Operating Company Versus Holding Company Valuation
By: Wlliam C. Herber, Robert J. Strachota and Scot A. Torkelson
Within their profession, business valuators wear many hats. Nowhere is this more true than when attempting to determine if a company being valued is an operating company, a holding company of assets, or some blend of both, particularly when real estate is included on the companyÆs balance sheet. Unfortunately, too often the business being appraised is simply treated by business valuators as an operating company, without regard to a companyÆs underlying asset base. These assets may be passive (such as cash, marketable securities, and/or real estate) and may carry far higher values than any corresponding operational value would produce. Or, in an equally inappropriate assessment, the income from a companyÆs real estate or marketable securities may be blended together with operating earnings and capitalized at inappropriately high capitalization rates. In this case, the income stream will be improperly evaluated when the actual bulk of earnings are related to the less risky passive holdings, rather than the operating entity itself.
This article intends to bring these issues to the business valuatorÆs attention and to emphasize the importance of accurately identifying the type of company being valued, which includes appropriately identifying the assets, evaluating the sources of all earnings, differentiating between passive and active assets, and applying the appropriate business valuation methods to the various components of the business. The objective is to prevent the error of appraising all companies strictly as operating entities without consideration for the independent values of all underlying assets.
Defining the Company: What Kind of Company Is It?
Holding companies are described by Raymond Miles in Basic Business Appraisal (1984), as "businesses which involve little or no goodwill as such, with essentially all of their earning power residing directly in the various assets they own." Mr. Miles concluded that because the value of such a holding company resides primarily in the assets held, "The replacement cost approach (asset approach) can provide the best available indication of the value of a business whose principal function is to manage income producing assets." In other words, the buyer of such a company is purchasing a collection of assets and the income stream produced from those assets. Therefore, in such an instance, an accurate valuation of all the underlying assets is required and provides the best indicator of value.
Conversely, an operating business is defined as an organized activity by means of which income is earned through the utilization of real, fixed, and personal assets that provide for a return on and of the assets utilized, as well as creating excess earnings (goodwill). An operating business can be identified by the successful production or distribution of goods and/or services, whereby its productive capacity primarily results from paid workers and synergies created by the beneficial collection of assets. The purpose of an operating company, unlike a holding company, is the generation of earnings in excess of a fair return on and of the utilized assets (i.e., the presence of goodwill). In other words, while a holding company anticipates a return on and of the assets held and may employ persons to manage those assets, an operating company seeks a level of earnings over and above the underlying asset returns. Buyers of operating companies are therefore more interested in the cash flows generated from the products produced or the services rendered, than in the underlying value of business assets carried on the balance sheet.
Alternative Value Methodologies for Operating vs. Holding Companies
As has been described, the primary source of value in an operating company is typically tied to earnings produced from products or services, and there is a corresponding value in excess of the market value of the tangible assets, which is called goodwill. While holding companies are best appraised by measuring the market value of the underlying assets less liabilities, operating companies are to be valued with a strong reliance on the earnings produced by the sale of products or services. Within the framework of valuation, operating companies are typically valued using one of three basic conceptual approaches which focus upon the companyÆs earnings. These include: 1) the asset approach (which includes the valuation of excess earnings and the calculation of goodwill); 2) the guideline company comparison approach (which includes a multiple of earnings, sales, equity, etc.); or 3) the discounted cash flow/capitalization of earnings approach. Earnings are the focus of valuation for operating companies because the earnings derived from operations carry a greater value than the underlying assets. In holding companies, however, the earnings tend to carry an equivalent or lesser value than the underlying assets. In fact, a test for many operating companies as to whether they ought to liquidate or continue operating, is if the earnings stream carries a greater value than the net underlying assets.
Another important aspect of holding companies which must be considered, is that the apparent underutilization of a holding companyÆs assets (i.e., lower income streams generated than the return rates on the operating companyÆs underlying assets would indicate) does not necessarily result in a lowering of market value, as is often the case. Rather, the value for holding companies is related to the direct valuation of the individual assets held. This is because assets of holding companies are often held for future appreciation and are not based upon the earnings which the assets can generate immediately.
An example of such a situation would be a company with vacant land generating no earnings, which could, in fact, experience a carrying expense. Common sense dictates that the land should not be valued at zero simply because it does not generate any income or earnings at the present time.
Thus, with respect to holding companies, the appropriate valuation methodology is accomplished through the market valuation of each component of the holding companyÆs balance sheet, the adjustment of each asset item to its appropriate market value, and the deduction of liabilities. The resulting adjusted 100% net equity value represents the market value of a holding company. Further, in instances where a company possesses both operating and holding company characteristics (for example, an operating business with significant real estate holdings where the real estate is separable from the business), "The real estate and the business should be appraised separately, with the income stream of the business charged with an appropriate rent expense." (Shannon Pratt, Valuing Small Businesses and Professional Practices, 1993). Thus, even for operating companies with significant assets which are not necessarily tied directly to operations, the various components require their respective valuation approaches and methodologies to provide an accurate final value conclusion.
A simple graphic demonstration of the differences between holding and operating companies can be portrayed as follows:
This representation demonstrates the typical relationship between an earnings driven market value of an operating company and the market value of an asset driven holding company.
Further Consideration
Other issues of significance impacting the valuation of holding companies versus operating companies relate to the lower risk levels accorded to holding companies (in many instances). In addition, the matter of control and how a lack of control can adversely affect value has generally less significance in a holding company versus an operating company.
As a result, in some instances where discount rates are appropriately developed (with the full consideration of the underlying assets generating an operating companyÆs earnings), there are no differences in value conclusions between the income approaches and asset approaches to valuing such a company (even when the assets held do not generate income, as for example, vacant land). When applying an appropriate earnings multiple, capitalization rate, or discount rate to the earnings of such an entityÆs operations, one of the common errors in the valuation of entities with significant holdings of tangible assets such as real estate, is the failure to give proper consideration to the lower risk of the underlying assets (i.e. land and building) and its impact on the operational earnings. More security means lower risk, which generally results in overall lower discount and capitalization rates.
Companies are very much like people - no two are exactly alike. In order to develop an accurate valuation, the appraiser must analyze the different earnings streams and become familiar with the various underlying assets. The question that always needs to be answered is, ôdo the earnings produced come from products and/or services, or simply from managed assets?ö What one discovers after appraising businesses over time is that there are very few entities which can be placed on either end of the spectrum (i.e., strictly an operating company or a holding company). Every company tends to have some aspects of each, and the task of the appraiser has always been to properly identify the assets which produce operational earnings, exclusive of non-operating assets. Only when the earnings are matched to the underlying assets or synergies of a business which produce the earnings in excess of the assetÆs net value, can risk be properly evaluated.
The appraiser must wear many hats to arrive at a concise and accurate valuation. The business valuator must understand rates of return for a wide variety of assets; from vacant land to mutual funds, from residential development to high tech industries. Prime consideration must be given to evaluating the underlying assets producing those earnings in order to determine whether the company being appraised is a holding company, an operating company, or some blend of both. If it is a blend, then it must be separated into its components before it can be accurately evaluated and appropriately valued.
So, is there really any difference between the valuation of an operating company versus a holding company?
Yes.
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