Here various valuation techniques are used by financial market participants to determine the price they are willing to pay or receive to effect a sale of the business.
This distinction derives mainly from the use of the results: stock investors intend to profit from price movement, whereas a business owner is focused on the enterprise as a total, going concern.
Normally, equity interests in these firms (which include corporations, partnerships, limited-liability companies, and some other organizational forms) are traded privately, and often irregularly.
As a result, previous transactions provide limited evidence as to the current value of a private company primarily because business value changes over time, and the share price is associated with considerable uncertainty due to limited market exposure and high transaction costs.
Anderson (2009) recently estimated the market value of U.S. privately held and publicly traded firms, using Internal Revenue Service and SCF data.
When done correctly, a valuation should reflect the capacity of the business to match a certain market demand, as it is the only true predictor of future cash flows.
However, these conditions are assumed because they yield a uniform standard of value, after applying generally accepted valuation techniques, which allows meaningful comparison between businesses which are similarly situated.
A measure of the income is the amount of cash flow that the owners can remove from the business without adversely affecting its operations.
Most treatises and court decisions encourage the valuator to consider more than one technique, which must be reconciled with each other to arrive at a value conclusion.
Income based valuation methods determine fair market value by dividing the benefit stream generated by the subject or target company times a discount or capitalization rate.
Capitalization and discounting valuation calculations become mathematically equivalent under the assumption that the business income grows at a constant rate.
Before moving on to calculate discounts, however, the valuation professional must consider the indicated value under the asset and market approaches.
Careful matching of the discount rate to the appropriate measure of economic income is critical to the accuracy of the business valuation results.
The rationale behind this choice is that this earnings basis corresponds to the equity discount rate derived from the build-up, or CAPM, models: the returns obtained from investments in publicly traded companies can easily be represented in terms of net cash flows.
as opposed to the cashflows to equity—and is thus applied to the subject company's net cash flow to total invested capital.
The capital asset pricing model (CAPM) provides one method of determining a discount rate in business valuation.
Public capital markets do not provide evidence of unsystematic risk since investors that fail to diversify cannot expect additional returns.
Total beta can help appraisers develop a cost of capital who were content to use their intuition alone when previously adding a purely subjective company-specific risk premium in the build-up approach.
This capitalization rate for small, privately held companies is significantly higher than the return that an investor might expect to receive from other common types of investments, such as money market accounts, mutual funds, or even real estate.
Depository accounts are insured by the federal government (up to certain limits); mutual funds are composed of publicly traded stocks, for which risk can be substantially minimized through portfolio diversification.
The risk of investing in a private company cannot be reduced through diversification, and most businesses do not own the type of hard assets that can ensure capital appreciation over time.
The asset based approach is the entry barrier value and should preferably be used in businesses having mature or declining growth cycle, and is more suitable for a capital intensive industry.
The adjusted net book value may also be used as a "sanity check" when compared to other methods of valuation, such as the income and market approaches.
Such comparison often reveals useful insights which help business analysts better understand performance relationship between the subject company and its downstream industry.
The comparison is generally based on published data regarding the public companies' stock prices and earnings, sales, or revenues, which is expressed as a fraction known as a multiple.
While it is not without valid criticism, Mergerstat control premium data (and the minority interest discount derived therefrom) is widely accepted within the valuation profession.
Marketability is defined as the ability to convert the business interest into cash quickly, with minimum transaction and administrative costs, and with a high degree of certainty as to the amount of net proceeds.
[citation needed] Several empirical studies have been published that attempt to quantify the discount for lack of marketability.
Still, the existence of a marketability discount has been recognized by valuation professionals and the courts, and the restricted stock studies are frequently cited as empirical evidence.
Prudent investors buy illiquid investments only when there is a sufficient discount in the price to increase the rate of return to a level which brings risk-reward back into balance.