A colleague had a great question: how do you decide which approaches and methods to apply to an appraisal? My first answer—it depends on case facts and circumstances and data availability—is true, but not particularly helpful. After I thought about it for a while, I came up with what I hope is a better one.
To keep it simple, restrict the discussion to operating companies; exclude holding companies. (The latter are usually valued using the Asset Approach, although assets such as stock in subsidiaries might be valued using any approach.)
- A life cycle analogy is apt: birth, toddler, adolescent, adult, middle age, old age, and death. Except for birth and death, it is hard to define the boundaries between them with precision, but most people would probably not differ by more than one stage in their assessment of where a person is in their life cycle, using the word “potential” for their future earning power
- A newborn infant’s potential is unknowable
- A toddler’s potential is highly uncertain.
- An adolescent’s potential is starting to become visible.
- A young adult’s potential is visible.
- A middle-aged person’s potential is extremely visible.
- An old person’s potential is starting to decline.
- A dead person’s potential is zero (unless heaven has employment opportunities).
- Extend that analogy to operating companies:
- A newborn company’s earning power is zero. We value it based on the investment made in it (Asset Approach).
- An early-stage (toddler) development company’s earning power is not quantifiable; we use option models to value it.
- A later-stage (adolescent) development company’s earning power can be guessed at; we use the probability- weighted expected return method to value it.
- An established (young adult) company’s earning power can be projected using a Discounted Cash Flow (DCF) methodology (varying annual growth rates).
- A long-established (middle-aged) company’s earning power can be projected using a Single Period Capitalization Method (SPCM) methodology (stable growth rate).An old-line (old person) company’s declining earning power can be projected using a DCF or SPCM methodology (varying or stable decline rates).
- A dying (dead) company’s earning power is less than its liquidated value. It is difficult, if not impossible, to apply the Market Approach (absent same-company stock transactions) to the first two and the last one.
There is judgment as to what stage of the life cycle a company is in, but in my estimation, most appraisers would not differ by more than one of them.
By Rand Curtiss, MCBA