What are the three main business valuation approaches? First, let’s start with ‘what is a valuation approach?’ A valuation approach is a process used to arrive at an indication of economic value of an owner’s interest in a business. The three most common valuation approaches are the income, market, and asset approaches.
The income approach determines the value of a business based upon its ability to generate economic benefit for the owners. It is forward looking, and the key objective is to reach an estimate of value by discounting the expected future income streams of the business by the expected rate of return of the business.
The income approach considers the return on investment available to an investor in that company. The earnings, once defined, are capitalized or discounted, depending on the conditions of that business, using a rate calculated to be commensurate with the overall risk characteristics of the target firm, including factors such as liquidity, leverage, cost control, growth, etc. Earnings are the foundation of this approach and it is often given heavy consideration in determining value.
The goal of the market approach is to establish business value by comparing historic sales of similar businesses to the Subject. Its basis is the Principle of Substitution, which states the economic value of something tends to be equal to the cost of acquiring an equally desirable substitute.
The market-based approach uses known information from sales of comparable companies to determine a valuation multiple. This is a particularly strong approach when it is based upon real transactions of similar, privately-held companies, as is often the case. The number of transactions and comparability of the transactions is a very important consideration. A strong point of this method is that once the market has been defined, the full spectrum of transactions can be viewed. The Subject can then be compared to the entire range of transactions, allowing for identification of where on the spectrum of transactions the target company fits best. Value is usually determined by using a market-based multiple of revenue or some measure of earnings, e.g. EBITDA, Discretionary Earnings, etc.
The asset approach seeks to determine the value of a business based upon the value of its assets. The approach involves establishing the fair market value of a firm’s assets, and then subtracting the firm’s liabilities. Like the market approach, it is also based upon the Principle of Substitution.
Each of the valuation approaches mentioned above has various methods for determining value; these methods are specific in their application for determining value. After considering the condition of the target company, the environment in which it operates, the scope and purpose of the assignment and the quantity and quality of information available, the business appraiser will select the valuation method(s) that best suit the Subject company.