Income, Asset, Market … Why Different Valuation Approaches Matter

Introduction

There are three primary approaches used when valuing a business: asset, income, and market. A valuation expert often considers valuation methods from each approach when arriving at a conclusion of value.

Asset Approach

The asset approach, sometimes called a cost approach, is defined as:

A general way of determining a value indication of a business, business ownership interest, or security using one or more methods. It is based on a summation of the value of the assets net of liabilities, where each of the assets and liabilities have been valued using either the market, income, or cost approach.

The asset approach is based on the principle of substitution, where a prudent investor would not pay more for an income-producing property than it would cost them to build or purchase a similar property. This approach derives the value of a business by estimating the value of each of the business’ underlying assets (including tangible and intangible assets) and liabilities.

This approach is most appropriate for valuing real estate, investment holding companies, or capital-intensive companies, such as construction companies with a large amount of equipment.

Income Approach

The income approach is often the primary approach for valuing operating companies. It is defined as:

A general way of determining a value indication of an asset, business, or investment using one or more methods that convert expected economic benefits into a single amount. The two primary ways of converting economic benefits into a value indication are the discounted cash flow method (DCF) and the capitalized cash flow method (CCF).

DCF

DCF is a multiple period valuation model that converts a series of benefit (cash flow) streams into value by discounting them to present value. Experts use a rate of return that reflects the inherent risks in the benefits stream.

CCF

CCF is a single-period valuation model that converts a benefits stream into value by dividing the benefit stream by a rate of return that is adjusted for growth. This method is a simplified version of the DCF method and is typically used when a valuation expert expects long-term stable cash flows into perpetuity.

Market Approach

The market approach determines value using similar investments that have been sold in the marketplace. It is defined as:

A general way of estimating a value of an asset, business, or investment by using one or more methods that compare the subject to other assets, businesses, or investments that have been sold or for which price information is available.

There are three common methods used under the market approach: prior transactions of the subject company’s own stock; the guideline public company method; and the transaction (merger and acquisition) method.

All three valuation methods under the market approach usually involve analyzing multiples of revenue or earnings of comparable companies that have been sold. That could involve prior transactions of the company being valued, publicly traded company multiples, or merger and acquisition transactions that occurred in the marketplace. Experts then apply appropriate multiples to the revenue or earnings of the business being valued.

Arriving at a Conclusion of Value

To arrive at a conclusion, a valuation expert analyzes the value indications from the methods applied along with quantitative and qualitative factors of the subject business. Valuation experts often base their concluded value on one of the valuation methods and use the other value indications to support their conclusion. In other instances, an expert may weigh various value indications to arrive at a conclusion of value.

An expert must take into account all of the relevant factors of the subject interest, the subject company being valued, and the conditions of the economy and industry in which it operates.