The valuation of companies has always been a special challenge for valuators, appraisers, and entrepreneurs. Everything revolves around the question, “What is my company worth?” This question arises when a company is bought or sold or because an entrepreneur wants to know what value to attach to their company.
Valuators commonly use three methods to answer this very question: The Income Approach, the Asset Approach, and the Market Approach.
Professional valuators determine which method is most appropriate based on the business’s historical trends, growth, and various other factors. Additionally, each method has different pros and cons, which valuators must be aware of when deploying them to determine what a business is worth.
Related: Valuation Basics: The Three Valuation Approaches.
Let’s Briefly Explain Each Method
The Income Approach: the “cash flow method.”
The Income Approach values a business based on its future benefits stream, measured by free cash flow. Valuators use one of two methods: the discounted cash flow or the capitalization of earnings method. The primary difference between these two methods is that a discounted cash flow utilizes projected cash flow, whereas the capitalization of earnings method uses current cash flow. The cash flow is then discounted (using a discount or risk rate) or capitalized (divided by the discount rate less the long-term growth rate).
The Market Approach: the “multiple methods.”
The Market Approach values a business by applying multiple earnings – think revenue, gross profit, or EBITDA – to the analyzed company. Multiples are derived by utilizing actual merger and acquisition data or public company data. The data is then compiled and trimmed down to remove outliers. A valuator then chooses the average or median multiple of the dataset to apply to the analyzed company.
The Asset Approach: the “the balance sheet method.”
The Asset Approach values a business based on the equity listed on the balance sheet. In addition, a valuator may use the adjusted book value to conclude to value. In this circumstance, the valuator may adjust the balance sheet to alter the value of certain assets or liabilities to their fair market value. In doing so, the book value of equity changes in accordance with the adjusted assets and liabilities.
Choosing a Method
Choosing which method to use in a case is often done after the valuator has gathered all the facts, discussed the company’s status with the management team, and weighed each method individually. That’s right: in every valuation, a valuator must analyze the Income Approach, Market Approach, and Asset Approaches in every case to determine if it is appropriate to use or not.
This begs the question: how does a valuator know if a method is appropriate to use or not?
Sometimes choosing a method is very straightforward. For example, if both the Income and Market Approaches yield negative values, the book value of equity may be the only feasible option to value the company.
But often, the answer to which method to choose is based on weighing the pros and cons of each method, along with all of the gathered information on the business being valued.
Let’s Discuss When to Use Each Method
While there is no “one-sized fit all” solution to choosing which method to use, valuators often use their experience and specific guidelines to limit which method to use.
The Income Approach
As we’ve mentioned, the Income Approach discounts or capitalizes on free cash flow to conclude a company’s value. Let’s break this down even more, to identify when this method is appropriate to use.
Starting with a discounted cash flow analysis (DCF), this method is suitable when a valuator is provided with pro forma financial statements. Free cash flow can be calculated and subsequently used in the DCF formula. Thus, for a DCF to be used in a valuation assignment, a litmus test for the projection’s feasibility must be done. For example, asking questions such as, “does the company’s historical performance back up the projected growth?” can help determine feasibility.
The other method under the Income Approach is the capitalization of earnings method. This method uses free cash flow in the present period, or a weighted average of prior periods, rather than projected free cash flow. Thus, this method assumes that the selected free cash flow is a good indicator of the company’s future performance.
The TLDR here is this: if a company is expected to grow (usually exponentially), a DCF may be appropriate so that the projected growth can be reflected in the company’s value. But, if the present free cash flow is a good indicator of what’s to come, perhaps capitalization of earnings should be chosen.
The Market Approach
As mentioned, the Market Approach uses precedent transactions, or public company data, to conjure up a multiple to be applied to the company being analyzed.
Many evaluators use the Market Approach for its simplicity and sound logic.
The application of using a multiple to value a company is simply multiplication. For example, if the company’s value has an EBITDA of $500,000, and your dataset produces an EBITDA multiple of 4, the company’s value would be $2,000,000.
The method is also very straightforward to understand. The primary assumption is that similar companies, defined by the goods they produce or the services they offer of similar size, will sell for a multiple of roughly the same amount.
The Asset Approach
Unlike the Income Approach or Market Approach, the Asset Approach doesn’t consider earnings when valuing a company. As mentioned previously, the method concludes to value based on the book value of equity, or the adjusted book value of equity.
The Asset Approach is often used to value companies that have significant tangible value in fixed assets. For example, holding companies with real estate are often valued using the adjusted book value method. The book value of the properties is adjusted to the appraised fair market value.
Also, in scenarios where the Market and Income Approaches yield negative results, the Asset Approach is the default method.
The Pros and Cons of Each Method
A valuator uses the information posed above to determine which method to apply in valuing a business. However, in addition to knowing when it’s appropriate to use a particular method, a valuator must understand the pros and cons of each method.
Pros and Cons of the Income Approach
The Income Approach is one of the most often used valuation methods, perhaps only second to the Market Approach. There are numerous reasons why valuators prefer this method over others.
First, consider the flexibility in using the Income Approach, particularly with a DCF. A DCF has many moving parts, including the components of free cash flow, the discount rate, and the terminal value. This allows the valuator to use their best judgment and the facts of the case to pinpoint their estimation of the value of the company being valued.
Second, the Income Approach uses free cash flow as a base for both methods. Free cash flow is generally seen as the most accurate way to measure cash flow available to shareholders after deductions for taxes, capital expenses, working capital, etc.
There are two notable cons of the Income Approach.
First, the projections used in a DCF must be backed up by historical performance and sound reasoning or explanation from the management team as to why the projected cash flows are feasible. Value can easily be overinflated when using a DCF, as the inputs are very sensitive.
Second, no one has a crystal ball. A DCF is done using projections of how a company may perform based on the information today. The valuator must be aware of this reality and choose an appropriate discount rate accordingly.
Pros and Cons of the Market Approach
The Market Approach is used by valuators to dues its simplistic application. If nothing else, the method is useful for determining a range of values that similar companies have sold for.
The benefits to using the Market Approach for concluding value include its straightforward calculation. Unlike the Income Approach, which has many moving parts, the Market Approach usually only has two variables: the multiple and the corresponding earnings metric (revenue, gross profit, EBITDA, or SDI).
Another benefit of the approach is that the information is up-to-date and accurate when using public company data.
Lastly, the Market Approach does not rely on a forecast. Recall the drawbacks of using a DCF. A DCF requires many assumptions to be made, which are never 100% accurate. However, the Market Approach concludes to value based on an adjusted earnings metric, which is based on the actual performance of the company being valued.
The Market Approach also has some downfalls. First, unlike when using public companies, precedent merger and acquisition transaction data comes from a third-party resource. Although the data is held to a high standard, the degree of accurateness is always questionable compared to public comps that are 100% up-to-date and accurate.
Another downside is that the method is not flexible in its inputs. Unlike a DCF, a valuator is somewhat limited, besides implementing a qualitative adjustment, a percentage-based increase or decrease to the multiple based upon the facts of a case.
Lastly, much like the Income Approach, the Market Approach is only as good as the inputs used. Comparative transactions or public comps may not be close enough in description to the company be valued. The result is a conclusion of value that the data doesn’t necessarily support.
Pros and Cons of the Asset Approach
The Asset Approach is typically used when valuators are faced with a company that has produced negative earnings or with companies with significant value in their fixed assets. Often, this approach is used to determine the lowest possible value that a company would be worth without considering the business’s ability to generate profits.
The Asset Approach, as mentioned above, can be used to determine the base level of value that a business could be worth upon liquidation. However, this value is often changed to adjust the assets and liabilities to their respective fair market value.
Another pro of the Asset Approach is that it’s very straightforward. The conclusion to value is merely Assets minus Liabilities. The process can be more complicated when adjusting certain assets or liabilities, but it’s still simple arithmetic!
The most significant pitfall of the Asset Approach is that it doesn’t consider a business’s ability to generate profit from its products or services offered. As such, this method should only be used when the Asset and Income Approach yield a lower value than the book value or adjusted book value or a company with significant value attached to its tangible assets.
Valuators have one of three approaches to choose from: The Income Approach, The Market Approach, or the Asset Approach. A valuator must consider each method when analyzing a company before determining value. It’s essential to understand when to use each method and the pros and cons of choosing the correct method or combination of methods.