliable source of financial information, especially for companies that rely heavily on tangible assets (such as manufacturers and real estate holding companies). Under U.S. Generally Accepted Accounting Principles (GAAP), assets are recorded at the lower of cost or market value. So, adjustments may be needed to align an item’s book value with its fair market value.

For example, receivables may need to be adjusted for bad debts. Inventory may include obsolete or unsalable items. And contingent liabilities — such as pending lawsuits, environmental obligations and warranties — also must be accounted for.

Some items may be specifically excluded from a GAAP balance sheet, such as internally developed patents, brands and goodwill. Value derived under the cost approach generally omits intangible value, so this estimate can serve as a useful “floor” for a company’s value. Valuators typically use another technique to arrive at a value estimate that’s inclusive of these intangibles.

Income approach

The income statement and statement of cash flows can provide additional insight into a company’s value (including its intangibles). Under the income approach, expected future cash flows are converted to present value to determine how much investors will pay for a business interest. GAAP earnings may need to be adjusted for a variety of items, such as depreciation rates and market-rate owners’ compensation.

A key ingredient under the income approach is the discount rate used to convert future cash flows to their net present value. Discount rates vary depending on an investment’s perceived risk in the marketplace. Financial statement footnotes can help in the evaluation of a company’s risks.

Market approach

The market approach derives a company’s value primarily from information taken from a company’s income statement and statement of cash flows. Here, pricing multiples (such as price to operating cash flow or price to net income) are calculated based on sales of comparable public stocks or private companies.

When looking for comparables, it’s essential to filter deals using relevant criteria, such as industrial classification codes, size and location. Adjustments may be required to account for differences in financial performance and to arrive at a cash-equivalent value, if comparable transactions include noncash terms and future payouts, such as earnouts or installment payments.

Note of caution

Not all financial statements are created equal. Audited financial statements are considered the gold standard in financial reporting. However, many smaller businesses rely on reviewed, compiled or internally prepared financial statements. In addition, smaller entities may issue cash- or tax-basis statements that don’t conform to GAAP. Differences in financial reporting practices can make it difficult to compare the subject company to peers when assessing risk and return under the income approach or determining pricing multiples based on comparables under the market approach.

It’s important for valuation reports to disclose the level of assurance that’s provided in the financial statements that are used to estimate the value of a business or business interest. Contact us to discuss the various levels of assurance and potential pitfalls of using unaudited financials.

(This is Blog Post #1383)