Business valuation approaches
Introduction
Valuation of a new business is a critical task at the time of merger or acquisition of a new business.
Three
different approaches are commonly used in business valuation: the income approach, the asset-based approach, and
the market approach. Within each of these approaches, there are various
techniques for determining the value of a business using the definition of
value appropriate for the appraisal assignment. Generally, the income
approaches determine value by calculating the net present value of the benefit stream generated by the business
(discounted cash flow); the asset-based approaches determine value by adding
the sum of the parts of the business (net asset value); and the market
approaches determine value by comparing the subject company to other companies
in the same industry, of the same size, and/or within the same region. A number
of business valuation models can be constructed that utilize various methods
under the three business valuation approaches. Venture Capitalists and Private
Equity professionals have long used the First chicago method which essentially combines the income approach with the
market approach.
1. Income approach
The
income approach relies upon the economic principle of expectation: the value of
business is based on the expected economic benefit and level of risk associated
with the investment. Income based valuation methods determine fair market value by dividing the benefit stream generated by the subject
or target company times a discount or capitalization rate. The discount or
capitalization rate converts the stream of benefits into present value.
2.
Asset-based
approaches
The value of asset-based analysis of a business is
equal to the sum of its parts. That is the theory underlying the asset-based
approaches to business valuation. The asset approach to business valuation
reported on the books of the subject company at their acquisition value, net of
depreciation where applicable. These values must be adjusted to fair market value wherever possible. The value of a
company's intangible assets, such as goodwill, is generally impossible to
determine apart from the company's overall enterprise
value. For this reason, the asset-based approach is not the most probative
method of determining the value of going business concerns. In these cases, the
asset-based approach yields a result that is probably lesser than the fair market value of the business.
3. Market approaches
The
market approach to business valuation is rooted in the economic principle of
competition: that in a free market the supply and demand forces will drive the
price of business assets to a certain equilibrium. Buyers would not pay more
for the business, and the sellers will not accept less, than the price of a
comparable business enterprise. The buyers and sellers are assumed to be
equally well informed and acting in their own interests to conclude a
transaction. It is similar in many respects to the "comparable sales"
method that is commonly used in real estate appraisal. The market
price of the stocks of publicly traded companies engaged in the same or a
similar line of business, whose shares are actively traded in a free and open
market, can be a valid indicator of value when the transactions in which stocks
are traded are sufficiently similar to permit meaningful comparison.
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