You can value a business using three commonly used approaches: the market, income and asset-based approaches. You must also make adjustments to reflect characteristics specific to with respect to liquidity and control. These are known as valuation discounts. You can find relevant information in a company's , which should detail any restrictions on transfers of interests and corporate control issues such as voting rights. Once the value of the business is determined, the specific share value is determined by calculating the proportionate ownership interest. For example, if a business is valued at $100 and you need to calculate the value of a 10 percent partnership share, you would multiply 10 percent by $100 to arrive at a partnership share value of $10.
The involves analyzing transactions involving guideline companies that are highly comparable to the subject business in terms of line of business, size and profitability. Transaction values are used to develop valuation multiples, which are then applied to the subject company's financial metrics. For example, if a peer company with annual net income of $1 million is acquired at a deal price of $10 million, this implies a ratio of 10.0 ($10 million transaction price divided by $1 million in net income). If your subject business has annual net income of $500 thousand, applying a price to earnings ratio of 10.0 results in an indicated value of $5 million (P/E ratio of 10.0 multiplied by $500 thousand).
The premise underlying the income approach is that it is more valuable to hold a dollar today than to receive it some time in the future, because it can be invested today in securities and earn a return. This is known as the time value of money, and implies that a business's value is the present value of the sum of its expected future cash flows. The two basic inputs in the income approach are cash flow (or earnings) and risk. Risk is represented by the , which reflects the typical investor's required rate of return on the business. It is the percent return that is required to entice an investor into investing in the company, given the various associated with the investment. For example, if common stocks historically earned returns of 12 percent, an investor in a particular common stock may use a discount rate of 12 percent to calculate expected returns going forward. These risks include market-related risks and company-specific risks. A higher discount rate is indicative of higher perceived risk. Using the income method, cash flow is , or converted into value. For example, if a company is expected to generate free cash flow of $100 per year in the future, using a 12 percent discount rate, cash flow is capitalized by dividing it by the capitalization rate. Therefore, cash flow is converted into value by dividing $100 by 12 percent, resulting in a value of $833.33 ($100/12 percent).
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The asset approach focuses on the and is best applied to holding companies, or companies with assets with carrying values that already closely approximate market value, like an investment company that holds . The approach calculates net asset value by subtracting the fair market value of the business's liabilities from the fair market value of its assets. For an operating company, the net asset value can be viewed as a floor of value, because, at a minimum, the company is worth what it can obtain from liquidating its assets, after paying off its liabilities.
Partnership interests are generally illiquid and often restricted by the partnership agreement from being transferred. In some cases, a right of first refusal is in place, which states that if a partner wishes to sell his interest, the interest must first be offered to the partnership or other partners for sale at the desired transaction price. Also, limited partners are generally exercising little control over the business. Due to these factors, there are two types of valuation discounts typically applied to partnership interests:
- Discount for lack of marketability - Investors greatly value and discount the value of securities lacking liquidity. The discount for lack of marketability reflects the reduction in price required to entice a hypothetical investor into investing in the partnership given the factors surrounding its lack of liquidity. Partnerships can commonly be discounted between 20 percent and 35 percent due to illiquidity.
- Discount for lack of control - Corporate control is valuable because it allows you to set dividend policy and influence the company's operations. Just as investors pay a premium for control, they apply a discount for , which can be similar in magnitude as illiquidity discounts.