Valuation approaches are methods that business valuation experts use to determine the value of a business. There are various approaches that can be used, and a good business valuation report will include several. Within each approach, there are different methods a valuation expert can employ. Any combination of approaches can be used as long as the results are credible.
Below we will discuss the three most common valuation approaches a business valuation expert utilizes. These include the asset approach, the income approach, and the market approach.
An asset-based approach uses the current value of the company’s net tangible assets. The idea is to determine the fair market value of the assets less liabilities. Under this approach, the valuation analyst adjusts the value of the assets and liabilities (both reported and not reported) of the business from their stated values to the chosen standard of value for the engagement, i.e. fair market value.
This approach is most useful for asset-intensive companies like real estate firms, manufacturing companies, and start-ups with heavy research and development costs. In addition, this approach is often utilized in situations where the earnings of a business are insufficient and do not provide a reasonable return on assets.
The income approach converts future expected economic benefits – generally cash flow – into a present value. It is best suited for businesses that are established and profitable. The two most common methods under the income approach include the capitalization of earnings method and the discounted cash flow (DCF) method.
Capitalization of Earnings Method
Using the capitalization of earnings method, the analyst estimates the appropriate measure of economic income for one period (i.e, one period before the valuation date or one period after the valuation date). This period is then divided by an appropriate capitalization rate as discussed below.
The capitalization rate or factor reflects what a reasonable rate of return an investor would expect. It also helps to identify the risk the buyer will be exposed to if expected earnings are not met.
This approach is best suitable for businesses that have a long and stable history of operations as the data is more accurate.
Discounted Cash Flow Method
This method considers the intrinsic value of the business. It uses 3-5 years of projections to estimate the value of future cash flows. All future cash flows are then discounted to present value using a discount rate rather than a capitalization rate.
This approach is best suited for businesses that have a good financial history and have built reliable forecasts in the past. Keep in mind, this method is limited because it relies on future cash flow estimates which can be subjective.
The market approach bases the value of the business by using comparable businesses from private or public markets. This approach is the most widely-used and understood. Just like when you are shopping for a car or house, you research comparable cars or homes in your local area. The market approach does just this.
This approach uses market multiples also known as valuation multiples. Market multiples are ratios comparing one financial metric (i.e. Share price) to another financial metric (i.e. Earnings per Share). Valuation analysts use multiples as financial measurement tools to compute the value of a company and compare it to similar companies. Using multiples helps adjust company financials for differences in size and volume. Three common valuation multiples used to value small businesses include the revenue multiple, EBITDA multiple, and seller’s discretionary earnings (SDE) multiple.
In situations where data is limited, other approaches may be more applicable.
The best business valuation will use a combination of valuation approaches. Doing so helps to determine a more accurate fair market value. Depending on your specific situation, one approach may be more applicable than another. Working with a valuation professional will provide you with the most objective assessment of what your company is worth.