Three approaches to valuing a business
Valuing a private business is a complex endeavor. But, when all is said and done, valuation analyses boil down to three general approaches.
1. Market approach
Under this approach, valuators derive pricing multiples from public or private comparable transactions. These pricing multiples are then applied to the subject company to derive its value.
For example, an expert might calculate a median price-to-earnings multiple of 4.5 based on a sample of six comparable transactions. Then the valuator would multiply the subject company’s earnings by 4.5 to arrive at its value. The expert also must consider whether adjustments are warranted to account for the differences between the subject company and comparable firms.
Two popular methods fall under the market approach. First, the guideline public company method uses the prices paid for shares of similar publicly traded companies to estimate a business’s value. Second, the guideline transaction (M&A) method uses sales of entire comparable companies to estimate a business’s value.
In general, courts prefer the market approach for its perceived objectivity. But it’s often difficult to apply because many industries lack a sufficient number of meaningful comparables to produce credible results.
2. Income approach
When using the income approach to value a company, a valuator projects the subject company’s future earnings and discounts them back to present value using a discount rate commensurate with the company’s risk. Two methods fall under the income approach.
First is the capitalization of earnings method. Here, earnings (typically net free cash flow) for a single representative period are divided by a capitalization rate. This method is better suited for mature companies that have stable earnings streams.
Second is the discounted cash flow method, which allows for greater variability in earnings, growth rates and capital structure. This method begins with an earnings forecast over a discrete period (usually five to seven years). Next, a terminal (or residual) value is calculated based on the amount that the business could theoretically sell for at the end of the discrete period. The value of the business equals the sum of the present values of 1) the cash flows over the discrete period and 2) the terminal value.
3. Cost (or asset) approach
This technique requires the valuator to establish the market value of all the company’s assets and liabilities. The identification and valuation of intangibles and unreported items is the most troublesome aspect of this approach. It’s usually reserved for asset-intensive companies (such as investment holding companies) or those with lackluster earnings that are facing potential liquidation.
No universal approach for all businesses
An expert must consider all three approaches when valuing a business. However, in practice, it’s customary to choose one primary approach or method, and then use one or two others to serve as checks or supports of that value.
What’s appropriate depends on several factors, including the valuation’s purpose (for example, M&A, tax or shareholder disputes), the type of interest being valued (for example, controlling or minority) and the relevant standard of value (for example, fair market value, fair value or investment value). Discuss your situation with a valuation professional to determine the optimal approach.