Here you will find information on a business valuation according to IDW S 1. For a complete presentation, please refer to the standard itself. Here you will find an easily understandable overview to familiarize yourself with the topic.
Do you need a business valuation according to IDW S 1? As an independent appraiser, I would be happy to prepare a report according to IDW S 1 for you.
Call NowThe IDW S 1 is the standard of the Institute of Public Auditors in Germany (IDW) for business valuation and includes, in particular, formal requirements, explanations of the procedure, and recapitulates the application of subjective and objectified valuation methods (capitalised earnings method, DCF methods), including the determination of interest rates.
Would you like to understand the principle of a business valuation? Please read the explanations on the capitalised earnings method.
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Call NowIn a business valuation, the benefit of the future net cash flow is related to the present time and expressed in monetary units (future earnings value) (para. 4). This is done by discounting with a capitalization rate.
Assume that a company enables a cash flow of 12,000 monetary units (MU) gross and after taxes (30%) of 8,400 MU (distributions). This cash flow grows annually by 2%. The valuation subject (investor) can obtain the same cash flow through a bank investment. The bank offers him a gross interest rate of 5%, which corresponds to a net interest rate of 3.75% after a tax rate of 25%.
With a value of 480,000 MU, the valuation subject receives the same cash flow (including growth) through a bank investment as through the company.
The value of the company is therefore 480,000 MU (if no taxes are due on the capital gain). In Table 1, you can find the example of the alternative investment at the bank. The valuation subject cannot withdraw the entire net interest income, as the investment must increase each year to receive interest income in the following year that compensates for the growth.
The example is taken from the explanations of the capitalised earnings method. There you will find a step-by-step explanation.
Table 1: Business Value Calculation incl. Growth and Taxes
| Description | Year 1 | Year 2 | Year 3 | Year... |
|---|---|---|---|---|
| Capital | 480,000 | 489,600 | 499,392 | ... |
| Interest Income Gross | 24,000 | 24,480 | 24,969.6 | ... |
| Taxes | -6,000 | -6,120 | -6,242.4 | ... |
| Withdrawal | -8,400 | -8,568 | -8,739.36 | ... |
Source: own representation.
According to paras. 8-11, business valuations can occur due to entrepreneurial initiatives, from the application of valuation standards (external accounting, tax law), or from legal or corporate regulations.
The listings in paras. 9-11 are not exhaustive. Reference is made here to the explanations of Matschke and Brösel (2013). The classification is lengthy and will be spared here.
It is important that different valuation occasions can result in different valuation methodologies. This will be briefly outlined below.
According to para. 17, there are three business values, namely:
The first value, the objectified business value, is calculated in the function of a neutral appraiser. The subjective decision value, on the other hand, is calculated in the function as an advisor. Lastly, the compromise value is described. Here, as a mediator/arbitrator, a compromise is found, taking into account the situation and the subjective value conception of the valuation subjects (para. 12).
The choice of the value to be determined thus depends significantly on the valuation occasion/valuation purpose.
Para. 13 explains the difference between the value and the price of company shares. A direct determination (cash flow to the owner) and an indirect determination (derivation from the total value) of the business value are described. In the case of the objectified value, it is a proportional share of the objectified total value. The subjective value takes into account individual circumstances and goals of the valuation subject. The price for company shares, on the other hand, results in particular from supply and demand on the free capital market.
Paras. 140-141 add that the lower value limit is generally given by the liquidation value. If the net proceeds from a liquidation (including debt offsetting and liquidation costs) are higher than the business value upon continuation, the value of the liquidation must be applied.
This classification differs from the classification in functional valuation theory. In that, a distinction is made between
Here, the decision value represents the limit of advantageousness for the respective participant. This results from a (non-)linear optimization, a mathematical procedure. In technical terms, one speaks of a base program and a valuation program (Hering, 2017). You can imagine it as if a financing plan (VoFI) is set up before and after the transaction. The decision value is the value at which the withdrawals (the available money) of the valuation subject are identical in both situations. It is evident that personal tax rates, alternative investments, and withdrawal preferences lead to different values for different valuation subjects.
The arbitration value is an umpire value which can be calculated by an appraiser from the decision values of the participating valuation subjects. Argumentation values are business values that are calculated to influence the other party.
In science, there is a vehement discourse about whether objectified or subjective business values should be calculated. Anyone interested can follow this in Quill (2016). The essential core point is that an objectified business value does not correspond to the decision value of the valuation subject and the CAPM or Tax-CAPM model is used for determining interest rates.
The principles according to IDW S 1 are essentially described in paras. 17-58.
There are general principles for business valuation and principles that relate to subjective and objectified business valuation. Here, the general principles are first summarized.
Relevance of the Valuation Purpose
The business valuation, and thus the methodology of value determination, is carried out depending on the valuation purpose (para. 17).
Valuation of the Economic Business Unit
The principle of overall valuation as an economic unit applies (paras. 18-21). The interaction of all tangible and intangible values enables a future cash flow to the owners. (Neither the sum of the book values nor the sum of the liquidation values reflect this.)
Stichtag Principle (Cut-off Date Principle)
The valuation is carried out as of the valuation date (paras. 22-23). It is essential that only information that could have been known up to the cut-off date may be processed.
Principle of Cash Flow Orientation
The valuation is cash flow-oriented and takes income taxes into account (paras. 24-28). In essence, these are two principles. They are summarized here because cash flow orientation includes the tax effect. It is not the profit, but the cash flow between the company and the owner that is considered.
Valuation of Non-operating Assets
Non-operating assets are valued according to their best use (holding vs. liquidation) (paras. 59-63). (Basically, a liquidation is also a future earnings value, based on the present moment.)
Irrelevance of the Prudence Principle
The prudence principle is disregarded (paras. 64-65). The prudence principle causes a distortion that is desired in the German Commercial Code (HGB) but is inappropriate in business valuation. This principle is particularly important in the function of the neutral appraiser.
Transparency of Valuation Approaches
The business valuation must be documented transparently (paras. 66-67). A proper valuation enables verification by another expert (paras. 173-179).
Depending on whether a subjective or an objectified business value is to be determined, the principles to be applied differ. Subjective means that personal assumptions are explicitly included (para. 48). This applies, for example, to the capital structure of the valuation subject, to unrealized strategies, and personal abilities.
| Aspect | Subjective | Objectified |
|---|---|---|
| Consideration of Taxes | Personal, but (as far as possible) standardized tax rates are used (paras. 43-47). | The actual personal tax rates apply (para. 58). |
| Consideration of Synergies | Unrealized synergy effects are considered, but only in case of (partial) realization (para. 34). | All synergy effects are considered, provided they can be realized by the valuation subject (paras. 50-51). |
| Net Cash Flow: Distribution Assumption and Retained Earnings | During the planning period, distributions and retained earnings are to be considered as much as possible according to the company's concept. Subsequently, distributions may generally be capital market equivalent and retained earnings net present value neutral (paras. 35-37). | The individual assumptions of the valuation subject are to be considered (paras. 52-55). |
| Company Concept and Success Factors | Only (partially) realized plans and potentials are to be considered (para. 32). | Unrealized plans and potentials are also considered (para. 49). |
| Management Factors | Management is generally interchangeable. Individual influences are to be eliminated (paras. 38-42). | Individual assumptions and influences are to be considered (paras. 56-57). |
IDW S 1 describes various permissible methods of business valuation (para. 99). These include:
The first three methods of business valuation are so-called equity methods (net methods). The last two methods are entity methods (gross methods). They should theoretically all lead to the same result if the models are correctly calibrated (paras. 101 and 124).
In equity methods, the net cash flow to the owners is the focus.
In entity methods, the cash flow to the owners and debt capital providers is the focus. Here, a correction is subsequently made to account for the value of the debts (value additivity). Income taxes are also recorded in entity methods (para. 139).
Which methods are not among the methods of business valuation according to IDW S 1? So-called multiples are permitted under the IDW S 1 standard only for plausibility checks, but not for value determination (paras. 143-144 and 164-169). The net asset value method is not allowed in paras. 170-172 because the reference to future financial surpluses is missing. It may only be applied if explicitly commissioned.
You can find much more information on the capitalised earnings method and the DCF methods in the links. It makes sense to read the explanation of the capitalised earnings method first and then the DCF methods.
Each of the methods mentioned above for business valuation aims to discount the cash flow (future earnings value) (para. 85). According to para. 87, it is generally assumed that the company has an unlimited life, although in individual cases it may be assumed to have a limited life. As an example, a quarry is mentioned.
Non-operating assets are assumed to be liquidated immediately, provided that holding them is not more advantageous.
Risk is to be considered in business valuation (para. 88), whereby this can be done by a deduction in the cash flow or a risk premium on the interest rate (para. 89). Mathematically, both can be transformed into each other (Terstege, 2023).
In paras. 90-92, it becomes apparent that the IDW strongly prefers the risk surcharge and favors a derivation from the CAPM model (Sharpe, 1964; Lintner, 1965; Mossin, 1966) or Tax-CAPM (Brennan, 1970). Further elaborations are given in paras. 114-122. For a critique of the risk surcharge on the discount rate and the CAPM model, refer to Hering (2017) and Hering (2021).
With regard to CAPM and Tax-CAPM, it should also be emphasized that in the capital structure, the value of the debts and not the book value of the debts is to be considered (para. 100). The capital structure is significant for deriving the risk using the beta factor.
In the objectified business valuation, the discount rate in practice consists of a maturity-equivalent basic interest rate (quasi risk-free rate) and a risk premium (paras. 114-122).
In determining the subjective decision value, individual assumptions are decisive (para. 123). Both the cash flow and the discount rate must consider income taxes in equity methods (para. 93). The consideration of income taxes also applies to DCF methods (para. 139). For formulas related to net interest rates, refer to Schneeloch et al. (2020).
In the planning period, growth is explicitly to be considered in the cash flow and implicitly at the planning horizon through a growth rate (paras. 94-98). Generally, nominal cash values and interest rates are used.
A formal presentation of the present value calculation, on which both the capitalised earnings method and the various DCF methods are based, follows.
Here, the formula for the discount factor is presented. ρ stands for the discount factor, t for the respective year, τ is a running variable for time, i for the interest rate, and r for the risk. If the risk is considered in the cash flow by a deduction, no risk premium may be applied to the interest rate.
Para. 86 assumes that a company has an unlimited life. This is represented by the following formula. The first part shows the discounting in the planning period, and the second part stands for the annuity at the planning horizon. C stands for the capital value, t for the respective year, T for the planning period, e for the cash flow, ω for the growth rate.
Para. 87 describes that some companies have a limited life. This becomes visible through the following formula. Instead of the perpetual annuity at the planning horizon, a present value is used. n stands for the years.
In the analysis and forecast of the company and its environment, it is a core problem of business valuation (paras. 68-71). Often, an analysis of the past (paras. 72-74) forms the basis for a forecast of the future (paras. 75-80).
Usually, the forecast is made in different phases, with the last phase referring to a "steady state". It is suggested in para. 80 to carry out a multi-valued planning to uncover uncertainty. The approach of uncovering risk and not compressing it is highlighted in Hering (2017).
Here, reference is made to a scheme for the analysis and forecast of companies and their environment.
The forecast must be consistent in itself (para. 81). Furthermore, the data basis must be reliable (paras. 82-84).
(For high-growth companies, there are special rules, particularly with regard to the analysis of the past (paras. 146-148).)
The planned balance sheets and planned income statements can be prepared according to HGB, US-GAAP, IFRS, or other standards (para. 102). The goal is to estimate the future cash flow. Various adjustments are to be made for the preparation (para. 103).
Paras. 104-108 outline how a planned income statement could be prepared, and paras. 109-111 specifically address financial planning, including interest. A detailed description will not be provided here.
Para. 127 provides a formula for determining the cash flow from a planned income statement for the WACC method.
(The liquidation of non-operating assets, provided that holding them is not more advantageous, can conceptually also be considered in the planned balance sheet and planned income statement. An immediate liquidation is assumed if necessary.)
Different principles apply partly to the valuation of high-growth companies. High-growth companies mean companies where the owners make significant upfront investments (para. 146). Complex investments enable long-term profits. In these companies, a prognosis based on past analysis is usually not sufficient (para. 147). According to para. 148, the focus is particularly on modeling the long-term steady state.
The procedure essentially corresponds to the above principles and the usual approach, only that the focus is on modeling a steady state in the future. Uncertainty (risk) and growth must be adequately considered.
The valuation of low-earnings companies is outlined in paras. 149-151. It is essential that special importance is attached to liquidation or the liquidation value. In para. 151, the principles are specifically related to low-earnings companies.
In non-profit-oriented companies, according to paras. 152-153, not the future earnings value but the reconstruction value is the focus. The term reconstruction value is self-explanatory. It is important that non-operating assets are recognized at their liquidation value.
The liquidation value for the non-profit-oriented company (i.e., also of the operating assets) does not represent the lower value limit for the business value according to para. 153. This can be explained by the fact that the company has a different objective than profit-oriented companies.
The valuation of small and medium-sized enterprises (SMEs) is regulated in paras. 154-169. Essential aspects are that
In paras. 164-169, it is pointed out that multiples are often used for value determination in SMEs. However, these should only be used to plausibilize the calculated business values.
An appraisal according to IDW S 1 includes some essential points, which are presented in para. 179. Here is a brief overview.
First, the valuation task is defined. Who is the client and what is the precise assignment? The question of the assignment is important because, depending on the valuation purpose, a subjective decision value, an objectified business value, or a compromise value is calculated. Depending on the value, the methodology of value determination differs.
Subsequently, the valuation principles and methods are to be presented.
An analysis of the valuation object according to legal, economic, and tax foundations follows. Perhaps the term due diligence is known to some.
Then it is shown on which information base the valuation is built. The information base is critically assessed according to origin and quality. (This includes management assessments of future development as well as third-party appraisals.)
A forecast (planned balance sheet and planned income statement) is created. This must be checked for plausibility.
The operating assets are valued using one (or more) valuation methods. Usually, a phase model with a detailed planning period and a perpetual annuity at the planning horizon in the "steady state" is applied. Alternatively, para. 87 allows a present value at the planning horizon.
Subsequently, the discount rate is to be presented. Regularly, the basic interest rate and risk premium are determined using the Tax-CAPM and explained accordingly. The growth discount is also to be presented.
A presentation of the valuation of non-operating assets follows.
The business value is presented, preferably with plausibility checking.
A concluding statement follows.
Hering, T. (2017). Investitionstheorie (5th ed.). De Gruyter Oldenbourg.
Hering, T. (2021). Unternehmensbewertung (4th ed.). De Gruyter Oldenbourg.
Mossin, J. (1966). Equilibrium in a Capital Asset Market. Econometrica, 34(4), 768-783.
Quill, T. (2016). Interessengeleitete Unternehmensbewertung. Springer Gabler.
Terstege, U., Bitz, M., & Ewert, J. (2023). Investitionsrechnung klipp & klar. Springer Gabler.