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Approaches to business valuation

There are three different approaches to business valuation:

The asset-based approach to business valuation

Some call this approach ‘the cost approach to business valuation.”
This approach is only valid on its own for non-operating companies. For operating companies, it must combine with either, or both of, the other approaches.

The methods in this approach include

  • net asset value,
  • tangible book value
  • economic book value
  • marketable asset value, and
  • fire-sale asset value

There is a some more to learn about the asset approach to business valuation here.

The market approach to business valuation

This limted approach has accuracy issues. It may appear to include some excellent and reliable methods, but be careful.
In no particular order of frailty they include:

  • Public company comparisons
  • Industry-wide guidelines
  • Rules of thumb
  • Contemporary business comparisons

There are obvious limitations comparing a listed public company to a private one:

  • Liquidity of their respective shares
  • Proportion of traded shares
  • Reporting standards
  • Available data

Industry-wide guidelines are akin to socialist command economy directives. Sure,it makes for easy succession or retirement planning. But what if your business is better than a product of a "generally accepted multiplier"?

Like industry guidelines, rules of thumb are a recipe for value to price inequity.

Using contemporary business comparisons is an unrealistic ideal. No matter what anybody tells you, there is no sample size of any relevance.

We have more to say about the market approach to business valuation here.

The income approach to business valuation

The methods in which fall under this approach are either based on

  • historic income statement items, or
  • expected or projected future cash flow

History-based methods
They take known performance in a current or recent period. Then in simple formulas, they compute "a value". The formulas will fall into the following methods

  • simple multiplier formulas
  • weighted average multipliers
  • capitalised owner benefit

These methods are easy to use and re-use. Their limitation is in knowing the multiplier, weighting, or capitalisation rate to use.

Projection-based methods
The weakness is in projecting future cash flows. That is dealth with using appropriate discounts for risk.

  • discounted cash flow,
  • discounted dividend flow, and
  • internal rate of return regression

Each of these include risk discounts for the business, the industry, and the country. Sellers should avoid their use in pitches to buyers.

Having said that, buyers and investors prefer the projection-based methods. They give results for justifying holding or acquiring assets.

We unpack much more about the income approach to business valuation here.