The more you know your valuation methodology, the more time you can save in client meetings, research, and report writing. This is because you can focus like a laser on the right methods to use, and eliminate the wrong ones. In this post I will discuss procedures that are not methods and those that are, with emphasis on when to use them and when not to do so.
For example, Rules of Thumb are a valid but lousy method because there is no supporting empirical data for them (except that somebody said so). Moreover, if the rule of thumb value is 1 times sales and your value is 1.1 times sales, now what? This method stinks.
Prior transactions in a company’s stock are valid (and closely scrutinized) indications, but you must be sure that nothing material has changed since then and that the prior transactions were at arms length and did not involve other considerations.
Similarly, reliance on buy-sell formulas or agreed upon prices requires that you investigate what fair market value would be otherwise, so these are really not methods per se.
The Excess Earnings Method is valid but makes you look like a chump. This is because it is only to be used when better evidence is not available. If better evidence is not available: how are you going to develop the two capitalization rates required? Whatever evidence allows you to do that will allow you to use the Income Approach!
The Justification of Purchase Test is not a valuation method. This is because it assumes a value, it does not develop one. It substantiates value developed by other methods (much better than rules of thumb).
Public guidelines are a great method, but they are simply not similar, relevant and comparable to small private companies.
Private guidelines are also a great method, but you have to have enough of them to be statistically confident.
Asset Approach methods for going concerns are rarely used, except for financial reporting assignments (where individual intangible assets need to be valued). If a business is a going concern, why would you consider a liquidation (premise of) value?
(As I write this, I am realizing this post is sort of like Survivor: Business Valuation in that various methods are getting voted off the “appropriate” island.
We are down to the Income Approach, having discussed every other common method I can think of. It is really rate that I do not use the Income Approach in a going concern valuation. After all, it gives me a valuation based on cash-on-cash returns. So the choice is multi-period discounting or single-period capitalization. I almost always use the former because I develop a forecast; the latter is used when benefits will grow at a constant rate (positive, negative or zero).
So, the winner is Multi-Period Discounting, which I plan to use in every valuation, accompanied by whichever of the other valid method works. The latter is the focus of my diagnostic thinking: how else am I going to value this business besides discounted future cash flow!