Business Valuation and Good Judgment

Valuations require judgment. They are not primarily a technical exercise. The parties effected by a valuation, whether they be a buyer, seller, a judge, or lawyer, should take the time to become assured that sound judgment is applied to arrive at the conclusion of value.

Sentient Partners is often retained to estimate the fair value or fair market value of a company or security for a variety of purposes, including an enterprise acquisition, complete or partial stock sale, employee stock option plan, and a variety of litigation matters including bankruptcy, shareholder disputes, partner disputes, intellectual property infringement, contract disputes, and other controversies. Most often these valuation engagements utilize the Income Approach to derive the value, and more specifically the Discounted Cash Flow (DCF) method.

To arrive at a conclusion of value, the DCF method first requires a projection of the company’s results of operation for a discrete, multi-year period, five years is a common standard. The discrete cash flow projection is then converted to a single present value through applying a discount factor to that cash flow. More importantly, the DCF method generally requires that a “terminal value” be determined at the end of the initial discrete projection period. Terminal value is most often defined as the present value of the stabilized benefit stream capitalized into the future.

The “future” for purposes of deriving the terminal value means in perpetuity. The terminal value is supposed to capture all the future periods after the initial discrete projection period. Frequently, the terminal value can account for 75 percent or more of the total company or security value under the DCF methodology, especially when the initial projected period is short, such as less than five years. The fact that the terminal value can account for such a large proportion of the total value should be understood by all parties affected by a valuation. Small changes in the selected long term growth rate used to determine the terminal value leads to large swings in the resulting value derived. The selected long term growth rate requires considerable judgment. The analyst should understand the events and circumstances that can drive growth in an organization, and understand the industry in which the organization operates. The valuation analyst can obtain this judgment through practical hands on experience driving the growth of organizations, or consulting with someone whom has such experience. If you are considering a valuation or you will be affected by the results of a valuation it would be prudent to come to understand and trust the terminal value. It may be the single most important factor driving the outcome of the valuation.

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