The Three Approaches to Business Valuation

There are three basic approaches used to value a business – the income approach, the market approach and the asset approach.

Income Approach: The income approach calculates a value based on the assumption that the value of a business is equal to the sum of the present values of any expected future benefits. In other words, the value is based on the company’s future ability to generate income. The two most common methods within this approach are the capitalized cash flow (CCF) method and the discounted cash flow (DCF) method. When historical cash flows are expected to continue in the future the capitalized cash flow method is typically used. A DCF method is often used when the company is expected to have materially different cash flows than it has seen in the past. The DCF is also often used for companies with little or no earnings history.

Market Approach: The theory of the market approach is that the value of a business is determined based on comparisons to similar companies for which values are known. These comparable companies may be publicly traded (Guideline Public Company method) or they may be recently sold with the terms of the transactions disclosed (Comparable Transaction method). When applying the market approach, the analyst must be careful in determining what companies are truly comparable to the subject company. Some factors to consider for comparison are 1) industry, 2) size, 3) methods of operations, 4) markets and customers served, 5) accounting methods, 6) projected growth in sales and earnings. Analysts use many available databases to begin their search for comparable companies. Unfortunately, especially as it relates to smaller companies, finding an appropriate number of comparable companies is often difficult. In today’s valuation environment, the method is more often used as a sanity check than a conclusion of value.

Asset Approach: The asset approach is a way of determining the value of a business using one or more methods based on the value of the assets net of liabilities. The asset approach represents the value of all tangible and intangible assets and liabilities of a company. This approach typically begins with the book value of the business. Book value is an accounting concept of the cost of assets less the cost of liabilities. In an Adjusted Book Value method, assets and liabilities are restated to their fair market value. Some assets such as cash and accounts receivable may not need to be restated as book value could be considered fair market value. Other assets such as equipment will often need to be adjusted in order to reflect its fair market value.

After determining a company’s value using an appropriate approach and method, an analyst will often use sanity checks as a reasonableness test for the value determined. Sanity checks are not a substitute for a valuation, but can be used to give you insight as to the level where a business may be sold based upon general rules of thumb for an industry.

Rules of thumb for valuing businesses have been widely discussed. Business brokers often refer to them for a particular industry and business. Rules of thumb are market driven and reflect average multiples paid in transactions but are not traceable to specific transactions.

Another way to look at a sale price for reasonableness is to determine if the buyer is able to pay for the purchase from Company profits while still maintaining a reasonable level of compensation. This is often referred to as a payback analysis.

Every business being valued is unique. The facts and circumstances of each valuation will determine the best approach and method for the valuation.