Business valuation can be one of the most challenging aspects of commercial litigation. Forensic accountants are often hired as expert witnesses in order to give their expert opinion as to the value of a particular business. There are many factors that go into calculating the value of a business. When approaching business valuation, expert witnesses can take one of three distinct approaches, each with their own methodologies.
The Income Approach
The income approach is the most widely used approach in business valuation. When using an income approach, forensic accountants base their valuation on the direct stream of income that a business generates. The business value can depend on the business’ current earnings or the future earnings that the business expects to accrue. When employing the income approach to valuation, forensic accountants might opt to use a discounting or capitalizing method.
Gunnar J. Gitlin of The Gitlin Law Firm in Woodstock, Illinois, defines the discount method: “Each increment of the projected economic income of an investment is discounted back to a present value rate of return known as a discount rate.”
The capitalization method divides a single period’s income by a rate of return called the “capitalization rate.”
Though both methods require the expert to determine a normalized income stream, the discounting method is generally employed when a business anticipates future earnings that exceed those of the current period.
The Market Approach
The market approach is used to value businesses by comparing the company to similar business interests that have been recently sold. Comparison figures usually come from “guideline companies,” which Gitlin describes as, “Companies that provide a reasonable basis for comparison to the relative investment characteristics of the company being valued.”
There are various methods that are used to find an appropriate guideline company including:
Publicly Traded Guideline Company Method: Forensic accountants who use this method find comparable publicly traded companies in order to estimate the value of the company in litigation.
Comparative Transaction Method: In this method a valuator inspects recently sold companies in order to find comparable businesses that can act as guideline companies.
The Asset-Based Approach
The asset-based approach, or cost approach, is based on the premise that a potential buyer of the business would not pay more than the cost to replace any individual assets of the entity with equal assets minus the cost of any liabilities incurred by the business entity. This is known as the “principle of substitution.”
The primary method for determining value in the asset-based approach is the adjusted net asset value method. This method of valuation adjusts a company’s assets and liabilities to fair market value.
Business valuation is a vital service and is just one way that expert witnesses are used during litigation. Since there are different means of valuating businesses, it’s important to employ an expert forensic accountant that can ensure that a business is valuated according to the correct standards and methodologies, while also providing a figure that is most beneficial to your client’s assets.