Valuation Methods

All valuation methodologies can be classified into one of three approaches:

  1. Income Approach
  2. Asset Approach
  3. Market Approach

The Income Approach values a business by predicting cash flows to the owners. After making adjustments for fringe benefits, non-recurring events and future taxes paid (tax affecting), the analyst must apply a discount rate that adjusts future dollars into current dollars. If one can receive a risk-less 2 percent annual return, then one is theoretically indifferent between receiving $100 today and $102 a year from now. For risky investments, such as equity ownership, this discount rate will be far higher. In real terms, this means investors will demand a higher return in order to invest money into the business. A promise of $100 from a treasury bond is worth more than a promise of $100 from a business. The following factors might make a company riskier than the average equity position:

  • High financial leverage
  • Small size
  • Participation in a risky industry

Asset-based approaches to business valuation values a business as the sum of its parts less outstanding liabilities. Theoretically, a business owner would not be willing to buy a business for more than the cost of acquiring the individual parts of the business. For asset-intensive and distressed businesses, this may be a reasonable approach. However, many modern businesses consist of intangible assets that are hard to value and/or impossible to buy such as:

  • Specialized employees.
  • Goodwill with customers.
  • Reputation and brand value.
For this and other reason, many companies trade or sell at a multiple of their asset-based value.

Market approaches to business valuation attempt to use the value of comparable companies as a guideline to the subject company’s value. Comparable market valuations are commonly obtained through two methods:

  1. Market Capitalization — Market capitalization is the outstanding value of all publicly traded shares.
  2. Similar transactions — Some private data sources aggregate voluntarily-reported selling prices of privately held businesses.

Once similar companies have been identified, the analyst can scale their valuations to the subject company through any of numerous multiples, including:

  • Price to Sales Ratio — The ratio of the business’s value to gross revenue, total sales less no expenses.
  • Price to Book Ratio — The ratio of the business’s value to the asset based approach.
  • Price to EBITDA Ratio —The ratio of the business’s value to earnings before interest, taxes, depreciation and amortization. This can be computed by adding depreciation and amortization back to net income.

Numerous other approaches exist and are occasionally applied both to small companies and large, publicly traded companies.