Abstract: Business valuation professionals typically apply three different approaches when valuing a business. This article explains common valuation methods that fall under the cost, market and income approaches. A sidebar highlights the excess earnings method, which draws from both the cost and income approaches.
What’s it worth?
3 approaches to valuing a business
Business valuation professionals typically apply three different approaches when valuing a business — the cost, market and income approaches — ultimately relying on one or two depending on the type of case and other factors. It’s vital that attorneys and clients who rely on business valuations understand the basics of each approach.
- Cost approach
The cost (or asset-based) approach derives value from the combined fair market value (FMV) of the business’s net assets. This technique usually produces a “control level” value, meaning the value to an owner with the power to sell or liquidate the company’s assets. For that reason, a discount for lack of control (DLOC) may be appropriate when using the cost approach to value a minority interest. This approach is particularly useful when valuing holding companies, asset-intensive companies and distressed entities that aren’t worth more than their net tangible value.
The cost approach includes the book value and adjusted net asset methods. The former calculates value using the data in the company’s books. Its flaws include the failure to account for unrecorded intangibles and its reliance on historical costs, rather than current FMV. The adjusted net asset method converts book values to FMV and accounts for all intangibles and liabilities (recorded and unrecorded).
- Market approach
The market approach bases the value of the subject business on sales of comparable businesses or business interests. It’s especially useful when valuing public companies (or private companies large enough to consider going public) because data on comparable public businesses is readily available.
Under this approach, the expert identifies recent, arm’s length transactions involving similar public or private businesses and then develops pricing multiples. Several different methods are available, including the:
Guideline public company method. This technique considers the market price of comparable (or “guideline”) public company stocks. A pricing multiple is developed by dividing the comparable stock’s price by an economic variable (for example, net income or operating cash flow).
Merger and acquisition (M&A) method. Here, the expert calculates pricing multiples based on real-world transactions involving entire comparable companies or operating units that have been sold. These pricing multiples are then applied to the subject company’s economic variables (for example, net income or operating cash flow).
Under the market approach, the level of value that’s derived depends on whether the subject company’s economic variables have been adjusted for discretionary items (such as expenses paid to related parties). If the expert makes discretionary adjustments available to only controlling shareholders, it may preclude the application of a control premium. If not, the preliminary value may contain an implicit DLOC.
- Income approach
When reliable market data is hard to find, the business valuation expert may turn to the income approach. This approach converts future expected economic benefits — generally, cash flow — into a present value. Because this approach bases value on the business’s ability to generate future economic benefits, it’s generally best suited for established, profitable businesses.
The capitalization of earnings method capitalizes estimated future economic benefits using an appropriate rate of return. The expert considers adjustments for such items as discretionary expenses (for example, for above- or below-market owner’s compensation), nonrecurring revenue and expenses, unusual tax issues or accounting methods, and differences in capital structure. This method is most appropriate for companies with stable earnings or cash flow.
The discounted cash flow (DCF) method also falls under the income approach. In addition to the factors considered in the capitalization of earnings method, the expert accounts for projected cash flows over a discrete period (say, three or five years) and a terminal value at the end of the discrete period. All future cash flows (including the terminal value) are then discounted to present value using a discount rate instead of a capitalization rate.
As with the market approach, the income approach can generate a control- or minority-level value, depending on whether discretionary adjustments are made to the future economic benefits.
No universal formula exists for all businesses. Therefore, it’s essential for experts to explain why they chose a specific method (or methods) over all the possible options.
Sidebar: Excess earnings method blends the cost and income approaches
The excess earnings method derives value from the sum of 1) adjusted net assets, and 2) capitalized “excess” earnings. The second component represents the extra earnings that the company has been able to achieve beyond the return that comparable businesses earn on a similar set of net assets.
Essentially, this method equates capitalized excess earnings with the value of the business’s goodwill. It’s calculated using a technique similar to the capitalization of earnings method (see main article) — that is, excess earnings are divided by an appropriate capitalization rate.
This method was originally developed to compensate distilleries and breweries for loss of business value during the Prohibition era. However, to date, there’s no reliable source of market data to support comparable returns on net assets or capitalization rates for excess earnings. So, experts generally refrain from using it as a sole method of valuation, unless a particular court has shown a preference for this technique. In addition, IRS Revenue Ruling 68-609 suggests that the excess earnings method be used only if there are no other appropriate methods.