Business Valuation Model and Approaches to Value

Business Valuation Model

A business valuation model is a set of assumptions and a choice of valuation methods made for performing a business valuation engagement. A well-developed plan to conduct a business valuation engagement requires the valuator to make a number of choices that are unique for each business appraisal.

A set of assumptions made about the business valuation.
The selection of business valuation methods to be used for calculating the business value.

In the language of professional business appraisers, the assumptions boil down to these two important choices:

Standard of business value to be used.
Premise of value selection.

Your assumptions drive business valuation results. It makes a big difference to the business appraisal result if the business is to be sold on a going concern basis rather than being liquidated. This is an example of two very different premises of value – going concern and forced liquidation. Similarly, a defensible business valuation result presented to a tax authority may be different from that prepared for a group of strategic business investors. Here, the difference is in the choice of the business value standard - fair market value versus investment value.

Business valuation methods for every situation

You can calculate what a business is worth using a number of generally accepted business valuation methods. The choice of the methods to be used depends upon the specific business being valued.

For example, a young start-up has little historic track record. Income-based valuation methods such as the Discounted Cash Flow are an excellent choice to value such companies since they require future business earnings forecast and risk assessment.

For a well-established company, the value of business goodwill may be considerable. In this situation, the Capitalization of Earnings valuation method may be advisable.

If your business is in the industry where similar companies are traded often, you may decide to use market-based valuation methods. These methods let you estimate your business worth by comparing the actual selling prices and financial performance of similar sold businesses.

Asset-intensive companies such as manufacturing or real estate-driven firms, may benefit from using the asset-based approach. If the company is sold, the business valuation can be used to properly allocate the business purchase price in order to recover the initial investment quicker and reduce taxes.

Approaches to Value

The three main approaches for valuing a business are:

The Income Approach
The Market Approach
The Cost Approach

Income Approach

The Income Approach is most commonly used for established businesses with profitable or almost profitable operations. This is due to its focus on cash flows. The Income Approach considers three key characteristics of a business: the level of cash flows, the timing of cash flows, and the risk associated with those cash flows.

The Income Approach is based on the premise that equity holders are investors, and they view their ownership as they would any other investment. Financial theory holds that an investment is a current commitment of money to a business venture that will result in future payments to the investor that are greater in value. The Income Approach is thus “forward-looking.” Further, it discounts those future payments back to their present value, incorporating the risks and opportunity costs inherent in any future project into the discount rate. The emphasis on future cash flows is a unique attribute of this approach that distinguishes it from the other approaches.

When to Use the Income Approach

The Income Approach could be appropriate for a business when the future cash flows have the following characteristics:

Future cash flows are positive.
Future cash flows are relatively stable – not highly volatile.
Future cash flows can be reliably forecasted for several years into the future.

Pros

Focused on future cash flows which are of utmost importance to investors.
Unlike the Market Approach, the Income Approach is not as reliant on similar past transactions or comparable companies which can never truly match the unique characteristics of the subject company.
Unlike the Cost approach, the Income Approach considers value derived from both tangible and intangible assets.

Cons

Not as relevant when valuing businesses that are years away from achieving positive cash flow.
Potential to become highly complex and involve many underlying assumptions.

Market Approach

The Market Approach establishes a value for a business by comparing it to similar companies that have a value attached to them that is publicly known. The premise is that an investor (a willing buyer) would look at the values of what is referred to as the “comparable companies” or “comps” and would price the subject company according to the values of these similar companies.

Thus, the Market Approach relies on publicly available data for pricing data which can arise from three primary sources:

Sales transactions of comparable companies.
Publicly traded comparable companies.
Sales of interests in the subject entity.

Notice that the first two sources rely on pricing data for other companies whereas the last source relies on the subject company itself. Neither is a perfect apples-to-apples comparison given the present-day subject company will have unique qualities that are not necessarily replicated in comparable companies or were not present in its prior stages. Moreover, it is possible that relying on more than one of these methods within the Market Approach would result in a more accurate value for the subject company.

The following is an expanded version of the bulleted list that includes the widely accepted industry names for each of these methodologies:

Guideline Company Transaction Method – Sales transactions of similar companies.
Guideline Public Company Method – Publicly-traded similar companies.
Guideline Sales of Interests in Subject Company – Sales of interests in the subject entity.

The underlying theory of the Market Approach is that a rational financial buyer will only be willing to pay the market rate for a company, and this market rate is based on the pricing data of companies with highly similar qualities to the subject company.

When to Use the Market Approach

The Market Approach could be appropriate for a business when the following characteristics are present:

The pricing data for comparables is robust and readily available.
In situations where future cash flows are negative or highly unpredictable.

Pros

The Market Approach is “forward-looking” because market prices reflect investor expectations about the future.
Assumptions, adjustments, and third-party data are required, but the overall analysis is typically less complex than the Income Approach.
The value derived considers all of the operating assets, including tangible and intangible.

Cons

Insufficient or low-quality market data can limit the accuracy of the Market Approach or render it unsuitable.
Key assumptions are often excluded; an example would be the growth expectations for the comparables which can be available for public companies but rarely for private comparables.

Cost Approach

The Cost Approach (also referred to as the Asset Approach) is used to ascertain the value of a business from a balance sheet perspective. In other words, a valuation expert will determine the overall enterprise value based on the underlying value of the business’s assets net of its liabilities.

As you might expect, the Cost Approach is the least reliant on forward-looking projections. Instead, the Cost Approach typically begins with the book-basis balance sheet and “builds up” or “restates” the assets and liabilities to fair value (financial reporting) or fair market value (tax and other purposes). This build up exercise is performed because balance sheet values rarely reflect market values. Over time, this separation between historical cost and market value tends to grow wider, particularly for illiquid assets.

The underlying theory to the Cost Approach is that – despite its historical bias and limitations – it can be more suitable for certain businesses versus the Income Approach or Market Approach. For example, when a holding company or asset-intensive business (like a real estate company) is being appraised, the valuation expert could conclude that the Cost Approach is suitable because the underlying assets make up most of the value and can be separately appraised. In this case, a greater weighting is placed on this approach than the others.

When to Use the Cost Approach

The Cost Approach is typically used only in specific situations. For example:

For use in valuations for financial and tax reporting purposes when minimal progress has been made on a company’s business plan.
For tangible asset-intensive businesses.
For investment, holding, and real estate companies where cash-flowing operations tend to contribute less of the value than the underlying assets.
For small businesses where there is little or no goodwill.

Pros

Does not rely on the challenging process of forecasting future cash flows.
Simple to understand and relatively straightforward to execute.

Cons

Rarely applicable to operating companies because an earnings-based approach is likely more relevant.
Does not directly value intangible assets so the valuation expert still needs to assess their value separately or use an additional Cost Approach, such as a cost to recreate, to value the intangible assets.

Some of the key concepts discussed in the article were obtained from content from the following sites: www.valueadder.com and www.redwoodvaluation.com

Yamil Rivera, CPA/ABV. Last updated on January 11, 2024.