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A business valuation is often required to determine the value of individual assets or an entire business. The approach used to value a business will depend on what is being valued. The most common reasons for business valuation are to sell the business or reorganize the corporation.
There are three main valuation approaches used: asset-based, income based, and market-based. Asset-based approaches are used to value holding companies or companies that do not have excess earnings. Income-based approaches are used when the company has active operations and excess earnings, and there are various methods within this approach. Market-based approaches are used when publicly available information can be used to determine a valuation multiple.
The fair market value of a business can be determined after applying the appropriate valuation approach.
- Asset based approaches:
An adjusted net asset approach is normally used to value holding companies that do not conduct active operations but are considered going concern. This approach is also used to calculate the “floor” value of the business which is the lowest value that would be accepted in a sale transaction. This approach is also appropriate if an entity has active operations but does not have excess earnings and therefore no inherent goodwill.
Under this method all assets are valued at their FMVs net of disposition costs; liabilities are deducted and the tax consequences of selling the assets and settling the liabilities are adjusted for.
- Income based approaches:
Where the entity has active operations and excess earnings, an income based approach is most appropriate. There are a few income based approach methods for valuations, these could include:
- Capitalized cash flow approach:
A capitalized cash flow approach is appropriate where a business has consistent cash flows that are reflective of the future operations. In this approach, the cash flows expected to occur consistently in the future are determined and a capitalization rate is applied to the expected future annual cash flow to obtain a value for the entity.
- Discounted cash flow approach:
If the historical cash flow is negative and is not reflective of the potential cash flow that the entity could generate on a going-forward basis or past cash flow is not representative of future cash flows of a company. In these scenarios, discounted cash flow approach is also appropriate. In this approach the cash flows for a given number of years are calculated and individually discounted to obtain an initial value for the business.
- Capitalized earnings approach:
Similar to capitalized cash flow approach, this approach is based on historical earnings of the corporation. Under this approach, earnings are multiplied by a multiplier or divided by a capitalization rate to determine the value of the company. The multiplier is the multiplicative inverse of the capitalization rate.
- Discounted earnings approach:
The discounted earnings approach is mostly used in merger or acquisition valuations. Under this method, future earnings are expected to be volatile before levelling out. Earnings during the volatile years are valued separately from the earnings in the steady-state years, similar to the discounted cash flow approach.
Under this approach, estimates of future earnings from the business for each forecasted period are determined. The estimated earnings for each year are then discounted at the appropriate discount rate to determine their present value.
- Market-based approach:
A market-based approach is used when the information required to determine a valuation multiple is publicly available and reasonably comparable. A market-based approach is used as a corroborative approach to other income-based approaches.
Market data is used to determine a valuation multiple based on a valuation multiples used to value companies that are comparable in size, geographic location, product mix, capital structure etc. The valuation multiple is then applied to the entity’s earnings before interest, taxes, depreciation, and amortization (EBITDA) to obtain a market-based value for the business. To obtain a market-based value for the equity of a business, a valuation multiple is applied to the entity’s net earnings.
After applying the appropriate approached provided above, a Fair market value of the business can be obtained.
If you have any questions regarding Fair Market Valuation of your business, please don’t hesitate to contact us. Shajani LLP Chartered Professional Accountants and Advisors have a team of Calgary Accountants, Edmonton Accountants and Red Deer Accountants ready to assist you in your personal and corporate tax filings and tax planning strategy.
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