Approaches to business valuation

Three approaches to business valuation

The asset-based approach to business valuation

Some call this approach ‘the cost approach to business valuation.” In summary, this approach takes the sum of the values of individual assets as the value of the whole.
This approach is only valid on its own for non-operating companies. If it is used for operating companies, it must combine with either, or both of, the other approaches (market approach and income approach).

The methods of the asset-based approach to business valuation include

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

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 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. If one considers that the definition of business value is "the present value of the sum of future cash flows adjusted for risk", then these methods are not valid. They do, however, provide a quick and easy way of pricing a company or business.

Projection-based methods
These methods include variations on the same theme: projecting the future earnings, and then expressing those projections in terms of today's money.

  • 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.

Buyers and investors all use the projection-based methods. They give results for justifying holding or acquiring assets. "If we spend 1000 coins on the business, what will we get back? How long before we get our money back? Can we get the same return elsewhere?"

The weakness is in projecting future cash flows. The seller of a business will have both an expressed view and a secret view. The buyer of a business will also have two views: expressed and secret.

The buyer will negotiate with expressed views of the future earnings, usually based on mathematical models which draw on performance to date. Their secret views are based on what they intend to do with the business once it is in their control or under their influence.

Nobody knows for certain what the future holds, and hardly any forecasts have ever been accurate. But we all know there is a future. The future is the reason people buy, sell, or hold businesses. The investment in the business provides for the future.

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

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Business Valuations

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