Business appraisals are a critical part of mergers and acquisitions, equity transactions, estate planning, litigation support, and other financial situations. Appraisals aim to determine the fair market value of a business based on its financial performance, assets, market position, and future prospects. 

While appraisals incorporate both quantitative and qualitative factors, there are several technical methodologies and adjustments that appraisers rely on to reach an objective valuation. This article will provide an in-depth overview of key technical aspects of business appraisals, including discounted cash flow analysis, market multiples valuation, and common adjustments like control premiums.

Discounted Cash Flow (DCF) Analysis 

Discounted cash flow (DCF) analysis is a valuation method that estimates business value based on projected future cash flows discounted back to the present value. It allows appraisers to account for expected growth and risks associated with the business operations.

There are three main steps in a DCF analysis:

Forecasting Cash Flows

The first step is to forecast the business’s unlevered free cash flows (UFCF) for a discrete projection period, usually 5-10 years. Important inputs include:

– Revenue growth assumptions and drivers

– Profit margins based on historical performance 

– Capital expenditures needed to support growth

– Changes in working capital requirements

Appraisers build out a detailed financial model to estimate projected cash flows. Growth rates and margins should align with management forecasts and industry benchmarks.

Determining the Discount Rate 

Once cash flows are projected, the next step is determining the appropriate discount rate to apply, which is based on the business’s weighted average cost of capital (WACC). Important inputs include:

– Cost of equity based on investors’ required returns

– After-tax cost of debt based on current interest rates 

– Optimal capital structure (debt vs. equity mix) for the company and industry

The discount rate compensates investors for the riskiness of future cash flows and brings them to present value.

Terminal Value

The terminal value represents the business’s value beyond the discrete projection period. It’s calculated by applying an assumed long-term growth rate (often 2-4%) to the final year projected cash flows.

The terminal value gets discounted back to the present based on the discount rate. It often represents a significant portion of the business’s total value.

After discounting the projected cash flows and terminal value, the appraiser sums these up to determine the net present value – this represents the total equity value of the business.

Market Multiples Valuation

Another common approach to value businesses is the market multiples method. This involves applying valuation multiples from comparable public companies or transactions to the business’s financial metrics. Key steps include:

Selecting Comparable Companies

Appraisers carefully select a group of public companies that are similar to the subject business in terms of industry, size, growth, margins, and other financial characteristics. The more comparable the companies, the more accurate the valuation.

Calculating Multiples

Common multiples used in appraisals include P/E, EV/Revenue, EV/EBITDA, P/B, among others. These are calculated by dividing the enterprise value (equity + debt – cash) or market cap by the relevant financial metric.

Applying Multiples

The multiples are benchmarked and applied to the subject company’s financial performance. For example, if comparable companies trade at an average EV/EBITDA multiple of 10x, this 10x multiple is applied to the subject’s EBITDA to estimate its enterprise value.  

Adjustments may be made to the multiples to account for differences between the subject business and comparables. Multiples valuations are often used in combination with DCF analysis.

Adjustments and Premiums

Appraisers also incorporate various adjustments into the valuation to account for specific factors affecting the business’s fair market value.

Control Premiums

A control premium may apply if the appraisal involves selling a controlling stake in the business. By acquiring control, buyers gain increased oversight and can implement changes to enhance value. Typical control premiums range from 20-40%.

Minority Interest Discounts

Conversely, a minority interest discount may apply if selling a non-controlling minority stake. Since minority owners lack control, the value is decreased. Discounts typically range from 15-35%.

Liquidity Discounts 

Privately held businesses lack liquidity compared to public companies. This makes it more difficult for shareholders to sell their stakes. Appraisers may apply a liquidity discount, typically in the range of 10-30%, to account for this.

Conclusion

Applying technical valuation methodologies correctly is crucial for arriving at a reasonable determination of business value. Key techniques like DCF analysis, multiples, and adjusting for premiums/discounts help appraisers maximize accuracy and minimize subjectivity. While appraisals involve some art, emphasizing the technical aspects results in appraisal reports that withstand scrutiny and create trust in the ultimate valuation.