How is the value of your company’s stock in your employee stock ownership plan (ESOP) determined? How do the experts come up with a final number? What approaches and calculations are used?
It doesn’t have to be a mystery. Here are the three approaches used to value ESOPs:
Income approach
The income approach is based on the theory that an investment is worth the present value of future cash flow – with some adjustments for risk.
Valuation experts use the discounted cash flow (DCF) method in this approach.
The management team provides a financial forecast for the company. They make predictions and assumptions about what the future holds. These predictions of future cash flows are discounted back to present value.
Experts also evaluate the risks of achieving those future cash flows to determine the value of the company, and consequently the company’s shares held by the ESOP.
What are the strengths and weaknesses of this approach?
This can be a reliable valuation method if your management team has a good track record of hitting their forecasts or an accurate vision for the future.
If management has poor visibility and can’t see how their business model will work in future years or adapt to changing circumstances, this could be a less reliable method.
Market approach
The market approach bases a company’s worth on what similar companies have sold for. A great example of this valuation approach is found in real estate.
When selling your home, your realtor will pull comparables (or comps) in your neighborhood. These comps might provide an evaluation on square footage, amenities, age of the home, geographic location, school district, remodels, etc.
They make adjustments based on how your house compares to each recent home sale, and estimate your home’s market value using a price per square footage calculation.
Valuation experts essentially do the same thing when valuing your company held by the ESOP. But, they have access to public company stock prices and mergers and acquisition databases.
These resources provide a foundation for potential comparable transactions. They find recent business sales and make adjustments and comparisons to your company to establish a fair market value.
What are the strengths and weaknesses of this approach?
Both the strengths and weaknesses of this approach rely on the number of comparable companies available to your expert.
If there are a lot, your expert can nail down a more precise value of your company’s shares held by the ESOP.
If they’re hard to find, your expert may have to make more adjustments to account for the differences between the comparables.
If your company is similar to many public companies – or if there’s a large number of comparable companies that sold recently – this is a robust valuation approach.
Cost approach
The cost approach assumes a company’s value is equal to the market value of its assets subtracted by the market value of its liabilities.
Sometimes this approach is used to establish a bottom, or floor, value.
What are the strengths and weaknesses of this approach?
This approach is simple and it’s appealing to use. It’s quite valuable for companies with many tangible assets and low cash flow.
But, if your company has high levels of goodwill or profitability, it’s less advantageous to use.
An experienced valuation expert will consider all three approaches before valuing your company’s shares held by the ESOP. He will select the approaches that are the most relevant and applicable to your business.
This is a careful examination and selection process. It’s done to ensure your company’s ESOP valuation is reliable, sound, and defensible.
Have questions about ESOP valuations? Let’s talk!
