In our prior article “Valuations FAQ – The Beginning”, we explored a situation where “Seller”, the owner of TargetCo (Target), a family-owned and managed business, had been approached by BuyerCo (Buyer), who has offered to buy all of Target’s shares for $2 million. Seller and “CBV” held preliminary discussions on a potential valuation engagement, where we outlined some of the common questions that are asked at the beginning of an engagement. In this article, we will continue the conversation between Seller and CBV, exploring the next steps following the signing of an engagement letter, including discussing the various valuation approaches.
The following is an excerpt of the follow-up meeting held between Seller and CBV
Seller: Following our last meeting, I signed the engagement letter you had sent and responded to your preliminary information request list. You should now have the financial statements of Target. Now tell me, is my company worth $2 million? Is it worth more?
CBV: While I can appreciate your enthusiasm for wanting to sell Target at top dollar, there is more to a valuation engagement than just reviewing financial statements. We must determine the appropriate valuation approach.
Seller: You’re telling me there are different ways to value a company?
CBV: That’s correct. There are two primary valuation approaches used: the going concern approach and the liquidation approach. Our review of Target’s financial information and operations helps us determine which approach is most appropriate for this engagement.
Seller: So which method are you going with? Target’s revenue has grew an average of 10% annually between fiscal 2017 to 2019. However, it averaged 3% in 2020 and 2021 due to COVID-19. Now that things are slowly opening up, we are in talks with some of our customers about signing contracts that could drastically accelerate short-term growth. If I don’t get these contracts, revenue would likely continue to grow at 3%.
CBV: Per the financial statements for the period, Target’s earnings and cash flows have been positive. Therefore, the going concern approach appears to be the most appropriate. Based on what you have just described about the company’s outlook, a capitalized cash flow (“CCF”) or the discounted cash flow (“DCF”) methodology could be appropriate.
Seller: Let’s just go with the methodology that maximizes the fair market value (“FMV”) of Target’s shares.
CBV: Unfortunately it doesn’t quite work like that. If the contracts are likely to be signed, and if you can provide a financial forecast, the DCF method could potentially be used. This is where we take your forecast and sum the expected future cash flows back to present day, after giving consideration to the time value of money and the risk of achieving those cash flows.
Seller: Come to think of it, there’s probably a high chance we might not win those contracts.
CBV: If you are unsure, and if you think that the company’s future growth will likely remain at current levels, then the CCF method may be the most appropriate. This is where we take the average normalized cash flows for the 3 to 5 years and apply a multiple on those cash flows to eventually arrive at the FMV of Target’s shares.
Seller: That sounds reasonable to me. Oh, by the way, a friend of mine recently had their real estate holding company valued for tax planning purposes and the valuator used the adjusted net assets (“ANA”) method. What does that mean?
CBV: In your friend’s case, the valuator concluded that the underlying value of his company came from the FMV of its net assets. To determine the value of a real estate holding company, we would adjust the value of that company’s assets based on supporting information (e.g. recent appraisal reports and/or investment statements) and deduct the FMV of the company’s liabilities. This amount, with some further adjustments, would then bring us to the FMV of that company.
Seller: Okay, I understand. Now let me hit you with a hypothetical scenario. If a business was suffering losses and the bank wanted its loan back, how would this impact the valuation approach?
CBV: The liquidation approach (a version of the ANA method) would be used if a business is distressed and is not expected to continue to operate. This would also be used in cases where a retiring business owner has decided to wind-up their business because they could not find a buyer for their business.
Seller: Well, let’s hope that doesn’t happen to Target. Thank you for the Valuations 101. I can’t wait to see the valuation report!
CBV: Great! We’ll make sure to keep you informed throughout the process, so that you understand our analysis and conclusions. Don’t hesitate to reach out with questions in the meantime, ahead of our next meeting.
If you or your client would like to know how a CBV can be of assistance, please feel free to reach out to Grewal Guyatt LLP. Our team of business valuators and litigation support experts are ready to assist with any of the services outlined above, and more.