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Is business valuation an art or a science? Years ago, this question was put to a panel of business valuation experts at a training session, and predictably there was no consensus. One noted expert said business valuation was more of a science, but he also acknowledged that it had some aspects of art as well. Another panel expert also recognized the existence of both elements but believed art was the predominant element.artful calculator

Defining Science and Art

Fast forward to today and the debate still goes on. So exactly what is business valuation? There is still no consensus, but perhaps a closer examination can shed some light on the matter.

Let’s start with some definitions from Merriam-Webster’s Collegiate Dictionary, 11th Edition.

Science: A system or method reconciling practical ends with scientific laws.

Art: Skill acquired by experience, study, or observation.

The Case for Science

As the discipline of business valuation matures and expands, there’s a clear trend to rely more on scientific evidence and methods. For example, valuators increasingly use regression analyses when projecting cash flows, quantifying discounts and analyzing sales transactions.

In determining discount and capitalization rates used in the income approach, valuators analyze the data sources that make up the building blocks of those rates. One example is the Butler-Pinkerton Calculator, a method of using a “total beta” applied to comparable public companies to determine a total cost of equity for a privately held business.

In determining the discount for lack of marketability (DLOM) the older benchmark studies have been subjected to a number of scientific analyses (for example, regression analyses) to point out their weaknesses and assist the valuator in determining a supportable DLOM. Emerging scientific methods to quantify DLOM include option models and input models such as the Quantitative Marketability Discount Model.

Artistic Elements

As hard as one might try to substitute concrete evidence and proven methodology for an expert’s professional judgment, business valuation will always result in an “estimate of value” that’s somewhat subjective. The resulting conclusion of value that derives from a valuation engagement is a hypothetical value and cannot be “proven” in the scientific sense.

The art part of business valuation is integral to the process. It’s also the part that makes it both unique to the individual providing the opinion and to the user of the valuation conclusion. The experience, study and observation that characterize “art” is what’s important to the end-user of a valuation. An experienced valuation analyst adds to the scientific processes his or her experience, study and valuation over the years to take into account those intangibles which impact the valuation.

The specifics of the business being valued, the impact of the economy, the quality of management, and the state of the industry are some of the qualitative aspects a valuation analyst must consider in arriving at a conclusion of value — and those are only done in an artful manner. Science will not help to evaluate the impact of those factors on the value of the business.

The importance of these artistic elements underscores the need to hire a trained valuation professional who’s earned credentials from a recognized appraisal organization.

The Right Mix

Valuing a closely held business requires a blend of quantifiable scientific methods and qualitative artful considerations. The user of a business valuation prepared by an experienced valuation analyst should feel comfortable that the value conclusion includes a proper mix of scientific processes and artful consideration. It’s this combination of art and science that provides the user with a quality product.

Michael Harvey is our business valuation and litigation expert and he can help you with any questions you may have.

Michael Harvey

Michael Harvey, CPA/ABV/CFF, CFE, CGMA Senior Manager, Business Valuation & Litigation Support

865-769-0660/mharvey@pughcpas.com

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