(Part 1 of 4)
Over the course of our next several communications, our team will address some of the basic but common questions we encounter as valuation analysts. Our aim is to provide useful information and allow you to become more comfortable with the entire valuation.
One of the most common questions we get when meeting with someone in need of a business valuation is, “What is the valuation process?” In general, it is straightforward and can be broken down into five steps: defining the engagement, gathering information, analyzing the information, determining the value and writing the report.
1. Defining the engagement
This step identifies the key ingredients for the valuation: who, what, when and why. The client is the user of the valuation results, and thus is the who. Valuation analysts can value all of a company’s equity, a portion of the equity (e.g., 10 percent), a specific asset or a group of assets, therefore establishing what is to be valued — the what. The valuation date establishes the cutoff for information to consider in determining the value: the when. Finally, the reason for the valuation often directs the standard of value applied in the engagement. Therefore the purpose of the valuation is the why.
Defining the engagement is typically a short conversation between the client (or their representative) and the valuation analyst. Defining the engagement is vital in order to produce results that are useful in the particular situation.
2. Gathering Information
Information gathering can be an easy process for those that are organized and difficult for those who are not. It typically starts with a formal questionnaire from the valuation analyst, which covers a number of general topics and includes requests for documents necessary for the financial analysis, operational assessment and governance review necessary in the valuation of a business.
In addition to a questionnaire, most valuation analysts also perform a management interview and/or site visit. This meeting is a more focused attempt at gathering information. Many of the questions and issues discussed at this interview stem from initial answers or documents obtained through the questionnaire.
In many cases, the information gathering process begins early in the valuation process but continues in varying degrees as the engagement progresses.
3. Analyzing the Information
Step three in the process is where the valuation analyst spends a majority of their time. Using the information provided, the valuation analyst constructs financial models to help identify and break down risks and value drivers in the particular circumstance.
The analysis process involves both financial and non-financial matters. Financial analysis tools like trend (horizontal), common-sizing (vertical) and ratio analysis are reviewed in order to better understand the financial workings of the company. Non-financial items like customer concentration, strength of management, market share, state of the industry and other factors are also reviewed to identify non-financial risks surrounding the company and their potential impact.
4. Determining the value
Determining the value is where the art of valuation meets the science. It is at this step that the valuation analyst couples financial models and non-financial risk assessments to arrive at a conclusion.
This step often involves a review of the available valuation approaches and their specific methodologies. The generally accepted valuation approaches are the income, market and asset approaches. Within each of these approaches are numerous valuation methodologies that can be utilized to derive the value of the company.
It is also during this step that valuation discounts or premiums are evaluated. A discount for lack of control (minority discount) may be necessary when valuing a partial ownership interest that doesn’t control the company. A discount for lack of marketability is usually warranted when valuing a privately held business, to quantify the lack of liquidity associated with the ownership interest.
5. Writing the report
The last step is communication of the value and the analysis that was performed to the client. For many valuation analysts, writing the report starts long before a value has been determined; keeping notes along the way is often easier than drafting something from scratch at the end.
A report may come in a number of different forms, but is almost always a written communication. This is because of the need for detailed explanations of the assumptions and assessments that went into determining value.
Knowing these five steps should be helpful when you need a valuation. If we can be of any assistance with a valuation need or in understanding the general valuation process, please contact Amber Hoover at (317) 613-7844 or [email protected].