FAQ Advanced Valuation Concepts

Interested in Valuing your Business? Contact a Certified Appraiser in the United States

Business Valuation FAQs

Find answers to common questions about company valuations, methodologies, and financial analysis

Search through our valuation knowledge base

When to use DCF vs comparable company analysis?

Use DCF (Discounted Cash Flow) analysis when valuing businesses with unique characteristics, significant growth opportunities, or operational improvements that future cash flows will capture but historical comparables cannot reflect, while comparable company analysis works best when sufficient market data exists for truly similar businesses. DCF excels for companies with predictable cash flows, detailed financial projections, competitive advantages, or strategic initiatives that will materially change future performance beyond what past results indicate. It provides granular understanding of value drivers and allows sensitivity analysis showing how assumptions impact value, making it ideal for investment decisions requiring detailed analysis. Comparable company analysis offers objectivity based on actual market transactions and works well for mature businesses in industries with active M&A markets and available comparable data. Use DCF for high-growth startups, businesses undergoing transformation, or unique companies lacking good comparables. Apply market approach for stable businesses with numerous comparable transactions, main street businesses following industry patterns, or situations requiring quick market-based validation. Most comprehensive valuations use both methods, weighting each based on data quality and appropriateness.

What is a control premium?

A control premium is the additional value that a buyer pays above the pro-rata minority interest value to acquire a controlling ownership stake that provides the ability to direct business operations, elect directors, set strategy, declare dividends, and make fundamental decisions about the company. Control premiums typically range from 20 to 40 percent above minority interest values, varying by industry, company circumstances, and potential synergies available to controlling buyers. These premiums reflect the economic benefits of control including ability to sell or merge the company, change management, modify compensation, redirect strategy, access cash flows, and implement operational improvements that minority owners cannot effect. Control premiums are derived from analyzing acquisition transactions where buyers pay premiums over pre-announcement trading prices of public company targets. The control premium concept is mathematically related to minority discount; if minority interests trade at a 25 percent discount, the implied control premium is 33 percent (1 / (1 minus 0.25) minus 1). Control premiums apply when valuing controlling interests in businesses where minority interests would trade at discounts due to lack of control.

What is a minority discount?

A minority discount is a reduction in value applied when valuing non-controlling ownership interests that lack the power to direct business operations, force distributions, or make fundamental decisions about the company, typically ranging from 15 to 35 percent depending on the degree of control minority owners lack. This discount reflects the economic disadvantages of minority ownership including inability to control distributions, set compensation, sell the company, access financial information, or influence strategic direction. Minority discounts are most significant in closely-held businesses where controlling shareholders make all major decisions and minority owners have limited rights or protections. The discount magnitude depends on ownership percentage (10 percent interests warrant larger discounts than 49 percent interests), shareholder agreement provisions protecting minority rights, company distribution history, and state law protections against oppression. Minority discounts are mathematically related to control premiums but are not simple inverses; a 25 percent minority discount implies a 33 percent control premium. These discounts apply when valuing non-controlling interests for estate planning, gift tax, shareholder disputes, or other situations where the ownership stake being valued lacks control.

What is a discount for lack of marketability (DLOM)?

A discount for lack of marketability (DLOM) is a reduction in value applied to ownership interests in private companies that cannot be readily sold due to lack of an established market, transfer restrictions, or limited buyer pools, typically ranging from 15 to 40 percent depending on company-specific factors and holding period expectations. DLOM reflects the economic cost of illiquidity including inability to quickly convert ownership to cash, transaction costs of finding buyers, time delays in selling, and uncertainty about ultimate sale prices. This discount applies even to controlling interests in private companies because they lack the immediate liquidity of publicly traded stocks. DLOM magnitude depends on company size (larger companies have more potential buyers), profitability (profitable companies are more marketable), distribution history (regular dividends reduce liquidity needs), transfer restrictions (buy-sell agreements limit marketability), and expected holding period until liquidity events. Research studies analyzing restricted stock transactions, pre-IPO transactions, and option pricing models provide empirical support for DLOM ranges. The discount is larger for minority interests combining both lack of control and lack of marketability, potentially reaching 40 to 60 percent combined discount.

What is a key person discount?

A key person discount is a reduction in business value applied when a company depends heavily on specific individuals whose departure would significantly harm operations, customer relationships, revenue generation, or overall business performance, typically ranging from 10 to 30 percent for businesses with extreme owner or key employee dependence. This discount reflects the risk that losing critical personnel through death, disability, retirement, or competition could devastate business value and operations. Key person discounts are most significant for professional practices, personal service businesses, or companies where owner relationships drive customer retention and revenue generation. The discount magnitude depends on how concentrated expertise and relationships are in specific individuals, whether systems and processes exist to continue operations without key people, depth of management team, and transferability of customer relationships. Companies can reduce key person discounts by implementing succession plans, cross-training employees, documenting processes, diversifying customer relationships across multiple team members, and purchasing key person life insurance. Buyers of businesses with key person risk typically demand discounts, insist on transition periods with key people remaining, or structure earnouts tying payments to retention of customers and performance after key person departures.

How do you value intangible assets?

You value intangible assets using specialized methodologies including the relief-from-royalty method for trade names and intellectual property, multi-period excess earnings method for customer relationships, cost approach for developed technology, and with-and-without method for non-compete agreements, each technique matching the specific asset's economic characteristics. Intangible asset valuation typically occurs in purchase price allocation after acquisitions, identifying and separately valuing assets like customer relationships, trade names, proprietary technology, non-compete agreements, and workforce. The relief-from-royalty method calculates the present value of royalties the company avoids by owning rather than licensing the intangible asset, using market royalty rates from comparable licensing agreements. The multi-period excess earnings method isolates cash flows attributable to specific intangible assets after charging for contributory assets like working capital, fixed assets, and workforce. The cost approach estimates replacement cost for intangible assets like software or databases by calculating development costs, adjusting for obsolescence. These valuations require specialized expertise in intangible asset identification, appropriate methodology selection, market research for royalty rates and discount rates, and documentation meeting accounting and tax standards.

What is goodwill in a business valuation?

Goodwill in business valuation is the residual value exceeding identifiable tangible and intangible assets, representing the going concern value, assembled workforce, synergies, market position, reputation, and other value elements that cannot be separately identified and valued. Goodwill emerges when total business value determined through income or market approaches exceeds the sum of identifiable assets including tangible assets like equipment and inventory plus identifiable intangible assets like customer relationships and trade names. This residual value reflects factors like competitive advantages, operational efficiency, market position, trained workforce, business systems, and synergies between assets that create value beyond individual asset contributions. For accounting purposes under ASC 805, goodwill is calculated as purchase price minus fair value of identifiable net assets acquired, and must be tested annually for impairment. Goodwill has infinite life for accounting purposes but cannot be amortized for tax purposes, while identifiable intangible assets can be amortized over their useful lives. The amount of goodwill varies significantly by business type, with service businesses and companies with strong brands typically showing higher goodwill percentages than asset-intensive manufacturing businesses.

How do you value intellectual property?

You value intellectual property using methods including the relief-from-royalty approach that calculates present value of avoided royalty payments, the income approach that isolates cash flows attributable to the IP, or the cost approach that estimates replacement or reproduction costs adjusted for obsolescence. Patents, trademarks, copyrights, and trade secrets each require tailored valuation approaches reflecting their specific characteristics and economic benefits. The relief-from-royalty method researches comparable licensing agreements to determine market royalty rates, applies these rates to projected revenues, and discounts the resulting royalty savings to present value. Income approach methods project incremental cash flows the IP generates compared to not having the IP protection, isolating the specific contribution of intellectual property from other business assets. Cost approaches work well for early-stage technology by calculating development costs including R&D expenses, testing, regulatory approvals, and market introduction, adjusted for technical and economic obsolescence. IP valuations serve purposes including purchase price allocation, licensing negotiations, litigation damages, tax planning, and financial reporting, each potentially requiring different valuation standards and methodologies.

What is the difference between enterprise value and equity value?

The difference between enterprise value and equity value is that enterprise value represents the total value of business operations available to all capital providers including both debt and equity holders, while equity value represents only the value available to shareholders after subtracting debt obligations. Enterprise value equals equity value plus debt minus cash and cash equivalents, reflecting what an acquirer would pay to own the entire business and assume its capital structure. Enterprise value is calculated using methods like DCF analysis with WACC discount rate or applying EV/EBITDA multiples from comparable companies, producing values independent of financing decisions. Equity value is calculated by subtracting interest-bearing debt from enterprise value and adding cash, or by using equity-specific methods like capitalizing net income or applying price-to-earnings multiples. The distinction is critical when applying valuation multiples; EV/EBITDA multiples apply to enterprise value while P/E multiples apply to equity value. For debt-free companies, enterprise value and equity value are identical. Understanding this difference prevents valuation errors like applying enterprise value multiples to equity metrics or vice versa.

How do you adjust for non-operating assets?

You adjust for non-operating assets by first calculating business value using only operating cash flows and operating assets, then separately valuing non-operating assets like excess cash, marketable securities, real estate not used in operations, or investments in other entities, and adding these values to reach total company value. Non-operating assets don't contribute to the business's core earning power and should be excluded from operating value calculations to avoid double-counting or distorting operating multiples. Excess cash beyond working capital needs is identified and added at face value to enterprise or equity value depending on the calculation method. Real estate owned but not essential to operations is valued separately at fair market value and added to operating business value. Investments in other companies, life insurance cash surrender values, and other non-operating assets receive separate valuations at fair market value. This separation provides clearer understanding of operating business value versus total asset value, helps buyers understand what they're acquiring, and prevents distortion of operating multiples by including non-operating items. The adjustment is particularly important for holding companies, businesses with significant real estate holdings, or companies with substantial investment portfolios separate from core operations.

What are normalizing adjustments in valuations?

Normalizing adjustments in valuations are modifications to historical financial statements that remove one-time items, non-recurring expenses, owner perks, excess compensation, and non-operating items to reflect the sustainable earning power a business would generate under new ownership operating at market standards. Common adjustments include adding back owner compensation exceeding market rates, removing personal expenses like owner vehicles or family member travel, eliminating one-time legal settlements or restructuring costs, adjusting related party transactions to arm's length terms, and removing gains or losses from asset sales. These adjustments also consider whether revenue or expense levels are sustainable, adjusting for lost customers, expiring contracts, or temporary market conditions. Normalizing adjustments significantly impact value because they change the earnings base to which multiples are applied or that gets capitalized into value. Each adjustment requires clear documentation and justification because buyers, tax authorities, or opposing experts will scrutinize them. The normalization process is particularly important for small businesses and family-owned companies where financial statements often include discretionary expenses and owner benefits that inflate costs beyond what market operators would incur.

How do you value a startup with no revenue?

You value a startup with no revenue using methods including the venture capital method that works backward from expected exit value, the Berkus method that assigns values to achievement milestones, the scorecard method that compares the startup to funded companies, or the risk factor summation method that adjusts average valuations for company-specific risks. The venture capital method estimates the company's value at expected exit (typically acquisition or IPO in 5 to 7 years), applies a target return rate (typically 30 to 60 percent annually for early-stage ventures), and discounts back to present value, then divides by expected ownership percentage to determine pre-money valuation. The Berkus method assigns up to $500,000 value for each of five key elements: sound idea, prototype, quality management team, strategic relationships, and product rollout or sales, potentially reaching $2.5 million for pre-revenue startups achieving all milestones. The scorecard method compares the startup to similar funded companies in the region and industry, adjusting average valuations for differences in management team, market size, product, competition, and other factors. These methods are highly subjective and produce wide valuation ranges, reflecting the extreme uncertainty and risk in pre-revenue startups.

How do you value a business with negative earnings?

You value a business with negative earnings using methods including revenue multiples from comparable companies or transactions, asset-based approaches valuing tangible and intangible assets, DCF analysis projecting when the company will achieve profitability and discounting future positive cash flows, or liquidation value if the business cannot achieve sustainable profitability. Revenue multiples work when the company has meaningful sales and operates in industries where revenue multiples are standard, like SaaS or technology companies commonly valued at 1x to 5x revenue despite negative earnings. The asset-based approach provides a floor value by identifying what assets could be sold or what it would cost to recreate the business's current position. DCF analysis requires credible path to profitability with detailed projections showing when and how the company will generate positive cash flows, using higher discount rates reflecting increased risk of early-stage or turnaround situations. For businesses with no clear path to profitability, liquidation value may represent the most realistic valuation, calculating what assets would fetch in orderly or forced sale scenarios. The valuation approach depends on whether negative earnings reflect early-stage investment in growth or fundamental business model problems.

What is the venture capital method of valuation?

The venture capital method of valuation is a technique commonly used for early-stage startups that works backward from an expected exit value at acquisition or IPO, applies a target rate of return reflecting high-risk investment requirements, and calculates present value considering expected ownership dilution from future financing rounds. This method begins by estimating the company's value at exit (typically 5 to 7 years) using comparable exit multiples applied to projected revenues or earnings at that future date. It then applies a target annual return rate, typically 30 to 60 percent for seed stage, 25 to 50 percent for early stage, and 20 to 35 percent for later stage, reflecting the risk level and expected returns for venture capital investors. The calculation discounts the exit value to present using the target return rate, then divides by the expected ownership percentage after considering dilution from anticipated future financing rounds. For example, if exit value is projected at $100 million in 5 years, target return is 40 percent annually, and the investor expects 20 percent final ownership after dilution, the pre-money valuation would be approximately $7.3 million. This method is highly sensitive to exit value assumptions and target return rates.

What is a pre-money vs post-money valuation?

Pre-money valuation is the company's value immediately before receiving new investment capital, while post-money valuation is the company's value immediately after the investment, calculated as pre-money valuation plus the amount of new capital invested. These concepts are critical in startup financing because they determine how much ownership percentage investors receive in exchange for their capital. For example, if a company has $5 million pre-money valuation and receives $2 million investment, the post-money valuation is $7 million, and the investor receives 28.6 percent ownership ($2 million divided by $7 million). The negotiation between entrepreneurs and investors centers on pre-money valuation, with higher pre-money valuations resulting in less dilution for existing shareholders. Post-money valuation is simply the mathematical result of adding investment to pre-money value. Understanding this distinction is essential for term sheet negotiations, cap table management, and calculating ownership percentages across multiple funding rounds. Some term sheets now specify post-money valuations directly to reduce confusion, making it clearer what ownership percentage investors receive. The relationship between pre-money and post-money valuation affects all shareholders' ownership percentages and future dilution from subsequent financing rounds.

How do you value stock options and warrants?

You value stock options and warrants using option pricing models like Black-Scholes or binomial models that consider the underlying stock value, exercise price, time to expiration, volatility, risk-free interest rate, and expected dividends to calculate the present value of the option's potential future payoff. The Black-Scholes model provides closed-form solution for European-style options, while binomial models handle American-style options exercisable before expiration and complex features like vesting schedules or performance conditions. Key inputs include the current fair market value of underlying stock (requiring separate valuation for private companies), the option's strike price, time remaining until expiration, expected stock price volatility (estimated from comparable public companies for private firms), risk-free interest rate from Treasury securities, and expected dividend yield. The resulting option value represents the present value of expected payoff considering the probability of finishing in-the-money at expiration. For private companies issuing employee stock options, 409A valuations establish fair market value of common stock that becomes the exercise price, and option pricing models value the options for financial reporting under ASC 718. Warrants issued to investors or lenders are valued similarly but may have different terms and purposes.

What is the Black-Scholes model for option pricing?

The Black-Scholes model for option pricing is a mathematical formula that calculates the theoretical value of European-style options by considering the current stock price, exercise price, time to expiration, volatility of the underlying stock, risk-free interest rate, and dividend yield to determine the present value of the option's expected payoff. This Nobel Prize-winning model revolutionized option valuation by providing a closed-form solution rather than requiring complex simulations. The model assumes the underlying stock follows a log-normal distribution, markets are efficient, no transaction costs or taxes exist, the risk-free rate and volatility are constant, and the option can only be exercised at expiration (European-style). For call options, the formula calculates the present value of expected stock price at expiration minus the present value of the exercise price, weighted by probabilities the option finishes in-the-money. The model is widely used for valuing employee stock options, warrants, and other equity-based compensation, though it requires modifications for American-style options exercisable before expiration. The most challenging input for private companies is volatility, typically estimated using comparable public company volatilities adjusted for size and leverage differences.

How do you value preferred shares?

You value preferred shares by analyzing their specific rights and features including liquidation preferences, dividend rates, conversion rights, redemption provisions, and participation features, then applying appropriate methodologies that may include dividend discount models, option pricing models, or scenario analysis depending on the preferred stock characteristics. Non-convertible preferred shares are valued similarly to bonds, discounting promised dividend payments and redemption value at appropriate rates reflecting the preferred shares' risk profile. Convertible preferred shares contain embedded options to convert into common stock, requiring option pricing models that consider the value of conversion rights versus the value of remaining preferred. Participating preferred shares that receive both liquidation preferences and participation in remaining proceeds require scenario analysis examining payoffs under different exit values. The liquidation preference (typically 1x invested capital) provides downside protection, while conversion rights provide upside participation, creating asymmetric payoff profiles. Preferred share valuation is particularly important for startups with multiple financing rounds creating complex capital structures with different preferred share classes having varying rights and preferences. These valuations support 409A compliance, financial reporting, and negotiations between common and preferred shareholders.

What is a liquidation valuation?

A liquidation valuation determines the net proceeds that would be realized if a business ceased operations and sold all assets, either through orderly liquidation over reasonable time periods or forced liquidation under time pressure, subtracting liabilities and liquidation costs to calculate net proceeds available to owners. Orderly liquidation assumes assets are sold over 6 to 12 months through normal marketing channels, achieving higher recovery rates typically 60 to 80 percent of fair market value for equipment and inventory. Forced liquidation assumes assets must be sold quickly, often through auctions or bulk sales, achieving lower recovery rates typically 30 to 50 percent of fair market value. Liquidation valuations consider that certain assets like specialized equipment, custom inventory, or intangible assets may have little value outside the business context. The valuation subtracts liquidation costs including broker commissions, legal fees, facility closure costs, employee severance, and lease termination penalties. Liquidation value provides a floor value for businesses and is relevant for bankruptcy proceedings, distressed situations, or businesses with no going concern value. It's typically significantly lower than going concern value because it ignores earning power and treats assets individually rather than as an operating system.

What is the difference between going concern and liquidation value?

The difference between going concern and liquidation value is that going concern value assumes the business continues operating and generating cash flows indefinitely, valuing it as an operating enterprise, while liquidation value assumes the business ceases operations and assets are sold individually, typically producing significantly lower values. Going concern valuations use income and market approaches that consider earning power, growth prospects, customer relationships, and synergies between assets that create value beyond individual asset contributions. Liquidation valuations use asset-based approaches that calculate what individual assets would fetch in orderly or forced sales, ignoring intangible assets like goodwill, customer relationships, and assembled workforce that have no value outside the business context. The gap between going concern and liquidation value can be enormous; a profitable business worth $10 million as a going concern might yield only $3 million in liquidation after selling equipment, inventory, and receivables, paying liabilities, and covering liquidation costs. Going concern value is appropriate for healthy operating businesses, while liquidation value applies to failing businesses, bankruptcy proceedings, or situations where continuing operations is not viable. The going concern assumption is fundamental to most business valuations unless evidence suggests the business cannot continue operating.

What is the difference between market value and investment value?

The difference between market value and investment value is that market value represents what a hypothetical willing buyer would pay a willing seller in an arm's length transaction, while investment value represents what a specific buyer would pay based on their unique circumstances, synergies, strategic objectives, or financial situation. Market value, also called fair market value, assumes a hypothetical transaction between typical buyers and sellers without considering any particular party's special advantages or motivations. Investment value considers buyer-specific factors like operational synergies, cost savings, revenue enhancements, tax benefits, or strategic positioning that make the business more valuable to that specific acquirer than to typical market participants. Investment value is typically higher than market value when strategic buyers can realize significant synergies or when the acquisition fills critical gaps in the buyer's capabilities or market coverage. For example, a business might have $8 million fair market value to financial buyers but $12 million investment value to a strategic acquirer who can eliminate duplicate facilities and cross-sell products. The standard of value used in valuations depends on the purpose; estate tax and gift tax require fair market value, while acquisition decisions consider investment value to specific buyers.

How do you determine the appropriate discount rate?

You determine the appropriate discount rate by assessing the risk associated with achieving projected cash flows and calculating the return investors would require to compensate for that risk, using methods like the Capital Asset Pricing Model (CAPM), build-up method, or Weighted Average Cost of Capital (WACC) depending on whether you're valuing equity or enterprise value. CAPM calculates the cost of equity as the risk-free rate plus beta times the equity risk premium, where beta measures the company's volatility relative to the overall market. The build-up method starts with the risk-free rate and adds equity risk premium, size premium for smaller companies, and company-specific risk premium for unique risks not captured in other factors. WACC blends the cost of equity and after-tax cost of debt weighted by their proportions in the capital structure, appropriate for enterprise value calculations. Discount rates typically range from 12 to 25 percent for small businesses, 10 to 20 percent for middle-market companies, and 8 to 15 percent for larger established businesses, varying by industry, size, leverage, and company-specific risks. Higher discount rates reduce present values, so discount rate selection significantly impacts valuation conclusions and requires careful analysis and documentation.

What is beta in business valuation?

Beta in business valuation is a measure of a company's stock price volatility relative to the overall market, used in the Capital Asset Pricing Model (CAPM) to calculate the cost of equity by quantifying systematic risk that cannot be diversified away. A beta of 1.0 means the company's stock moves in line with the market; beta above 1.0 indicates higher volatility and risk requiring higher returns, while beta below 1.0 suggests lower volatility and risk. Public companies have observable betas calculated from historical stock price movements relative to market indices like the S&P 500. Private companies require estimating beta using comparable public companies in similar industries, calculating their average beta, and adjusting for differences in financial leverage between the comparable companies and the subject company. The levered beta reflects both business risk and financial risk from debt, while unlevered beta isolates business risk by removing the effects of financial leverage. Appraisers unlever comparable company betas to remove their specific leverage effects, then relever to the subject company's capital structure. Beta selection significantly impacts the discount rate and resulting value, so appraisers carefully select comparable companies and document their beta calculations.

How do you calculate free cash flow?

You calculate free cash flow by starting with operating income or EBITDA, subtracting taxes, adding back non-cash charges like depreciation and amortization, subtracting capital expenditures required to maintain and grow the business, and adjusting for changes in net working capital to arrive at cash available to all investors or equity holders. The specific calculation depends on whether you're calculating free cash flow to the firm (FCFF) available to all capital providers or free cash flow to equity (FCFE) available only to shareholders. FCFF starts with EBIT or EBITDA, subtracts taxes, adds depreciation, subtracts capital expenditures and changes in net working capital, producing cash flow before debt service used with WACC discount rates. FCFE starts with net income, adds depreciation, subtracts capital expenditures and changes in net working capital, adds net borrowing, producing cash flow available to equity holders used with cost of equity discount rates. Working capital changes are critical; increasing receivables or inventory consumes cash (reducing free cash flow) while increasing payables provides cash (increasing free cash flow). Capital expenditures include both maintenance capex to sustain current operations and growth capex to expand capacity, both reducing free cash flow.

How do you forecast future cash flows?

You forecast future cash flows by analyzing historical financial performance, understanding business drivers and industry dynamics, developing assumptions about revenue growth, operating margins, capital needs, and working capital requirements, then projecting detailed financial statements typically for 5 to 10 years into the future. The process begins with revenue projections based on historical growth rates, market analysis, competitive positioning, planned initiatives, and industry trends. Operating expenses are projected as percentages of revenue or absolute amounts based on historical relationships, expected efficiency improvements, and anticipated cost changes. Capital expenditures are forecast based on maintenance requirements, growth plans, and asset replacement cycles. Working capital projections consider receivable collection periods, inventory turnover, and payable payment terms. The projections should reflect management's strategic plans while being realistic and supportable given historical performance and market conditions. Sensitivity analysis tests how value changes with different assumptions about key drivers like growth rates, margins, or capital intensity. The forecast period should extend until the business reaches steady-state operations with stable growth and margins, at which point terminal value calculations capture value beyond the explicit forecast period.

What is a sanity check in valuation?

A sanity check in valuation is a reasonableness test that compares the valuation conclusion against alternative methods, industry benchmarks, comparable transactions, or logical relationships to verify the result makes intuitive sense and doesn't contain mathematical errors or unreasonable assumptions. Common sanity checks include comparing the implied valuation multiple to industry norms (if the result implies 15x EBITDA for a mature manufacturing company, something is wrong), checking that enterprise value minus debt equals equity value, verifying that terminal value assumptions are reasonable relative to long-term economic growth, and confirming that the valuation conclusion aligns with recent transactions or market evidence. Appraisers also check that growth rates don't exceed reasonable limits, discount rates reflect appropriate risk levels, and working capital assumptions are consistent with historical patterns. The sanity check might involve calculating what return an investor would earn at the concluded value given projected cash flows, or comparing the concluded value per employee or per customer to industry benchmarks. These checks help identify errors in spreadsheet formulas, unrealistic assumptions, or methodology misapplications before finalizing the valuation report. If sanity checks reveal inconsistencies, the appraiser investigates and corrects the underlying issues.

How do you account for working capital in valuations?

You account for working capital in valuations by analyzing the net investment in current assets like receivables and inventory minus current liabilities like payables that the business requires to operate, projecting how working capital will change with revenue growth, and treating working capital increases as cash outflows that reduce free cash flow available to investors. Working capital requirements are typically expressed as a percentage of revenue based on historical relationships, considering receivable collection periods, inventory turnover, and payable payment terms. When revenue grows, working capital typically increases proportionally, consuming cash that must be funded either from operations or external financing. In DCF analysis, increases in working capital are subtracted from operating cash flow because they represent cash tied up in the business, while decreases in working capital are added back because they release cash. The normalized working capital level should reflect sustainable operating requirements, excluding excess cash, non-operating assets, or temporary fluctuations. At the end of the forecast period, terminal value calculations often assume working capital grows at the same rate as revenue in perpetuity. For acquisition valuations, buyers and sellers negotiate whether excess working capital above normal operating levels is included in the purchase price or retained by sellers.

What is the capital asset pricing model (CAPM)?

The capital asset pricing model (CAPM) is a financial theory and formula that calculates the expected return on equity investments by adding a risk premium to the risk-free rate, where the risk premium equals beta times the equity risk premium, providing a systematic method for determining the cost of equity used as the discount rate in valuations. The CAPM formula states that the cost of equity equals the risk-free rate (typically long-term Treasury bond yields around 4 to 5 percent) plus beta (measuring the company's volatility relative to the market) times the equity risk premium (the additional return investors expect for bearing equity market risk, typically 5 to 7 percent). For example, if the risk-free rate is 4.5 percent, beta is 1.2, and the equity risk premium is 6 percent, CAPM indicates the cost of equity is 11.7 percent (4.5 + 1.2 times 6). CAPM assumes investors hold diversified portfolios and only require compensation for systematic risk that cannot be diversified away. While widely used, CAPM has limitations including difficulty estimating beta for private companies, assumption of constant risk-free rates and risk premiums, and ignoring company-specific risks that may justify additional premiums.

What is the build-up method for discount rates?

The build-up method for discount rates calculates the cost of equity by starting with the risk-free rate and sequentially adding risk premiums for equity market risk, small company size, and company-specific risks, providing an alternative to CAPM that doesn't require estimating beta. The method begins with the risk-free rate from long-term Treasury bonds (typically 4 to 5 percent), adds the equity risk premium representing the additional return investors expect for bearing stock market risk versus risk-free investments (typically 5 to 7 percent), adds a size premium reflecting higher returns historically earned by smaller companies (ranging from 0 to 6 percent based on company size), and adds a company-specific risk premium for unique risks not captured in other components (typically 0 to 5 percent). For example, a small business might have a 4.5 percent risk-free rate, plus 6 percent equity risk premium, plus 4 percent size premium, plus 3 percent company-specific risk premium, totaling 17.5 percent cost of equity. The build-up method works well for private companies where estimating beta is difficult and for small businesses where size and company-specific risks are significant. The challenge is quantifying company-specific risk premium, which requires professional judgment about factors like customer concentration, management depth, competitive position, and industry dynamics.

How do you apply size premiums in valuations?

You apply size premiums in valuations by adding an additional return component to the discount rate that reflects the empirically observed higher returns earned by smaller companies compared to larger companies, compensating investors for the additional risks associated with smaller business size. Research studies analyzing historical stock returns show that smaller companies have generated higher returns than larger companies over long periods, even after adjusting for beta. These size premiums are typically derived from databases like Duff & Phelps Risk Premium Report or Ibbotson SBBI, which categorize companies by size measures like market capitalization or revenue and report average historical risk premiums for each size category. Size premiums generally range from 0 to 6 percent, with the smallest companies (under $50 million in value) warranting the highest premiums. The size premium is added to the risk-free rate and equity risk premium in the build-up method, or added to the CAPM result to capture size-related risks not fully reflected in beta. Size premiums reflect risks like limited access to capital markets, customer concentration, management depth, operational challenges, and higher failure rates that disproportionately affect smaller businesses. The appropriate size premium depends on the company's size metrics compared to the database categories and professional judgment about whether the subject company exhibits typical small company risk characteristics.

No questions found matching your search. Try different keywords.