Running Head: VALUATION APPROACH PAPER 1
Valuation Approach Paper
Julie Mather
Liberty University Online
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Abstract
The purpose of this paper is to discuss valuation approaches and compare their
similarities and contrast the differences. While valuation professionals may prefer one method
over another, the type of valuation approach most effective for determining the valuation of a
company depends on what information is available for use. The key objectives of this paper are
to identify the strengths of each valuation approach and determine how they can be used to most
effectively assess a company’s worth. Understanding the different approaches is useful for
valuation professions who are challenged by companies spanning multiple industries both
domestic and abroad.
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Valuation Approach Paper
Companies rely on valuation professions to accurately determine the value of their
business for multiple reasons – transfer of ownership, preparation for initial public offering
(IPO), exit strategy planning, mergers and acquisitions, or litigation. It is equally as important for
professions and business owners to use the valuation approach that will give them the most
accurate valuation of the company. The guidelines for each valuation approach give professions a
more thorough overview of the objects required for valuation and provide a forward-looking
premise for all parties involved. Investors want confirmation that their money will be returned as
value today always equals future cash flow discounted at the opportunity cost of capital
(Hitchner, pg 118) While the income approach to valuation most thoroughly incorporates this
premise, the market and asset approaches to integrate it to a smaller degree.
Valuation Types
The three valuation approaches discussed here are the income, market, and asset
valuation approaches. Business valuation means different things to the parties involved; for
example, a business owner may believe its company’s worth is in the connection to the industry
in which it operates while the investor may only see the company’s value based on its historical
performance and income. The timing and circumstances of business valuation could also impact
the final value. A company going bankrupt could quickly sell off its assets to avoid further
default, but not get the best value for their assets because they rushed the sale rather than
preparing a more thorough market value presentation to potential buyers. Preparing checklists,
learning how to comply with standards, and setting up models will be time-consuming (Parker,
2010). Measuring a company’s value depends on the expected price a business will sell for or
how a company’s net worth and position in the marketplace determine its sale value. Investors
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and valuation professionals should utilize the valuation approach that matches the company’s
strengths and provides the most accurate valuation.
Income Approach
The income approach primarily evaluates the money generated by a company, the reason
for running the business and relies on the future payments of the investment and the rate of
return required by management. Determining the future value stream of the company is the
primary goal of the income approach. Utilizing data like historical income and financial
statement analysis can help valuation professions see a broad spectrum of income contributing
factors that investors look for. Preparing a valuation report based on the income approach
provides the buyer and seller with a complete overview of the cash flows generating income for
the company. It is interesting to note that small businesses may have very similar cash flow and
income statements because there are fewer tax considerations and adjustments made for
subsidized income. “For every question about managing cash flow, there is a solution. Business
owners have access to proven tactics and a variety of resources that can help them build, operate
and grow their business efficiently and successfully (Guinn, 2017).” Likewise, valuation
professionals have the resources and processes in place to establish precise valuation models for
the benefit of their clients.
Within this valuation approach there are three methodologies that valuation professionals
commonly use to value private business – the discounted cash flow (DCF), capitalized cash flow
(CCF) and excess cash flow methods (ECF). While each of these methods is used to determine
“future benefit streams” the influencing factors are slightly different. The DCF method utilizes a
series of factors while the CCF only includes one numerator and denominator. Valuators can use
the ECF method as a hybrid of the DCF and CCF to determine the value of intangible assets such
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as goodwill, patents, and trademarks. The most common methods used to value professional
practices are those relating value to income, i.e., the capitalized returns method, the discounted
future returns method, and the excess earnings method (Hall, 2004). Each method is based on the
present value of future cash flow and historical data to build a reliable framework for valuation
professionals. “All other things being equal, the more certain the future streams of cash flow are,
the more valuable the asset or entity (Hitchner, 138).” The nature of cash flow follows beginning
revenues and expenses to period ending revenues and expenses.
Market Approach
The market approach gathers pricing data from sales transactions, publicly traded
companies, and the sales of interests in the industry (Hitchner, 291). It intrinsically relies on data
from the real market place to determine a business’s worth. Using other companies in a similar
industry and comparative in size and scope can provide a benchmark for business valuation
professionals to begin their valuation approach. Knowing the “going rate” for companies within
a similar market helps prepare the selling price for a potential sale. Buyers, likewise, should
know what the market price for a similar company is before entering a letter of intent to purchase
a company in the same industry. Historical financial information provides a history of where the
company has been, but the transactional sale price shows where the company is expected to go.
Advantages of the market approach include: simple application and understanding,
includes the value of all a business’s operating assets those tangible and intangible, and forecasts.
Largely one of the biggest benefits to the market approach is the variety of data available on
publicly traded companies. The Electronic Data Gathering, Analysis, and Retrieval (EDGAR)
program provides documentation on all publicly traded companies as it is required by the
Security and Exchange Commission (SEC). Additionally, the standardization of data and data
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periods as is required by the SEC for filings allow valuation professionals to research any
combination of time period, financial statements and industry analysis. Stock price and shares
outstanding also compute market value while response to industry change can quickly trigger
shareholder response. There are a few financial indicators that can influence the market approach
and include size of sales, profits, assets, and capitalization, historical growth rates, activity
among assets, and measures of profitability and cash flow. Within the financial statements
provided by EDGAR, valuation teams can review profit margins, the capital structure of
company and analytics from cash flow and earnings before income and taxes (EBIT). “If
appropriately applied, the market approach to valuation may be a powerful and persuasive
valuation technique that can help a valuation professional substantiate solvency and valuation
opinion (Shaked, 2010).”
Asset Approach
In contrast with both valuation approaches discussed before, the asset approach views
businesses as the sum of their assets and liabilities. While it may seem like a simple formula,
determining which assets and liabilities to include in the valuation is very important. Using the
balance sheet to evaluate which assets and liabilities are eligible for the valuation computation
can come with limitations as balance sheet items are based on historical cost not the fair market
value (FMV) of services, product, or other assets. There are several general steps to take in the
asset approach. First review the balance sheet, restate recorded assets and liabilities at fair market
value, evaluate all intangible assets and liabilities not listed on the balance sheet, and add current
and tangible assets and liabilities like cash, accounts receivable, and marketable securities that
are already listed at fair market value. “Although less commonly applied than the income
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approach or the market approach, the asset-based approach is a generally accepted business
valuation approach (Reilly, 2017).”
As less than 1% of U.S. companies are publicly traded, the vast majority of companies
are privately held meaning that their valuation cannot be determined by a stock price ticker on
Wall Street at any given point. In the adjustment of balance sheet items from historical value to
fair market value, a company’s valuation beings to take shape. “It is important to note that if the
income or market approach valuation reflect higher values than the asset based approached,
typically it will be thrown out as both the income and market-based valuation approaches
provide a more intricate reflection of the intangible assets not listed on the balance sheet (Hall,
2004).” It is also interesting to distinguish that the asset-based valuation approach is normally
used when companies have sustained losses over several quarters or act as a holdings company
for several other smaller businesses.
Compare and Contrast
After a thorough analysis of the valuation approaches discussed above there are several
distinguishing characteristics that set them apart. Most importantly, the asset-based approach is
more often used for companies that are not publicly traded and or have sustained losses. A
valuation team would want to review all potential assets and liabilities before presenting the
company for sale if it was in a position to liquidate its assets to reduce further financial
hemorrhaging. The market approach uses FMV and the going rate of other industry businesses to
determine the net worth and similarly the asset-based approach converts all assets and liabilities
to fair market value before the final evaluation is presented. Both approaches utilize the
important factors of market behavior, response, and demand for a company’s valuation.
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In contrast, the income-based approach does not rely on market information as much as
the asset-based and market approaches do, but rather, use financial ratios to determine the most
appropriate valuation of a company. Like the asset-based approach, it does rely on the financial
statements to determine the DCF, CCF, and ECF valuation equations. While the income-based
approach does not have a sustainable way to include intangible items in its valuation when solely
using the DCF or CCF valuation models, the market-based approach and asset approach do
include these intangibles which often are very important in the sale of company. Goodwill alone
can account for millions of dollars on a large company’s balance sheet and should be considered
during the sale process.
In the evaluation process, professionals should consider what valuation approach will
provide the most accurate reflection of a company’s net worth. Using multiple valuation
approaches to determine what influencing factors truly make up a company’s value can be
beneficial, but only if the approaches result in a similar outcome. “In the current financial
markets environment, much less weight should be placed on the comparable-companies method
and more placed on the discounted future earnings in valuing small businesses (Hall, 2003).”
Utilizing actual market transactions rather than depending on historical data alone gives the
market-based approach an edge on other approaches which must convert from historical data to
fair market value.
Companies want the most accurate valuation a consultant can provided and often the
timeline associated with determining this valuation can be a longer process if the company is
privately owned. Due to lack of data immediately available, evaluators will need to spend more
time using the valuation approach that matches the information available. Valuation professionals
rely on the premises of value which establish where the value lies and to whom when preparing
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appraisals for the sale, transfer of ownership, or liquidation of a company. While the appropriate
standard of value is derived from multiple scenarios intended for use in appraisals, private sales,
and litigations, analysts must depend on the information at hand to accurately evaluate the
company’s worth. Therefore, the standards for valuation for privately held companies compared
to those that are publicly traded are more in depth. Determining which valuation approach gives
the client and valuation professions the greatest chance of success in a sale or acquisition is very
important and ensures that both the seller and buyer are satisfied.
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References
Guinn, M. (2017, March 13). Managing small-business cash flow. Arkansas Business, 34(11), 27.
Hall, S. C. (2003). Comparable-companies business valuation in the current financial markets
environment. Journal of Financial Service Professionals, 57(1), 9-10.
Hall, S. C. (2004). Applying income-approach business valuation methods to professional
practices. Journal of Financial Service Professionals, 58(3), 91-99.
Hitchner, J. R. (2017). Financial Valuation: Applications and Models. Hoboken, NJ: Wiley..
Reilly, R. F. (2017). The asset-based approach to business valuation in family law (part I of
III). American Journal of Family Law, 31(2), 69-80.
Shaked, I. (2010). Playing the market (approach): Going beyond the DCF valuation
methodology. American Bankruptcy Institute Journal, 28(10), 58-60.
