There are many business valuation methods that a business valuer has in their toolkit. There are 3 broad valuation approaches: Income Approach, Market Approach and Cost Approach. Within each broad approach there are several valuation methods to choose from and within those methods valuers will often carefully modify a method to suit the situation at hand.
Below is a brief description of the most common valuation methods.
The Valuation Ultimate software allows you to value a business using any one or more of these methods and you can even create your own custom method within the software.
Income Approach – Discounted Cash Flow
The discounted cash flow method of business valuation is a theoretically strong approach to valuing a business or any other financial asset. This approach considers the magnitude and timing of all future cash flows and converts them to a present value at an appropriate risk-adjusted rate of return. The discount rate or required rate of return takes into account various risks from general investment risks to company-specific risks and is weighted with the cost of debt where applicable to the business structure.
Whilst the underlying theory is sound, in practice this method is difficult to apply due to the sensitivity of the method to the underlying assumptions. Certainly the greatest limitation in using this method is to predict the various cash inflows and cash outflows for a business between the valuation date and the future cessation of the business, including any expected sale of the business.
This method is most useful when there is some level of certainty around the future cash flow expectations for the business going forward at least 5 and ideally 10 years. This method is also useful for creating hypothetical valuations under assumptions about potential future cash flow scenarios.
Where the valuation result is greater than the net operating assets of the core business, the surplus is commonly attributed to goodwill and other intangibles. Surplus excessive and non-operating assets and debts are typically adjusted to the valuation result when valuing the equity in the entity.
Income Approach – Capitalisation of Future Maintainable Earnings
This method is a modified version of the discounted cash flow method, but which predominantly uses historical profitability to formulate an assumed future maintainable earnings figure. This method is most useful when the historical earnings are relatively stable and expected to increase at a constant rate. To be clear, this is still a forward-looking assessment, but based largely on past performance as an indicator of future performance.
The capitalisation of earnings method uses a capitalisation multiple that the valuer determines to be reasonably appropriate, reflecting a risk-adjusted required rate of return and a constant growth rate of earnings. To calculate the business value, the future maintainable earnings are simply multiplied by the capitalisation multiple. The capitalisation multiple may be different to one that would be applied using the discounted cash flow method as the future maintainable earnings method often (but not always) uses earnings before interest and taxes, whilst the discounted cash flow method often (but not always) uses net cash flow to invested capital after tax.
This method is often used when valuing small businesses due to its perceived simplicity, but it needs to be used with great care as it is extremely sensitive to the assumptions used. In fact, the underlying mathematics can be proven to precisely correlate with the discounted cash flow method and so it is subject to the same types of misuse of earnings bases and discount rates.
Where the Enterprise Value is greater than the ordinary net operating assets of the core business, the surplus is commonly attributed to goodwill and other intangibles. Surplus and non-operating assets and debts are typically subsequently adjusted to the valuation result when valuing the equity in the whole entity.
Market Approach – Guideline Public Companies
This method involves the comparison of the business being valued with other businesses that have publicly traded securities, ideally in an informed and liquid market.
This method is useful where there are similar businesses listed on the open market. When using this method, the valuer will analyse the comparable companies and calculate implied valuation multiples (e.g. Enterprise Value/EBITDA) for a range of companies. The valuer will then use their judgement to choose a multiplier within the range, then adjust the multiplier for additional size and company-specific risks and apply it to the adjusted earnings of the business being valued.
This method is difficult to apply to small businesses in practice due to the absence of comparable businesses being publicly traded. The differences in size, scale and structure cause the comparisons to be unreliable and the subsequent discounts too arbitrary.
Market Approach – Comparable Transactions
This method involves the comparison of the business being valued with other businesses that have recently undergone a transaction that provides evidence of how the market perceives value in such a business.
This method does not necessarily need the comparable businesses to be listed on the open market. Often transaction information is available from business brokers, industry associations and other sources. When using this method, the valuer will analyse the comparable companies and calculate implied valuation multiples from the transactions (e.g. Enterprise Value/EBITDA).
This method can be unreliable in situations where the comparable businesses have been subject to transactions involving strategic value, which cannot be separated from the underlying financial value, making the comparisons false.
Market Approach – Rule of Thumb
This method involves researching and gathering anecdotal evidence on established norms in a particular industry relating to the value of businesses.
This method is a market approach (as opposed to an income approach) because it simulates the activities of seller and buyers based on knowledge and discussions from market participants and observers.
The market approach most often considers a metric of some kind and a multiplier to calculate a probable market value. The interest valued is often, but not always goodwill. Other assets and liabilities are then added and subtracted as relevant.
Asset Based Approach – Summation of Net Asset Values
An asset-based approach is commonly used for specific assets that do not produce business income (e.g. property) or for whole businesses where the valuation of the business under the income and market based approaches produces a value less than the net tangible operating assets used by the business.
This method is also commonly used in conjunction with an income or market-based approach to calculate the equity value of the entity where the other method has calculated the value of goodwill and other intangible assets.
Business valuers typically rely on the opinions of directors or independent valuers for the valuations of individual tangible assets.
Asset Based Approach – Unadjusted Net Assets
This method simply uses the net assets from the financial statements, being the total assets less the total liabilities on the balance sheet.
This method is only typically used when there is no information known about the business other than what is shown on its financial statements.