Business valuation approaches and methods
There are three major commonly used business valuation approaches: income approach, market approach and asset approach. Under each approach, the value of a business can be determined by a number of methods.
Income approach to business valuation determines the value of a business by converting anticipated future returns of a business into a present single amount. The returns are estimated as either a single value or a stream of income expected to be received by the business owners in the future. The returns are matched against the risk associated with receiving them fully and on time by means of the so-called capitalisation or discount rates. Methods available under this approach include:
- Capitalisation of Earnings method (also referred to as Capitalisation of Future Maintainable Earnings, CFME) converts a single measure of sustainable future earnings of a business into a value by dividing them by an appropriate capitalisation rate.
- Discounted Cash Flow (DCF) method establishes a business value by discounting a stream of future business earnings and the related cash flows for time and risk using an appropriate discount rate.
Market approach to business valuation determines the business value by comparing the subject business to similar companies (also referred to as guideline companies, comparables, peer group, etc.). This involves performing Comparative Company Analysis (CCA) – a process where the similar companies’ metrics (either trading multiples or transaction multiples) are identified and used as indicators of value for the subject business. Methods available under this approach include:
- Guideline Public Company method (GPCM) is a method whereby market multiples are derived from market prices of similar comparable companies that are actively traded on a free and open market.
- Guideline Transaction method (also referred to as Merger & Acquisition (M&A) method or Comparative Transaction method) uses multiples derived from the past transactions, such as mergers and acquisitions, of similar comparable companies.
- Market-driven Rules of Thumb method (also called Industry method) refers to common practices used to value businesses in a particular industry.
Recent Transactions method is another method under the market approach. It refers to previous sales of a share or the whole of the business being valued.
Asset approach to business valuation determines the business value based on the value of its assets net of liabilities (net assets). Methods available under this approach include:
- Book Value method works with book values of the assets and liabilities as they appear on the balance sheet (synonymous with Shareholder’s Equity).
- Adjusted Book Value method is a method whereby all assets and liabilities (including off-balance sheet, intangible and contingent) are adjusted to their fair market values.
- Liquidation Value method values a business based on the net amount that would be realised if the business is terminated and the assets are sold over a limited time period (forced realisation).
- Replacement Cost method calculates the business value as the replacement costs of all assets necessary for the business operations.
- Cost to Create method (also referred to as Cost to Duplicate, Entry Costs) calculates the business value based on how much it would cost to build a similar business from scratch.
- Capitalised Excess Earnings method calculates the business value as the sum of the net tangible assets at fair market value and the business goodwill (determined through the capitalisation of the excess earnings). This method is rather a hybrid of the asset and income valuation approaches.
By Julia Podgorbunskaya, CPA, Senior Business Valuer at Professional Business Valuers
(61) 02 4295 0079