Approaches to Corporate Valuation03/09/2022 0 By indiafreenotes
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.
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.
The asset approach may be applied when the benefits of operating a business do not outweigh the value that could be derived through the orderly liquidation of assets. Methods under this approach assume a controlling premise of value and include:
- Net Asset Value Method
- Adjusted Net Book Value Method
- Capitalization of Excess Income Method (also an income approach method)
The Net Asset Value Method
The Net Asset Value Method is based on the business’ assets less existing liabilities. This simplistic approach is used most commonly for a controlling interest and when valuing securities of businesses involved in the development and sale of real estate, investment holding companies, and certain natural resource companies.
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.
Expected returns on an investment are discounted or capitalized at an appropriate rate of return to reflect investor risks and hazards. From a theoretical perspective, enterprise value is based either on historical earnings or future cash flows.
Methods under this approach include:
- Capitalization of Excess Income Method
- Capitalized Economic Income Method
- Discounted Cash Flow Method
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.
This is done through the use of ratios that relate the stock prices of the public companies to their earnings, cash flows, or other measures. By analyzing the financial statements of analogous companies and then comparing their performances with those of a subject company, the appraiser can judge what price ratios are appropriate to use in estimating the market value of the closely-held entity.
Methods under the market approach include:
- Dividend-Paying Capacity Method
- Guideline Merged & Acquired Company Method
- Guideline Publicly-Traded Company Method
- Transaction Database Method