Reconciliation of Values in Business Valuation
Here is what you need to know about the reconciliation of values.
Publicly traded companies are different from privately traded companies. In public companies, the investors can easily know the value of their investment in real time, just by checking online and getting the latest stock quote. But with private companies, it is a bit complicated since the value isn’t obtained that easily. So, how does the business get its value? Well, that is where the business valuation method comes in. This method uses multiple IRS-approved methods to get the value of the private company in question.
Reconciliation of Values
Business valuation is the process of determining the economic value of a business, that is, the value for which the business would be sold. It is used to obtain the fair market value of the company’s stock. But business valuation is a lot more than just science. It also includes the process of reconciliation of values, which is an important part of the complete valuation process. When there is a thorough business valuation process, the valuator makes sure that they use the following three approaches to get the final value:
- Income approach
- Market approach
- Asset approach
In short, the appraiser would end up using several methods to reach the value of the company. Each method would give a different value, obviously. There are situations where the differences in the business valuation value would not be significant. And there are other times, where the differences in the end value of each method can be huge. That is where the business appraiser then uses the process of reconciliation in business valuation to get the actual value and final value of the company.
What is Reconciliation of values in business valuation?
From the above it is clear that when a company is valued, the appraisers use many different methods at the same time to get different values. And once these are obtained, the final step in the company valuation includes the reconciliation of the values. Normally, the values that are obtained by market-based and income approaches need to be consistent. They are also given more weightage (consideration) when they are greater than the company’s overall net asset value (to which no weight would be assigned). On the other hand, when the net asset value of the company exceeds the market approach and the income values, the highest asset-based value is given more consideration then.
Here is an example to help you understand it better:
|Weights of Investments
|Value of Investments
Some of the valuation experts apply explicit weights to business valuation values obtained by these methods. And the others use their professional judgment and choose the value that falls within the range as per the methodologies applied. Whatever the method used, the concluded value is always reconciled and supported by the valuation methods used. And this is what the reconciliation of values means.
Common Methods in Business Valuation
Business valuation is the process to obtain the economic value of a company. Professional evaluators take in all the details of the company to reach the value of the company using various valuation methods. The three most common methods used for business valuation include:
Market-Based Valuation Method
The market-based valuation method is one of the most subjective approaches to obtaining the worth of a company. In this method, your company or the company being valued is compared to similar businesses that have been sold (which means that the sold company has a market value – the value at which it was sold). This method is great for companies that can get enough market data on their competitors.
Due to this, the market-based approach is a challenging one, especially for sole proprietors. This is because it is not easy to get the comparative data on the sale of similar businesses, and also because they are individually owned businesses. With this said, since small business valuation methods turn out to be imprecise, the company’s worth would be based on negotiation, especially when selling it or getting an investor. Nonetheless, this method is a great way to get an understanding of the company’s worth. But it is always important to add other methods into this process as well.
Asset-Based Valuation Method
The next method is the asset-based method. In this, appraisers would get the company’s total net asset value. And this value is then subtracted from the company’s total liabilities. The total net asset value and the liabilities are obtained from the company’s balance sheet.
There is a simple formula that is used here, which is:
There are two methods under this method:
- Going Concern – The companies that are not going to be liquidated and are not going to be sold, need to use this method to get their valuation done. In this process. The business’ total equity is considered and is subtracted from the total liabilities of the company.
- Liquidation Value – This is used when the company is about to liquidate. In this, the value is based on the total cash that would be obtained if the company was terminated and the assets were sold. Normally, this process gives a lower business value. This is also why the liquidation value asset-based valuation method isn’t used much as compared to the “going concern” one.
Income Valuation Method or Discounted Cash Flow (DCF) Valuation Method
The income Valuation method is a commonly used valuation method for gaining the business valuation through the reconciliation process. It goes by two names – DCF method or income-based method. In this method, the business is valued based on its projected cash flow, which is discounted (adjusted) to its present value. This method is perfect especially if your company’s profits are not expected to remain consistent in the future.
Here is a table to help you understand each valuation method and what makes them different as well:
|What a comparable company is worth
|What the assets of your company are worth
|What your company’s future income is worth
|May or may not require a forecast
|Does not requires a forecast
Usually, all the three business valuation methods mentioned above are used to get the final value of the company. There are many other methods as well that some appraisers tend to add in based on the information they have about the company. To help you understand how the reconciliation process works, here is an example of reconciliation of multiple different valuation methods:
|Reconciliation of Value Methods
|Discounted Cash Flow Method (income method)
|Value of the company’s equity prior to marketability adjustment
|Less: Marketability Adjustment
|Non-controlling, non-marketable value of the company’s equity
|Concluded Value - 100% ownership interest in the company
|Concluded controlling, non-marketable value of 100% equity interest in the company (rounded average)
Hence, it can be clearly seen that the reconciliation process is very important to get the accurate and best business valuation value.
Explaining the Reconciliation Process
To begin with, the appraiser would use the income approach, asset approach, and market approach valuation method to get the different values of the company. Some evaluators use some other methods too, but at least these three methods are used. Moreover, under each approach used, there can be many other methods that are applied to get the value under that process for the company. For example, under the market approach method, the appraiser can use similar companies on stock exchanges from which this person then gets the value of the company, instead of using other private companies that have been sold as the comparison tool.
Since different processes and methods can be used, the appraiser usually has to ensure that they are selecting the right methods that would give accurate value to the company. The methods used for this are based on the appraiser’s knowledge and experience. It is also impacted by the company’s industry. The approaches used are then weighted to account for their significance or relevance.
Once the values are determined using the different methods, the weighting process comes in. It is an important step to reconcile any differences between the indicated values from the various methods used. One of the main advantages of weighting the values is that it helps the appraiser reconsider the methods they used and pick the ones that would help reach the proper value. It also helps determine the reasons why some methods can be more relevant than others.
To put it simply, here is a step by step process that shows how the reconciliation process takes place:
- Step 1 – Get an in-depth understanding of the business and the ownership interest in the business.
- Step 2 – Execute a thorough quantitative and financial analysis.
- Step 3 – Use all three valuation approaches – income, asset, and market-based approaches.
- Step 4 – Consider valuation adjustments.
- Step 5 – Reconcile indicated value to reach the final conclusive value.
- Step 6 – Present findings in a business valuation report.
Advantages & Risks in the Reconciliation Process
With the above process explained, let us now look into the advantages and risks of the process. The advantage is simple, we get the close accurate value of the company since using one method only to value a company won’t help at all. But with the advantages, there are many risks that come in with the reconciliation process. To begin with, since many methods are used in the process, the appraiser needs to ensure that they select the right methods that would be perfect to help in valuing the company. The selection of the appropriate methods is all based on the experience and knowledge of the appraiser.
The methods selected by the appraiser are then weighted (the process of weighting has been explained below) to account for their significance or relevance. During the weighting process, an important step is to reconcile all differences in the values obtained from the different methods used. Here are some of the common errors that take place during this reconciliation process:
- Disparities – There are times where the appraiser fails to reconcile the imbalances (disparities) between the methods. It is normal for the methods to have different values. And regardless of the size of the differences, the appraiser has to find out the reason they are different and explain them.
- Logic – The reasoning needs to have this explanation too – were the methods given appropriate weighting before being selected and used for the process?
- Reasoning – Do the disparities make any sense and do they have logical explanations for them?
Weighting vs Not Weighting
The next part of the reconciliation process is weighting the values. A few business appraisers believe that it is not right to “weight” the values. Weighting here means, selecting the methods that have higher values than the ones that have a lower value. The reason why they do not believe in weighting the values is – they feel that for each valuation there is one method that offers the best measure of the company’s value.
So, through this reconciliation process, the appraiser develops a comfort level with the accountability and relevance of the different methods for getting the company’s value. And all this eventually reflects on the weighting that was applied. In short, when an appraiser is valuing a company and using different methods, they need to reconcile the indicated values. Not doing this would result in unsupportable and unreasonable conclusions in a business valuation. And the report needs to be able to give proper supportable conclusions. And that is why the reconciliation process is a very important part of the business valuation process.
Looking to Value Your Business?
To get the value of a private company is not as easy as it is to get the value of a public company. A lot of methods and processes are involved in this process. You now know that the reconciliation process is a huge part of obtaining the final value of a business. It is not something anyone can do and can only be done by a professional. That is where Eqvista can help you. Our professional team would understand all about your company to get the information needed. The process would begin and you will get the most accurate value for it.