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As the new year approaches us, the closing of your annual books and yearly business valuations are as well. Before your valuation, it is essential to note the different types of approaches one can take.

The Asset Approach

The Asset Approach is a valuation methodology that concludes to value based on a business’s balance sheet indicated amount of equity. 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 Market Approach

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

Valuation analysts commonly refer to these comparison companies as “comps.” Finding a set of comps that fit the subject company is the trickiest part of deploying the Market Approach.

Closing remarks on the Market Approach:

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

Finally, even if a valuation analyst chooses to use a different valuation approach to conclude value, the indicated value from the market approach can still be a useful value benchmark.

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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, spending on capital expenditures, and spending on the change in net working capital.

There are two types of free cash flow: free cash flow to firm (FCFF) and free cash flow to equity (FCFE). The difference between FCFF excludes the impact of interest expense.

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 be the weighted average cost of capital (WACC) or the cost of equity (COE).

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

Discounted cash flow analysis (or “DCF”)

A DCF (Discounted Cash Flow) values a company based on its projected free cash flows, discounted at the appropriate discount rate. The DCF is used by valuators where a company can supply financial projects that show growth not captured in the present day. 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 returns applied to free cash flow throughout the discounted period. In a DCF, the discount rate is not constant, like when using a capitalization rate. Instead, the degree of the discount increases as time goes on. The reason is due to the fundamental principle of present value, where “a dollar today is worth more than a dollar tomorrow,” as well as factoring in uncertainty with the future benefits stream.

3) The terminal value: the firm’s value beyond the forecasted period. The terminal value can be quantified through either the perpetuity growth method (like the cap earnings method) or the exit multiple methods (like 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 + … FCFt / (1/1+discount rate) t + Terminal Value

Related: How Intangible Assets Affect Business Value.

Choosing a Valuation Method

The valuation of companies has always been a challenge for valuation professionals and investors alike. Everything revolves around the question, “What is my company worth?” Additionally, selecting the correct valuation approach is also a challenge. Below we analyze how to determine which approach to select in an assignment.

The Asset Approach

The Asset Approach does not take into consideration a company’s earnings. As mentioned previously, this method concludes to value based on the book value of equity, or the adjusted book value of equity.

This approach is often used to value companies with significant tangible value in fixed assets. For example, holding companies with properties utilize the asset approach, adjusting to fair market value for the owned properties.

The asset approach may also be applied depending on an assignment’s purpose and standard of value. For example, if a purpose of a valuation is to purchase the assets of another company, the asset approach would be appropriate. Likewise, if the standard of value is liquidation value, the asset approach should be selected.

Lastly, when the income or market approaches indicate a value less than the asset approach, the correct choice is to accept the asset approach. This is due to the “floor to value rule,” where a company cannot be valued less than its book value of equity.

The Market Approach

As mentioned, the Market Approach uses precedent transactions, or public company data, to determine a multiple to be applied to the subject company.

The Market Approach is favored by many for its simplicity and sound logic.

The application of using a multiple to value a company is simply multiplication. For example, if the company has an EBITDA of $500,000, and your dataset produces an EBITDA multiple of four, the company’s value is $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 comparable size, will sell for a multiple of roughly the same amount.

The Income Approach

As previously mentioned, the Income Approach discounts or capitalizes on FCF 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 an evaluator is provided with pro forma financial statements. FCF 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 FCF in the present period, or a weighted average of prior periods, rather than projected FCF. Thus, this method assumes that the selected FCF is a good indicator of the company’s future performance.

To conclude: if a company is expected to grow, a DCF is a suitable method so that the projected growth can be reflected in the company’s value. But, if the present FCF is a good indicator of the future, the capitalization of earnings method should be chosen.

Related: You Probably Don’t Know the Actual Value of Your Company.

Conclusion

Before a business valuation, it is important to understand how each approach works. Contact Quantive to see how your business fits into a valuation approach.