Going concern valuation

What Is Going Concern Valuation?

Going concern valuation refers to the assessment of a business's value assuming it will continue to operate indefinitely, without the intention or necessity of liquidation in the foreseeable future. This fundamental concept is central to financial accounting and valuation, forming the bedrock upon which most standard business valuations are performed. The going concern assumption posits that a company will be able to realize its assets and discharge its liabilities in the normal course of business. Without this assumption, financial statements and valuation models would need to be prepared on a liquidation basis, which would yield a significantly different and typically lower value for the entity. Understanding going concern valuation is critical for investors, creditors, and management, as it underpins the financial health and sustainability outlook of a company.

History and Origin

The concept of a "going concern" has long been an implicit assumption in accounting, stemming from the need for financial statements to reflect a company's ongoing operational reality rather than a snapshot of its breakup value. Over time, this implicit understanding evolved into a formal principle within accounting standards. For instance, the International Accounting Standards Board (IASB) through IAS 1 Presentation of Financial Statements and the Financial Accounting Standards Board (FASB) through ASC 205-40, explicitly require management to assess an entity's ability to continue as a going concern.¹²,¹¹ This assessment typically covers a period of at least 12 months from the financial statement date.¹⁰ The formalization of this principle became particularly pronounced after significant economic downturns and corporate failures, where the ability of companies to continue operating was severely questioned, impacting public trust and investor confidence. The collapse of major financial institutions, such as Lehman Brothers in 2008, highlighted the critical importance of evaluating a company's going concern status, as its inability to continue operating had cascading effects across global markets.⁹

Key Takeaways

• Going concern valuation assumes a business will operate into the foreseeable future, unlike a liquidation valuation.
• It is a fundamental principle in financial reporting and underlies most common valuation methodologies.
• Management is required to assess and disclose any material uncertainties related to a company's ability to continue as a going concern.
• The absence of a going concern assumption significantly alters how a company's value is assessed, usually leading to a lower valuation.
• Auditors play a crucial role in evaluating management's going concern assessment and issuing appropriate opinions.

Formula and Calculation

Going concern valuation itself isn't a single formula but rather the application of various valuation methodologies under the assumption that the business will continue its operations. The most common approaches used for going concern valuation include:

1. Discounted Cash Flow (DCF) Analysis: This method values a company based on the present value of its projected future cash flow. The formula for a DCF valuation typically involves forecasting free cash flows for a specific period (e.g., 5-10 years) and then calculating a terminal value, which represents the value of all cash flows beyond the forecast period. The sum of the present values of the discrete forecast period cash flows and the terminal value yields the enterprise value.

   $$EV = \sum_{t=1}^{n} \frac{FCF_t}{(1+WACC)^t} + \frac{TV}{(1+WACC)^n}$$

   Where:

   • (EV) = Enterprise Value
   • (FCF_t) = Free Cash Flow in year (t)
   • (WACC) = Weighted Average Cost of Capital (discount rate)
   • (n) = Number of years in the discrete forecast period
   • (TV) = Terminal Value, calculated often using the Gordon Growth Model: (TV = \frac{FCF_{n+1}}{(WACC - g)}), where (g) is the perpetual growth rate.

2. Market Multiples (Relative Valuation): This approach estimates a company's value by comparing it to similar companies (comparables) that have observable market values or recent transaction prices. Common market multiples include Price-to-Earnings (P/E), Enterprise Value-to-EBITDA (EV/EBITDA), or Price-to-Book (P/B).

   $$Value = Comparable \: Company \: Metric \times Target \: Company \: Metric$$

   For example, (Value = P/E : Ratio : of : Comparable \times Target : Company's : Earnings).

Both of these approaches inherently assume the business is a going concern, as they rely on future earnings, cash flows, or a comparison to publicly traded entities that are expected to continue operating.

Interpreting the Going Concern Valuation

Interpreting a going concern valuation means understanding that the resulting value reflects the business's capacity to generate future economic benefits under normal operations. When a company is valued as a going concern, it implies that its ongoing activities, brand reputation, customer relationships, and strategic initiatives are all factored into its worth. This contrasts sharply with a liquidation value, which would only account for the realizable value of its individual assets if the business were to cease operations and sell off its components.

The interpretation of a going concern valuation depends heavily on the underlying assumptions about the company's future profitability, growth prospects, and risk management capabilities. A high going concern value suggests robust future cash generation and stable operations, while a low value might indicate weak prospects or significant operational challenges, even if the business is not immediately facing financial distress. For financial reporting, the going concern assumption dictates how assets are recorded at historical cost less depreciation and liabilities are recognized at amounts expected to be paid in the normal course of business, rather than at fire-sale values.

Hypothetical Example

Consider "InnovateTech Inc.," a growing software company. An investor wants to determine its value.

Scenario 1: Going Concern Valuation

Under the going concern assumption, an analyst projects InnovateTech's future cash flow for the next five years, assuming continued development of its products, expansion into new markets, and stable customer retention.

• Year 1 Free Cash Flow: $10 million
• Year 2 Free Cash Flow: $12 million
• Year 3 Free Cash Flow: $15 million
• Year 4 Free Cash Flow: $18 million
• Year 5 Free Cash Flow: $22 million
  The analyst then calculates a terminal value based on a long-term growth rate, reflecting the perpetual nature of the business, and discounts all these cash flows back to the present using InnovateTech's Weighted Average Cost of Capital (WACC). This discounted cash flow analysis, which assumes ongoing operations, yields a valuation of $250 million. This figure represents the company's worth as an active, thriving business.

Scenario 2: Liquidation Value

Now, imagine InnovateTech Inc. is facing severe market disruption, and its management believes it has no realistic alternative but to cease trading. In this situation, a liquidation value would be determined. The valuation would focus on the immediate saleable value of its tangible assets (e.g., office equipment, intellectual property if it can be sold) and the settlement of its liabilities. The valuation would not consider future profitability or growth. In a liquidation scenario, InnovateTech's net realizable assets might only amount to $50 million after settling all debts, a significantly lower figure than its going concern valuation. This stark difference illustrates why the going concern assumption is paramount in most business valuations.

Practical Applications

The going concern valuation is a cornerstone across numerous financial domains:

• Financial Reporting and Auditing: Management is required to assess a company's ability to continue as a going concern for a reasonable period (typically at least 12 months) when preparing financial statements. If there are substantial doubts, these must be disclosed, along with management's plans to mitigate them.⁸ Auditors then review this assessment and provide an opinion on the financial statements, potentially including a "going concern modification" if material uncertainties exist. The Securities and Exchange Commission (SEC) oversees disclosures that inform investors about a company's financial condition and management's plans.⁷,⁶
• Mergers and Acquisitions (M&A): When one company acquires another, the valuation of the target company is almost always performed on a going concern basis. The acquiring company is purchasing the target's future earning potential and synergies, not just its breakup value. Valuation models like discounted cash flow are used to determine the intrinsic value of the operating business.
• Lending and Credit Analysis: Banks and other lenders assess a borrower's going concern status to determine their ability to repay debt. A company that is not a going concern poses a much higher risk, as its primary source of repayment shifts from future operations to the sale of assets, which may not cover the debt. Analysts evaluate a company's solvency and liquidity to gauge its ability to continue as a going concern.
• Investment Decisions: Investors rely on going concern valuations to make informed decisions about buying or selling securities. When they invest in a company's equity or debt, they generally assume the company will continue to operate and generate returns. Research Affiliates, for example, emphasizes fundamental investing strategies that anchor on a company's underlying business fundamentals, implicitly assuming the company is a going concern.⁵

Limitations and Criticisms

While fundamental to financial reporting, the going concern assumption has its limitations and faces criticisms, particularly when a company's viability is uncertain.

One primary criticism is the subjectivity of the assessment. Management's judgment regarding a company's ability to continue as a going concern often involves significant assumptions about future economic conditions, operational performance, and the effectiveness of mitigation plans.⁴ External events like natural disasters, geopolitical instability, or inflationary pressures can quickly render these assumptions invalid.³ This subjectivity can lead to an over-optimistic assessment, especially when a company is on the brink of financial distress.

Another limitation lies in the "binary" nature of the determination. A company is either a going concern or it is not. However, reality often exists on a spectrum of uncertainty. While accounting standards require disclosure of "material uncertainties," the underlying financial statements still often assume a going concern, which some argue does not fully convey the nuanced risk to users.² The failure of companies like Lehman Brothers, which continued to prepare financial statements on a going concern basis relatively close to its bankruptcy, demonstrated how quickly a company's going concern status can deteriorate and the challenges in adequately signaling this through traditional reporting.¹

Furthermore, even when disclosed, the "material uncertainty" disclosure can be complex for average investors to interpret, potentially obscuring the true extent of a company's viability issues. Critics suggest that more transparent and forward-looking indicators might be needed to supplement the binary going concern assessment, particularly during periods of economic instability or for companies with weak capital structure.

Going Concern Valuation vs. Liquidation Value

Going concern valuation and liquidation value represent two fundamentally different approaches to assessing a company's worth, based on contrasting underlying assumptions about its future.

The key distinction lies in the company's expected lifespan. Going concern valuation is appropriate when a business is expected to continue its operations, generating profits and cash flows into the future. It considers the company as a living, dynamic entity. In contrast, liquidation value is used when a company is expected to cease operations and sell its assets to pay off its debts, reflecting its value in dissolution.

FAQs

What does "going concern" mean in finance?

In finance, "going concern" refers to the assumption that a business will continue to operate and generate revenue for the foreseeable future without the need to liquidate its assets or be forced into bankruptcy. This assumption is crucial for preparing standard financial statements.

Why is going concern important for valuation?

The going concern assumption is vital for valuation because it allows for the use of methodologies that project future earnings and cash flow, such as discounted cash flow analysis. Without it, a business would only be valued based on the immediate sale value of its individual assets (liquidation value), which is typically much lower.

Who is responsible for assessing going concern?

Company management is primarily responsible for assessing the entity's ability to continue as a going concern. This assessment is then reviewed by the external auditor, who provides an opinion on whether the financial statements are fairly presented in accordance with accounting standards, including the appropriateness of the going concern assumption.

Can a company lose its going concern status?

Yes, a company can lose its going concern status if there are significant doubts about its ability to continue operating, and management has no realistic alternative but to liquidate or cease trading. This often happens due to severe financial difficulties, consistent losses, negative cash flow, or inability to meet debt obligations.

What happens if a company is no longer a going concern?

If a company is no longer considered a going concern, its financial statements must be prepared on a liquidation basis, which reflects the estimated realizable value of its assets and the amounts required to settle its liabilities upon dissolution. This often results in a significant write-down of asset values and can trigger default clauses in debt agreements.