There are three approaches used in valuing a business: the asset-based approach, the income approach, and the market approach. In a full business valuation, the valuation analyst must consider all approaches, and use their professional judgment to determine which of the three methods — or combination of methods — is most appropriate. In a calculation engagement, the valuation analyst and the client agree on which approach or approaches will be used.
Below is a brief summary of each approach.
Asset-based approach: This method uses the fair market value of the assets of a business, less any related liabilities. In most cases, the analyst considers the value of the net assets in the context of a business that will continue to operate. If the business includes real estate or specialized equipment, separate appraisals for those assets may be needed.
The asset-based approach usually ignores the value of intangible assets, such as reputation, brand, customer relationships, and a well-trained workforce. As a result, it frequently results in the lowest value of the three methods and may be used to set a “floor” for the value of the business.
Income approach: The income approach determines the value of a business based on its ability to generate future income for the owners of the business. If the trajectory of future earnings will be stable, the analyst can use capitalization of benefits methodology. This method involves applying a fixed growth rate to a single measure of future income. If some variability is anticipated, the discounted future benefits method is generally used. This method involves building a two-stage model consisting of a forecast period and a terminal period.
In both methods, it is crucial that the valuation adjust projected earnings to reflect only the net income that a hypothetical buyer will experience. These adjustments are known as normalization adjustments.
Once the future income stream is determined, the valuation analyst applies a discount rate to the future earnings stream. This discount rate must be developed and applied carefully, as small changes in the discount rate can produce significant changes in value.
Market approach: The market approach is a method of determining the value of a business based on the selling price of comparable businesses. The analyst can use either data on publicly traded companies, or data on the sale of comparable privately owned companies. This method generally relies on pricing multiples, usually of revenue or some measure of profit to arrive an indication of value.
Which method is best for my business?
There are no specific guidelines that require that a specific method is used for certain types of businesses or in certain situations. It is up to the valuator to use their professional judgment to determine which approach is best. Therefore, it is important to work with an experienced analyst, and preferably one with a professional certification in business valuation.
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