March 11, 2020

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Three Main Business Valuation Approaches: The Asset, Income, and Market Approach.

 

BY ANASTASIA BOURGEOIS

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INTRODUCTION

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In the broadest sense, a business valuation is a process of determining how much the business or a percentage of ownership in a business is worth.  According to the IRS Revenue Ruling 59-60 (follow this link to full text) no general formula may be used that is applicable to all different circumstances and facts of business valuations.  However, the general approach, methods, and factors which must be considered when performing a business valuation are defined by the IRS ruling 59-60. 

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Professional business valuators generally recognize three broad approaches used to value closely held businesses - the asset, market and income approaches.  Each of the valuation approaches includes several underlying methods that are applied by business valuation experts when deemed appropriate based on the circumstances and facts of each business valuation engagement. 

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According to the business valuation professional standards, business valuators are required to consider all three valuation approaches in every valuation engagement.  Business appraisers usually rely on one or two of the valuation approaches to arrive at the conclusion of value depending on the purpose and specifics of the valuation.  The valuation report should explain why some valuation approaches and methods were selected and some were not in determining the value of a business.  

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1.  ASSET-BASED APPROACH 

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The asset-based approach is defined as a general way of determining the value of a business based on the value of its assets net of liabilities.  Under this method, all tangible and intangible, recorded and unrecorded assets of the business are identified and reduced by the value of all outstanding liabilities. The two main methods within the asset-based approach typically used in professional business appraisals are the Book Value Method and the Adjusted Net Asset method.

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1.1  The Book Value Method, within the asset-based approach, allows business appraisers to estimate the value of a business by subtracting the book value of a company’s liabilities from the book value of its assets. Book Value is defined as a value of an asset or liability as it appears on the company’s balance sheet.

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Most professional business valuators agree that this method has several limitations. Even though this method is often used in buy-sell agreements, a conclusion of value established based on the Book Value Method may exclude or measure incorrectly the value of some assets.

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1.2 The Adjusted Net Asset Method, within the asset-based approach, allows valuation experts to adjust all assets and liabilities from book value to fair market value, and estimate the value of a business by subtracting the fair market value of a company’s outstanding liabilities from the fair market value of its tangible and intangible, recorded and unrecorded, assets.

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The Adjusted Net Asset Method is an appropriate method for estimating the value of non-operating businesses such as a closely-held partnership with large investments in stocks, bonds, or real estate, because the value of the company is closely related to the value of the underlying assets. This method is also applicable when valuing a business that continues to generate losses, when a company's net value based on income or cash flow is lower than its net asset value, or when liquidation is imminent. 

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To read more about the Asset-Based Approach and its underlying methods click here.

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2.  MARKET APPROACH 

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Using the market approach, business valuation professionals base the value of a company on how similar companies, both private and public, were priced in the market in the past. The market approach is the most direct approach for establishing the market value of a business. 

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When applying the market approach business appraisers aim to locate comparable businesses that are traded on a public market, or entire public or privately held companies that have been sold. Based on the identified transactions appropriate pricing multiples are calculated, such as price to revenue or price to earnings ratios, and applied to the revenue or earnings of a closely-held business being valued.   

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The four main methods, within the market approach, typically used in professional business valuations are the Guideline Public Company Method, the Merger and Acquisition method, the Prior Sales of Interest in Subject Company Method, and the Dividend Paying Capacity method.

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2.1 The Guideline Public Company Method, within the market approach, encompasses determining market multiples from market prices of stocks of guideline companies, which are publicly traded companies engaged in the same or similar lines of business as the company being valued.

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This method usually relies on transactions consisting of minority interests of publicly traded companies.  A minority interest represents an ownership interest of less than 50% of the voting interest in a business, and characterized by having no power to direct the management and policies of a business.

 

Several material differences between publicly traded and privately held companies make this method a challenge to use for relatively small, privately-owned businesses.

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2.2 The Merger and Acquisition Method, although similar to the Guideline Company Method in its use of price multiples, focuses on the transactions involving the sales of entire companies, rather than sales of minority interests of publicly traded stock. Entire companies represent controlling interest, which is an ownership interest of at least 50% of the voting interest in a business and characterized by having the power to direct the management and policies of a business. 

 

2.3 The Prior Sales of Interest in Subject Company Method focuses on the transactions involving the past sales of interest in the subject company and is similar to the Guideline Company Method in its use of price multiples.

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Arm’s-length transactions in the subject company’s stock can provide a good indication of value and must be considered when valuing a company. Generally, when applying this valuation method it is of key importance how comparable the economic factors that drove the subject company at the time of prior transactions are to those of the subject company as of the current valuation date.

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Since the past transactions can include sales of entire company or partial ownership interest, a derived value for the subject company using this method can result in a control or non-control value.

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2.4 The Dividend Paying Capacity Method is an income-focused valuation method but it is considered a market approach because it is based on market data. The difference between this method and the Capitalization of Earnings income-based method described below is the type of earnings used in the calculations and the source of the capitalization rate.

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The Dividend Paying Capacity Method is based on the future expected dividends to be paid out or the dividend-paying capacity. Within this method a business valuation expert capitalizes such dividends with a five-year weighted average of dividend yields of five comparable businesses.

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To read more about the Market Approach and its underlying methods click here.

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3.  INCOME APPROACH 

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The income valuation approach bases the value of a business on its ability to generate future economic benefits.  This valuation approach estimates the value of a closely-held business by converting business’s future expected cash flows or earnings into a single present value.  Future earnings, such as net cash flow after taxes, are projected and then capitalized or discounted to perform the valuation.

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Two main calculation methods are usually utilized within the income approach, the Discounted Cash Flow Method and the Capitalization of Cash Flows Method. 

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3.1 The Discounted Cash Flow Method, within the income approach, requires estimating the future cash flow streams of the business and discounting them by the discount rate. The discount rate represents the total rate of return that an investor would demand on the purchase of an investment considering the value of money and level of associated business and economic risk.

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The Discounted Cash Flow method is typically used when future expected cash flows or growth rates are expected to vary over a certain period of time.

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3.2 The Capitalization of Cash Flows Method, within the income approach, is most appropriate when a company’s historical earnings can reasonably be considered indicative of its future operations, and is best applied when valuing mature and well-established companies with steady earnings.  Within this method, a company’s future economic benefits for a representative single period are converted into value through division by a capitalization rate.  Capitalization Rate for a company is equal to the discount rate described under the Discounted Cash Flow Method above less the long-term annually compounded sustainable growth rate of the subject company.  

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To read more about the Income Approach and its underlying methods click here.

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CONCLUSION

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All three valuation approaches are crucial in determining the value of a privately-owned business. It is important for a business owner to understand these business valuation approaches in order to be able to communicate all relevant facts and circumstances to the professional business appraiser. A close collaboration between the company’s owner and top management, and a business appraiser aids in developing a thorough and well-supported valuation conclusion.

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Bibliography

 

AICPA, ASA, CICBV, NACVA and IBA (2017).  International Glossary of Business Valuation Terms. Retrieved from: ttps://s3.amazonaws.com/web.nacva.com/TL-Website/PDF/Glossary.pdf

 

Internal Revenue Service (1959). IRS Revenue Ruling 59-60. Valuation of Non-Traded Assets. Click This Link to Full Text (PDF)

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