Business Valuation Approaches in Practice: Income, Market and Asset

The IRS Business Valuation Guidelines say the three generally accepted valuation approaches are the asset-based approach, the market approach and the income approach, and that appraisers should consider all three and use judgment to choose the ones that best indicate value. That is also how a CPA should organize the work. This article covers how each approach is applied to a closely held company, how normalization feeds all three and where discounts enter. The professional standard that governs the engagement is covered in VS Section 100 valuation and calculation engagements.

Start with the assignment

The IRS guidance lists the standard and definition of value among the items the appraiser identifies when defining the assignment. The same company can have a different value under fair market value for a gift tax return, fair value for financial reporting and a negotiated price in a sale. Settle the standard, the valuation date, the interest being valued and the purpose first. Everything else depends on them.

Normalization comes first

Historical financial statements rarely show what a buyer would earn. Normalization adjusts them:

• Owner compensation set to what a replacement manager would cost, supported by a source. Reasonable compensation analysis is covered in S corporation reasonable compensation.
• Non-operating items such as excess cash, investments and personal expenses run through the company.
• Non-recurring items such as legal settlements, one-time gains and disaster costs.
• Related-party arrangements such as rent above or below market.
• Accounting method differences such as cash basis books, inventory methods and depreciation, to a consistent basis.

Each adjustment needs support, and the schedule should show both the unadjusted and normalized figures. The adjusted EBITDA bridge is covered in adjusted EBITDA add-backs and support.

The income approach

The income approach converts expected future economic benefits into a present value. Two common methods:

• Capitalization of earnings. A single normalized measure of earnings or cash flow is divided by a capitalization rate. It suits stable businesses with predictable results.
• Discounted cash flow. Projected cash flows for a discrete period and a terminal value are discounted at a rate reflecting risk. It suits businesses with changing growth or margins.

The capitalization rate is related to the discount rate: where it is derived from one, it equals the discount rate less the expected long-term growth rate, and it is applied to next-period earnings. The key judgments are the projections, the discount rate and the terminal value. The projections should reconcile to history and to management's plan, and the CPA should test whether management's forecasts have been met in the past. Document each rate component and its source. A discount rate with no support is the most common weakness an opposing expert or an examiner will find. Budgeting and forecast discipline in budgeting and forecasting for small business clients improves the inputs.

The market approach

The market approach uses prices paid for similar businesses or securities.

• Guideline public company method. Multiples of publicly traded companies, adjusted for size, growth and risk differences.
• Guideline transaction method. Multiples from sales of comparable private businesses, taken from transaction databases.

The IRS guidance lists the market prices of comparable publicly traded companies among the factors to analyze, along with past sales of the interest and the block size. The comparability problem is the weakness of the approach for small companies. State why each comparable was selected and why others were excluded, and record the date and source of every multiple. Where few comparables are available, the weight on the approach should fall.

The asset-based approach

The asset-based approach starts with the balance sheet restated to fair value, less liabilities. It fits holding companies, real estate entities, investment vehicles and businesses near liquidation. For an operating business, the approach often sets a floor. Intangibles that are not on the balance sheet, such as customer relationships and trade names, need identification and valuation. For the accounting treatment of similar assets in acquisitions, see ASC 805 business combinations.

Weighing the indications

When more than one approach is used, the CPA reconciles the indications to a conclusion. Weight depends on the quality and quantity of data behind each approach. A conclusion that simply averages three results without discussing reliability is weak. Explain why one approach received more weight, and why an approach was not used where that happened.

Discounts and premiums

The IRS guidance directs the appraiser to consider separately, where appropriate:

• Marketability. The effect of the lack of a ready market for the interest, considering the nature of the business, contractual and legal restrictions and market conditions.
• Control. The ability of the appraised interest to control the operation, sale or liquidation of the business.

State the basis for any discount and do not apply one by habit. Whether a discount applies depends on whether the earlier steps already reflect control or marketability. For example, a market multiple from public minority trades already reflects a marketable, non-controlling interest.

Quality checks before issuing

1. Do the normalized earnings tie to the financial statements by schedule?
2. Do projections reconcile to history and to the budget?
3. Is every rate and multiple sourced and dated?
4. Is the conclusion within the range of the indications?
5. Does the report state the standard of value and the valuation date?
6. Are the assumptions and limiting conditions disclosed?

FAQ

Which approach is best?

None is best in the abstract. The IRS says to consider all three and use judgment about which indicate value best.

Can a CPA value a business the firm audits?

Valuation is a nonattest service, and independence requirements apply. See independence and nonattest services.

Do discounts always apply?

No. Apply them only where the facts support them and the earlier steps do not already reflect the same factor.

CORAA prepares ready-to-review audit files for US CPA firms; see /us.

Sources

• IRS, Internal Revenue Manual 4.48.4, Business Valuation Guidelines: https://www.irs.gov/irm/part4/irm_04-048-004
• AICPA, Statement on Standards for Valuation Services, VS Section 100: https://www.aicpa-cima.com/resources/download/statement-on-standards-for-valuation-services-vs-section-100

AU-C references are to AICPA Professional Standards, paraphrased here; read the standard itself before relying on a requirement. This page is guidance, not professional advice. Report an error