Throughout its existence, a company will likely encounter various situations that will make it necessary to figure out the value of its assets. For example, a business valuation may be required in the context of a tax or succession planning strategy, when transferring ownership to the next generation, or integrating key employees.
Among other things, having access to professionals in the business valuation industry ensures an independent valuation process that is at once rigorous and credible in the eyes of all parties involved and by tax authorities.
So, how do we obtain a business’s fair market value (“FMV”)? Often, it is understood that the value of a business is determined by multiplying annual revenues. And yet, valuating a business is more complex and involved than simply applying this “rule of thumb."
DEFINITION OF FAIR MARKET VALUE
The Canadian Institute of Chartered Business Valuators (CICBV) governs the business valuation activities of individuals who hold the professional designation of Chartered Business Valuator (CBV) in Canada. It defines FMV as “the highest price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arms-length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.” [1]
PRICE AND VALUE
We must distinguish between the price and value of a business. Indeed, the value presented upon the issuance of an appraisal could be deemed reasonable, and yet differ from the actual price obtained if the business had been traded on the market.
DETERMINATION OF CONTEXT
In order to establish this FMV, we must start by determining the highest value between:
- The value of the company, assuming it maintains its operations (analysis of performance and continuity of operations);
- The value of the company should it go on to sell all of its assets (determination of liquidation value).
CHOOSING A VALUATION APPROACH
Based on the valuation context (continuity of operations or liquidation value), several valuation approaches[2] may be used by a professional who will be able to determine the best option for the situation at hand.
1. Asset-based approach: this approach will be chosen when:
(a) the assets make up the bulk of the business’s value;
(b) Income expectations are not sufficient to adopt an income-based approach; OR
(c) The business is no longer profitable and will need to cease its activities and be liquidated (liquidation context).
The company’s assets provide a certain level of protection against the risk incurred when investing in the company, because a potential investor could liquidate these assets and get a minimal return for his or her investment. In other words, the asset-based approach mitigates the investment risk.
2. Income-based approach: This approach is chosen when the company generates, as it continues to operate, income for the investor by generating cashflow in the future. As such, cashflow streams will be appraised as at the valuation date.
3. Market-based approach: A method used when information about similar companies having been involved in a transaction on stock exchanges or secondary markets is available. This approach involves calculating the valuation multiples related to the observed transactions, all while considering the many elements that differentiate the companies retained from the one being valued. This approach is generally chosen in order to corroborate the results of a primary method of valuation.
Please you have any questions, lease contact your FBL representatives. Our valuation and advisory service professionals have the experience and expertise required to guide you in your valuation steps and meet your needs..
[1] International Glossary of Business Valuation Terms, 2001.
[2] Ibid.