Valuation Approaches and Business Valuation Methods
Explanation of valuation approaches
Three types of approaches are mostly employed in business valuation. They are the income approach, the asset-based approach, and the market approach.
1. Income-based approach: Income-based approach determines fair market value by multiplying the benefit stream generated by the target company times a capitalisation rate. The stream of future benefits is converted into present value using the capitalisation rate.
2. Asset-based approach: Asset-based approach works on the concept that a business is equal to the sum of its parts. This approach is based on the principle of substitution – no rational investor will pay more for the assets than the cost of procuring assets of similar economic utility.
3. Market approach: The supply and demand forces will drive the price of business assets towards equilibrium in a free market. This is the economic principle of competition on which the market approach to business valuation is rooted. Buyers will not want to pay more and sellers will not accept a price less than that of a comparable business enterprise.
Explanation of business valuation methods
There are four categories of standard business valuation approaches for all methods of business valuation:
1. Asset accumulation: This approach is based on the principle that the property, plant and equipment (PP&E) of the company can be liquidated and the net proceeds would accumulate to the equity of the company once the company’s liabilities are paid off.
The asset approach is based on liquidity and does not take into consideration the fair market value of the assets.
2. Discounted cash flow method: This method of valuation based on the flow of free cash is considered an effective tool. It focuses on the potential of the cash generation of a business.
The future free cash flow is used in this method after all the liabilities discounted by the firm’s weighted average cost of capital are met.
3. Market value: This approach can be used only for quoted companies. Market value is the quoted share price of the company multiplied by the number of outstanding shares.
The value placed by the market on the shares and the perceptions of the investor about the prospects and performance of the company is reflected in this value.
4. Price-earnings multiple valuations: The price of a company’s common stock divided by its earnings per share indicates the price-earnings ratio (P/E). The business can be determined by multiplying this P/E multiple by the net income.
This method of valuation helps to provide a benchmark business valuation. At times, comparable P/E of quoted companies in an industry is used by non-listed companies.