Valuation Basics: The Three Valuation Approaches

Each approach also has different methods. For example, an analyst considering the Income Approach may use the capitalization of earnings method or a discounted cash flow analysis.

While there are numerous different methods, each case typically boils down to either using only a single method or a combination. That said, analysts usually don’t use more than three methods.

An analyst considers the specific facts of each case to determine which method to use in their conclusion to value.

Let’s get more granular with each of the three approaches.

#1 – The Asset Approach

The Asset Approach is a valuation methodology that concludes to value based on a business’s balance sheet as of the valuation date. The Asset Approach uses the fundamental equation associated with the balance sheet of Assets = Liabilities + Equity.

There are two standard methods associated with the Asset Approach:

1. The book value of equity method
2. The adjusted book value of the equity method

The book value of equity method is the most straightforward way of concluding to value, as the value is simply the equity on the balance sheet. Coincidentally, it is also used infrequently, as it does not consider two key factors:

• The fair market value of the subject company’s assets & liabilities
• The business’s ability to generate profit from its assets.

Let’s look at each of these two factors more closely.

First, the book value of equity method does not make any adjustments to the value of certain assets or liabilities on the balance sheet, resulting in a company being significantly undervalued. To showcase the scope of variance between book value and fair market value of assets, consider a holding company that owns apartment complexes in a major city. The company owns five different apartment complexes purchased in the 1980s for a million dollars each. Let’s assume the company’s balance sheet lists current assets of $1M, total fixed assets of $0 (as the apartment complexes are fully depreciated at cost), and no debt. The book value would be $1M, but do you honestly think five apartment complexes in a major city are worth nothing? I hope not!

This is what the adjusted book value of equity solves for. By changing the value of certain assets and liabilities to their respective fair market value, we can estimate more accurately what the value of the business might be.

Second, the book value of equity method does not account for the business’s ability to profit from its assets. Most companies (besides a company like what is shown above) use a combination of their tangible and intangible assets to generate profits. Since the Asset Approach is fixed on the balance sheet, a company’s ability to generate profits is not considered. Since the Asset Approach disregards a company’s ability to generate profits, the approach can undervalue a company. For this reason, the Asset Approach is typically only deployed in situations where a significant portion of the value is attached to a business’s fixed assets. And not its ability to generate profits.

#2 – The Market Approach

The Market Approach is a valuation method that concludes value by comparing a company to its peers, either in public companies or precedent transactions. The Market Approach applies the logic that a business will sell for roughly a similar multiple (of earnings) to other companies in a similar industry and size.

Analysts commonly refer to these comparison companies as ‘comps’ (sort of like when you buy a house). Unlike buying a home, finding a set of comps that fits the subject company is the trickiest part of deploying the Market Approach.

Comps can be from publicly traded companies or precedent transactions, each with different pros and cons.

A benefit of using public comps is that the data is verifiable and correct. Public companies are not only traded in real-time but their financial performance must also be disclosed publicly. A drawback, though, is that public companies are significantly larger than most private businesses. Often, this results in a higher multiple due to the size difference.

Precedent transaction data is compiled and available through valuation service providers. The data available from valuation service providers allows analysts to find comps that are more similar in size to the business they are valuing. There is some scrutiny, however, over the level of accuracy regarding precedent transaction comps.

The methods:

Recall that the Market Approach uses a multiple to apply to a business’s earnings metric to conclude to value. The most common multiple that an analyst relies on is certainly a comparison to earnings before interest, taxes, depreciation, and amortization (EBITDA).

Particularly for small businesses, an analyst may use a seller’s discretionary earnings (SDE or SDI) multiple, which smaller companies typically sell for, rather than a comparison to EBITDA.

Additionally, analysts may occasionally deploy the use of revenue or gross profit multiple. The issue, however, is that only looking at the top line disregards a company’s ability to manage its direct and indirect costs, which can result in an overvaluation of a business.

How do I apply a multiple?

Applying a multiple using the Market Approach is simple, so the method is favored by many. The chosen multiple is then multiplied by the corresponding financial metric (i.e., Revenue x Revenue Multiple) to determine value.

Closing remarks on the Market Approach:

The key to providing a client with a good approximation of their business’s value using the Market Approach is to use similar comps in size and structure.

Additionally, regardless of whether the analyst chooses to use the Market Approach in their conclusion to value, the Market Approach can still be functional as a value benchmark.

#3 – The Income Approach

The Income Approach concludes value by analyzing a company’s free cash flow and discounting, or capitalizing, depending on which method is chosen. Free cash flow is an earnings metric that accounts for taxes, tax breaks, capital expenditures, and networking capital change.

Alongside free cash flow, the second key component of the Income Approach is the discount rate, which is a measure of risk, and return. A discount rate can either be the weighted average cost of capital (WACC) or the cost of equity (COE).

Therefore, a business with more inherent risk will result in a higher discount rate.

The methods:

The Income Approach has two methods that are commonly applied in business valuation.

The capitalization of earnings method (or cap earnings)

Cap earnings value a business based on its future free cash flows, where cash flow is expected to grow at a low or modest rate (usually equal to 3% to 5%). The free cash flow, either a weighted average of historical free cash flows or a single period’s free cash flow, is then divided by a capitalization rate. Typically, this method is reserved for mature companies, where the chosen free cash flow is a good indication of the subject companies’ future performance.

Therefore, the three components of cap earnings are:

1) Free cash flow: a company’s earnings after accounting for taxes, tax breaks on depreciation, spending on capital expenditures, and change in working capital (the difference between operational assets and liabilities).

2) The growth rate: the growth rate used in cap earnings is typically between 3% and 5%. This correlates to how much constant growth the company will experience in perpetuity. An analyst should consider general economic factors and the company’s history and performance when selecting the growth rate input.

3) The cap rate: the cap rate is the difference between the selected discount rate less the growth rate chosen.

For example, let’s say an analyst values a construction company that has been in business for over 20 years. The company’s cash flow has been growing at around 3% year over year, and based on the analysts’ discussions with the management team; they expect this to be true for the future.

The Company is considered a small business but is established with over 20 years in operation. The analyst determines an appropriate discount rate of 22% based on the build-up method.

The company’s free cash flow is calculated to be at $1,200,000.

Discounted cash flow analysis (or DCF)

A DCF values a company based on its projected free cash flows discounted at the appropriate discount rate. The DCF is used by valuators where historical free cash flow is not a good representation of what the future holds for a company. A DCF can be used for all types of businesses where an upward shift in free cash flow is believed to occur. An analyst concludes to value using a DCF by summing up the present value of all future cash flows, plus the terminal value.

Therefore, the components of a DCF are:

1) Projected free cash flow: the definition of free cash flow remains the same, except that free cash flow is a projection. The projections should be substantiated by reasons uncovered through discussions with the management team.

2) Discount rate: the discount rate measures risk and return applied to free cash flow throughout the discounted period. In a DCF, the discount rate is not constant like in cap earnings. Instead, the degree of the discount increases as time goes on. The reason is the fundamental principle of present value, where a dollar today is worth more than a dollar tomorrow.

3) The terminal value: the value of the firm beyond the forecasted period. The terminal value can be quantified through either the perpetuity growth method (similar to the cap earnings method) or the exit multiple methods (similar to the Market Approach multiple methods). The terminal value is then discounted appropriately at the corresponding discount rate and year.

The formula for a DCF is as follows:

DCF = FCF₁ / (1/1+discount rate)¹ + FCF₂ / (1/1+discount rate)² + … FCF_t / (1/1+discount rate)^t + Terminal Value

Let’s walk through an example to showcase the mechanics of a DCF. Let’s take the same construction company, only this time. Management provides a forecasted P&L based upon their win of a major construction project. Given the following information, we can calculate the value of the company:

• Projected free cash flow of $1,440,000, $1,728,000, and $2,073,600 in years 2022, 2023 and 2024, respectively.
• A discount rate of 22%
• 2023 EBITDA of $2,695,680
• Exit Multiple: 3.5x EBITDA

We then sum up the discounted cash flows and terminal value to conclude to value. In this example, the estimate of value is $7,742,148.

Summing up:

An analyst considers the use of each valuation methodology and its corresponding methods when analyzing a business’s value. For an analyst to properly assess the valuation of a company, they must possess an understanding of the theory of each valuation approach. Not having a thorough knowledge of each valuation approach and method can result in undervaluing or overvaluing a business.