Valuation Methodologies: The Current Art and Science

• Author: James L. Horvath & Tim Dunham
• Pages: 473-531

473

Chapter 19

Valuation Methodologies:

The Current Art and Science

james l. horvath & tim dunham*

A. INTRODUCT ION

The valuation of a business, investment, or asset is often a complex exercise

involving the in-dept h analysis of numerous qualitative and quantitative

factors. Unique valuation issues will arise across companies and indus-

tries, but the basic pr inciples of valuation remain the same. Our goal i n

this chapter is to desc ribe current f undamental aspects of the valuation

process and to lay a theoretical foundation for those other chapters that are

focused on specif‌ic areas of technology-related valuation. The body of valua-

tion knowledge, tools, and techniques continues to develop a nd expand, as

do the information sources available for assistance in performing valuation

analysis.

The va luation of technology and high-tech companies, and the impact

of technology on the risk/return prof‌ile of non-technology companies, is in-

creasingly central to many valuation analyses. Indeed, technology is reshap-

ing many businesses and business models at an accelerated pace. While

the va lue of some old-economy assets is often readily apparent and easily

quantif‌ied, the rapid pace of change intrinsic to technology companies, and

the high rate of growth typically contained in future estimates of revenue

and prof‌itability, makes the valuation of these companies considerably more

complicated.

There are many valuation methodologies available in valuing an asset or

business. It is critical to select the appropriate method and understand how

to use it to ar rive at an accurate and meaningf ul conclusion. Regardless of

474 james l. horvath & tim dunham

the valuation methodology, however, technology va luations leave plenty of

room for subjective judgment. The value derived from any valuation model

is affected by both f‌irm-specif‌ic and broader industry and economic factors.

The value conclusion will age quickly for technology companies, and the

variables that drive the valuation model will require frequent updating to

ref‌lect all cur rent information.

This chapter also contains two detailed ex amples of formats commonly

applied to technology and intangible asset valuations — the Dual Excess

Earnings and Relief-from-Royalty methods. T hese methodologies provide

considerable utility to t he business valuator in allocating value bet ween

various forms of intangible assets, through exercises such as fair value ac-

counting and purchase price allocation.

B. CORE CONCEPTS

1) Valuation First Principles

When conducting a valuation, the valuator must consider several fu nda-

mental principles.

a. A valuation applies to a specif‌ic point in time. The valuator must con-

sider information in existence only on or before the specif‌ic valuation

date. The valuator cannot u se hindsight to conduct a valuation. This

does not mean that t he va luator should ignore all subsequent events.

Instead, the valuator should consider the event’s proximity to the valua-

tion date, any evidence of a material change in the nature or underlying

fundamentals of the business, and whether the event could have been

reasonably foreseen.

b. In determining the value of a business, one should assess

1. the present value of all f uture cash f‌lows expected to be generated;

and

2. the fair market value of t he net t angible and identif‌iable intangible

assets of the enterprise.

The higher of t hese two values will generally represent the fair market

value of the business.

When considering the present value of all future cash f‌lows, it is im-

portant to consider how much of the resulting value is transferable from

a commercial standpoint. Cash f‌lows generated by the specif‌ic t raits,

contacts, and personalit y unique to the owner are generally considered

to be non-transferable.

c. In deter mining the value of an intangible asset, one should assess

Valuation Metho dologies 475

1. the present value of all future cash f‌lows that the asset will generate;

and

2. the cost to reproduce or replace the asset with similar functionalit y.

The lower of these two values will general ly represent the fair market

value of the intangible asset.

If the cost to reproduce or replace the asset is higher than the associ-

ated present value of cash f‌lows, a purchaser would reasonably expect to

pay an amount equal to the present value of future cash f‌lows. Paying

more would mean that the price was higher than t he expected benef‌its.

If the cost to reproduce or replace the asset is lower than the associated

present value of future cash f‌lows, a purchaser would ex pect to pay this

price. Why would he pay a higher price if he could obtain the same bene-

f‌it simply by reproducing or replacing the asset?

d. The present values mentioned earlier should be based on market rates of

return at the valuation date.

e. In general, the higher the fair market value of a business’s net tangible

assets, the higher the overall value of the business, and the lower the re-

quired rate of return, holding all other factors constant. T his is because

1. the downside risk is relatively lower, since the sale of tangible assets

would generate more of the assessed value on liquidation, and

2. the business is less dependent for its cash f‌lows on intangible assets,

which typically require a higher rate of return to compensate for

their higher risk.

f. Risk is reduced as the amount of market liquidity available to the invest-

ment or asset increases. When liquidity is limited or restricted, a liquid-

ity discount may be appropriate.

g. There are special considerations when valuing individual interests in a

business. Controlling interests may attract a h igher value than minor-

ity interests, because minority shareholders have less inf‌luence on oper-

ational and strategic decisions about the company and, as a consequence,

they may have greater investment risk than the controlling shareholder.

Given these prevailing f‌i rst principles, t he topics mentioned below merit

further consideration in the majority of valuation assignments.

2) Price vs. Value

The discussion in this chapter revolves primarily around the fair mar-

ket value of a business, investment, or asset. Often this will differ from

price — the amount that prospective buyers and sellers will pay in the open

market. Fair market value (as the sta ndard of value) and pr ice (a market-