There are three approaches to valuing a business. I’ll discuss them in detail.
1. Asset Approach
Asset approach looks at a business from a set of assets and liabilities of the company for business valuation. It’s based on the economic principle of substitution and tries to answer the question:
What would cost me to recreate a similar business that generates the same economic benefits for its owners?
Every operating business holds assets and liabilities. So, valuing these assets and liabilities and taking the difference between the two values would give us the value of the company. While it sounds simple, valuing a business can be a daunting task since most of the components do not find a place in the balance sheet. Internally developed products (unless patented) are such an example. But the market value of these assets can be far greater than the combined value of all the assets that resides in the financial statement.
Few points noteworthy
- An asset-based valuation approach is usually adopted when a business has a very low or negative value as an ongoing business. Consider the case of an airline company that has few routes, high labor and operating costs, and is losing money every year. Using the other valuation methodologies, one can derive a negative valuation for the company. But to its competitors, the assets (routes, landing rights, leases, equipment and airplanes) can have a significant value. In this case, this approach will value the company’s assets separately and will set them aside from the money losing business. The asset-based valuation approach will typically yield the lowest valuation of the 3 approaches for a profitable company, but it may result in an appropriate value depending on the situation.
- Asset approach may be used in conjunction with the other valuation methods. For example, let’s consider a retail business which has only one location. It owns the property and the building in which the business operates. If the company has EBIT of $200,000 and a buyer is willing to pay 3x EBIT for a similar retail business which leases its operating facilities, the buyer will value it by adjusting EBIT for the cost the buyer would have to incur, if it were to lease comparable facilities, and adjusting the company’s valuation for the value of the property and building assets. If the buyer has to pay $20,000 a year for leasing similar property, and can sell the property and building for $600,000, the buyer might value this company at 3x adjusted EBIT, plus the value of the property and building.
3x ($200,000 – $20,000) = $540,000 + $600,000 = $1,140,000
2. Income Approach
Also known as real estate appraisal method, the income approach looks at the business from money making stand-point. Economic principle of expectation applies here and it tries to answer the question:
If I invest in a business, when and what economic benefits will it generate?
This question reflects future expectations, which means that the money is still not in the bank. So, there is a risk associated with it, which needs to be factored in while calculating the valuation. Since the business must be estimated at present value, the approach arrives at the figure through:
(i) Capitalization (expected earnings divided by the capitalization rate), and
(ii) Discounting (project the income over the years, determine the discount rate considering the risk factors, calculate the terminal value, and then discount the calculation to yield the present value of the business).
Few points noteworthy
- The income approach is common for hotels and buildings. Because it considers the rent and value of the real estate in the locality, it may not take into account various features that a property may demonstrate – condition of the property, neighborhood or financing concessions. As such, investors in property use this approach for a quick snapshot of the property’s worth. This methodology is one of 3 popular approaches to appraising real estates, the other two being cost approach and comparison approach.
- The income based approach works fine with stable, low risk instruments that are widely traded in the developed markets such U.S. Treasury bonds. But with respect to valuing a company, that is small, privately-held, not well established business, the projections of future cash flows and the selection of a discount rate are often highly speculative and subjective.
3. Market Approach
As the name suggests, the market approach relies on market realities and follows economic principle of competition. It looks at the question:
What similar businesses are worth?
Businesses never operate in vacuum. So, when we are trading in a business, we consider what is called “fair market price” – the price that a buyer is willing to pay, and a seller is willing to accept for the business. Both the parties are assumed to be aware of the facts, and neither of them is under any coercion to conclude the sale.
The market approach values a business by comparing the concerned companies in the similar region, which are of equal size or operating in the similar sector. For example, if a company’s EBITDA is $500,000 in its last fiscal report, and comparable companies had M&A with an average of 3x EBITDA, the concerned company’s valuation should be about $1.5 million.
For comparable companies analysis, it’s common to select public companies that are operating in the same or similar industry as the company to be valued (subject). But if the subject is not a public company or is much smaller than the public companies, it may pose limited usefulness. In comparing companies, the most common metric used is EBITDA. If comparable companies have been recently sold for 5x EBITDA, the concerned company’s valuation would be about 5x its EBITDA. Similarly, if the comparable companies have been valued at 3x book value, the subject company’s value would also be about 3x its book value.
Each of the above three approaches will generate different values; one method will be more appropriate to a kind of business valued than the other.
You may also refer my articles Startup Valuation: Pre-money and Post-money and Percentage of valuation in terminal value
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