One of the three approaches
No one method is suitable in every possible situation
There are various methods to estimate your business worth and all these methods calls into these three valuation approaches — Market Approach, Income Approach and Cost Approach. Selecting the valuation method depends on selecting the right valuation approach. An approach simply is a way of dealing with a circumstance and valuation approach is simply a way of dealing your business circumstances. These circumstances are made up of the appropriate base of value and premise of value, determined by the terms and purpose of the valuation assignment.
The three approaches described and defined below are the main approaches used in valuation. They are all based on the economic principles of price equilibrium — form of fair price between the seller and buyer, anticipation of benefits — estimation of amount current and future benefit from buying the business or substitution — aptness of one approach over the other to arrive at equilibrium price and quantifying the anticipated benefits.
Selection of the appropriate valuation approach
Humans have always used one of three approaches (Market Approach, Income Approach and Cost Approach) to estimate a value of an item, be it the entire business or even a toffee, they have sold or bought. Simple part of estimation is that, estimation is done through any one of the three approaches, but difficult part lies in choosing the right approach and applying it. Valuer needs to consider the respective strengths and weaknesses of the valuation approaches and methods, the appropriateness of each of the methods to estimate the business worth , approaches used by buyers and sellers in the relevant market, and the availability of reliable information needed to apply the method.
Approach 1: Market Approach
The market approach provides an indication of value by comparing your business with identical or comparable (that is similar) business for which price information is available. The market approach is applied and afforded significant weight under the following circumstances:
(a) shares of your business has recently been sold in a transaction appropriate for consideration,
(b) shares of business or substantially similar business are actively publicly traded, or
(c) there are frequent and recent sale transactions, though not publicly traded but information about the sale is observable through reliable private sources, in substantially similar businesses.
A Valuer considers applying Market approach, to indicate value, as a collaborative to a more suitable approach in the additional circumstances.
(a) Transactions involving shares of your business or substantially similar business are not recent enough considering the levels of volatility and activity in the market.
(b) The shares of your business or substantially similar business are publicly traded, but not actively.
(c) Information on market transactions is available, but the comparable businesses have significant differences to your business, potentially requiring subjective adjustments.
(d) Information on recent transactions is not reliable (ie, hearsay, missing information, synergistic purchaser, not arm’s-length, distressed sale, etc).
(e) The critical element affecting your share value is the price it would achieve in the market rather than the cost of reproduction or its income-producing ability.
The heterogeneous nature of your business means that it is often not possible to find market evidence of transactions involving identical or similar businesses. Even in circumstances where the market approach is not used, the use of market-based inputs should be maximized in the application of other approaches (eg, market-based valuation metrics such as effective yields and rates of return).
When comparable market information does not relate to the exact or substantially the same business, the Valuer performs a comparative analysis of qualitative and quantitative similarities and differences between the comparable businesses and your business. It will often be necessary to make adjustments based on this comparative analysis. Those adjustments are reasonable and the Valuer document the reasons for the adjustments and how they were quantified.
The market approach often uses market multiples derived from a set of comparables, each with different multiples. The selection of the appropriate multiple within the range requires judgement, considering qualitative and quantitative factors.
Approach 2: Income Approach
The income approach provides an indication of value by converting future cash flow to a single current value. Under the income approach, the value of your business is determined by reference to the value of income, cash flow or cost savings generated, or monetizable customers.
The income approach is applied and afforded significant weight under the following circumstances:
(a) the income-producing ability of your business is the critical element affecting value from the buyers perspective, or
(b) reasonable projections of the amount and timing of future income are available for your business, but there are few, if any, relevant market comparables.
A Valuer considers applying Income approach, to indicate value, as a collaborative to a more suitable approach in the additional circumstances.
(a) the income-producing ability your business is only one of several factors affecting value from a buyer’s perspective,
(b) there is significant uncertainty regarding the amount and timing of future income-related to your business,
(c) there is a lack of access to information relating to your business’s income-producing ability (for example, a minority owner may have access to historical financial statements but not forecasts/budgets), or
(d) your business has not yet begun generating income, but is projected to do so.
A fundamental basis for the income approach is that investors expect to receive a return on their investments and that such a return reflects the perceived level of risk in the investment. Generally, investors can only expect to be compensated for systematic risk (also known as “market risk” or “undiversifiable risk”).
Approach 3:Cost Approach
The cost approach provides an indication of value using the economic principle that a buyer will pay no more for your business than the cost to obtain another business of equal utility, whether by purchase or by construction, unless undue time, inconvenience, risk or other factors are involved. The approach provides an indication of value by calculating the current replacement or reproduction cost of your business and making deductions for physical deterioration and all other relevant forms of obsolescence.
The cost approach is applied and afforded significant weight under the following circumstances:
(a) participants would be able to recreate an asset with substantially the same utility as the subject asset, without regulatory or legal restrictions, and the asset could be recreated quickly enough that a participant would not be willing to pay a significant premium for the ability to use the subject asset immediately,
(b) the asset is not directly income-generating and the unique nature of the asset makes using an income approach or market approach unfeasible, or
(c) the basis of value being used is fundamentally based on replacement cost, such as replacement value.
A Valuer considers applying Cost approach, to indicate value, as a collaborative to a more suitable approach in the additional circumstances.
(a) Buyer might consider recreating your business of similar utility, but there are potential legal or regulatory hurdles or significant time involved in recreating the asset,
(b) when the cost approach is being used as a reasonableness check to other approaches (for example, using the cost approach to confirm whether a business valued as a going-concern might be more valuable on a liquidation basis), or
(c) the business was recently created, such that there is a high degree of reliability in the assumptions used in the cost approach.
The value of a partially completed business (business that are yet to commence) will generally reflect the costs incurred to date of commencement of the business (and whether those costs contributed to value) and the expectations of buyer regarding the value of the business when complete, but consider the costs and time required to commence the business and appropriate adjustments for profit and risk.
Cheatsheet on various methods under each of the approaches
A. Methods under Market Approach
- Comparable transactions Method
- Guideline publicly-traded comparable Method
- Anecdotal or “rule-of-thumb” valuation benchmark Method
- Comparable Method with adjustment for Discounts for Lack of Marketability (DLOM)
- Comparable Method with adjustments for Control Premiums
- Comparable Method with adjustments for Blockage discounts
B. Methods under Income Approach
- Discounted Cash Flow (DCF) Method
- Salvage value Method
- Gordon Growth Model (Constant Growth Model) Method
- Exit value Method
C. Methods under Cost Approach
- Replacement cost Method
- Reproduction cost Method
- Summation Method