Terry McGlinchey

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Valuation : how to assess an organizations wealth

Terry McGlinchey

Terry McGlinchey, Academic / Student


Valuation : how to assess an organizations wealth

The real value of an organization goes far beyond its profits and shares. Assessing how rich an organization is can quickly become a nightmare and many have lost a lot of energy and money in the process, just by not knowing how to properly valuate. The following addresses why you should always ask a professional to complete a valuation in order to win in the end

In recent years, we have heard so much about valuation that the word itself has become a synonym for fear for many businessmen. But in fact, and historically speaking, valuation might be the most valuable companion to any professional who needs to know what his business is worth in order to make the most profit out of it. Whether the goal is to sell the business, get your company on the NYSE, or simply due diligence, the valuation process should be done with the professionalism and expertise it requires.

The practice of the business valuation gained prominence during the U.S. prohibition in the 1920s, during a time when the population considerably grew. It was the beginning of big businesses, due to technological advances like the telegraph, the railroad and refrigeration, to name a few. By then, the valuation theory was developed by the idea that the value of a company is measured by its ability to generate cash flow, which creates goodwill. Already at that time, goodwill could be comprised of different components, such as a trained workforce, customer base, trade names and reputation in the community, among others.

Concretely, evaluating the worth of your organization can be done in several ways. Many specialists agree on saying that "there's no right way, though you could probably come up with several wrong ones", according to Stever Robbins, founder and President of LeadershipDecisionworks Inc., a national training and consulting firm that helps companies develop leadership and organizational strategies (1).

Robbins mentions two approaches the first is to start by looking at the value of the business assets (what the business owns, i.e. equipment and inventory), saying that the business is at least worth the replacement cost if someone was to start the same business elsewhere.

The other valuation approach perceives a business as a "stream of cash flow", coming up with a value for that stream of cash. In this case, businesses have to be really careful when assessing the "revenue", because revenue doesn't necessarily mean "profit".

Warren Buffett uses the concept of a "discounted cash-flow analysis", looking at how much cash a business generates each year and projecting it into the future. From that, Buffett calculates the worth of that cash flow stream, "discounted" using the long-term cost of capital.

The asset-based method also has its limitations, according to Anthony Charlton, arbitration specialist and writer for the Kluwer Arbitration blog. "Whilst the asset-based approach can appear conceptually simple, it is often misunderstood and easy to get wrong", (2) states Charlton. "Proper application of this approach requires inter alia dealing with complex concepts such as the recognition and measurement of assets for the purposes of financial reporting, the effects of inflation, the competitiveness and dynamics of markets for inputs, the role placed by replacement costs, the true economic costs of replicating assets (including time to rebuild and the costs of failure)". And these elements are typically forgotten during many valuations.

Both the net asset value method and the discounted cash flow method can be used and lead to drastically different results. Valuation companies use these methods as well, but they need to have the full knowledge of a business environment in order to make an accurate valuation. Having the valuation done by an expert is always a good idea, but the expert has to know the company, its sector and its precise need in order to give a fair perspective on what the business is worth.

This is the case for Duff & Phelps, founded in 1932 in New York as one of the first valuation firms. Today, Duff & Phelps is the leader in global valuation and corporate finance advisory with specific expertise in complex valuation. Even though the practice of valuation has evolved, historic valuation firms like Duff & Phelps have adapted to the new requirements to serve their clients: "There are many situations where a family will call us first wanting an evaluation of a business for one family member to buy out another, and it may transform into the sale of the company. We may see a client in financial distress and in need of some type of advice, but often the solutions or alternatives that are in front of them are complex and not straight forward. The cornerstone of any M&A assignment is in fact valuation", says Robert A. Bartell (3), managing director at Duff & Phelps Chicago.

Duff & Phelps applies three historical pillars of valuation - "we measure, we monitor and maximize value", and has followed long-term major clients for decades accompanying them during their growth. Real estate transactions and due diligence have become a major turn out today and companies need precise and knowledgeable data in order to produce reliable and qualified results during the due diligence process.

The valuation of patents has also become crucial, as legislation around patents has evolved. Assessing these intangible assets of intellectual property rights (IPRs) is a complex task in which many companies have specialized in, "considering that in the past as much as three-quarters of the market capitalization of U.S. companies consisted of intangible assets, accurate estimation of the value created by IPRs is essential even to most bread-and-butter business valuations with which the bulk of our readers are most familiar", writes Christopher Bakewell, managing director at Duff & Phelps Houston (4).

Therefore, the valuation process of a company needs to be completed, considering all of these assets that can sometimes be difficult to put a price on. Having the valuation done by a firm that has no direct interest in your business is significant in order to have a fair point of view. The old adage "people do what you inspect, not what you expect" applies to valuation engagements and businesses need to find not only finance and valuation experts, but people who have an expertise in their specific sector.

There is a true gap between theory and practice of firm valuation according to Franck Bancel and Usha Mittoo, who conducted a survey of European valuation experts, revealing that firm valuation could only be accurate if they were done by valuation experts with that specific industry knowledge, the data of intangible assets, real estate and much more. "These wide disparities indicate that two valuation experts could arrive at substantially different valuation estimates, despite using the same model", according to Bancel and Mittoo, who urge any businessman to really take valuation seriously in order to make the most profit out of it in the end.

(1) How to value a business, Stever Robbins, Entrepreneur, January 12th 2004
(2) Asset based methods - Part 3, valuation and the financial crisis, April 10th 2012, Kluwer Arbitration blog
(3) Duff and Phelps puts professional values first in valuation and restructuring practices, Daily CSR, December 12th 2015
(4) Valuation of patents, legislative and judicial developments on images in infringement cases, Christopher Bakewell.

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