How to Value a Business: The 3 Most Common Valuation Approaches
The process of valuing a business is not a simple one. For starters, there are a variety of methods that can be used. Beyond that, there’s a level of depth that can be explored within each of those methods. Further complicating the process is the fact that there’s no real “correct” answer: It is widely accepted, for instance, that different qualified experts will come to different conclusions depending on the purpose and their assumptions.
Still, business owners and investors often require valuations. If you’re reading this article, it’s likely you’ve already determined your need for a business valuation. A few of those needs may include shareholders’ disputes, fundraising activities, employee stock grants, or “strategic” valuations for a potential merger or acquisition. Beyond those, we’ve laid out a host of reasons why a valuation is needed for businesses and investors alike.
None of these matters should be taken lightly. The end-users have too much at stake for an amateur valuation to dictate the outcome. A thoughtful approach will assess the value of a business using one – or all – of three primary methods: the Income Approach, the Market Approach, and the Cost Approach.
Getting familiar with these methods is critical. This article will shed light on how to value the economic engine that is your business. In addition, it will provide insight into the field of valuation itself, translating what can seem like an arcane practice into more approachable terms.
Business Valuation Approaches
As mentioned before, the three primary approaches for valuing a business are as follows:
- The Income Approach
- The Market Approach
- The Cost Approach
Every possible method or perspective on valuation can be seen through the lens of one of these three broad approaches.
This is important to keep in mind as you work with a valuation expert and think about your business. Oftentimes one of the three will be more familiar given your particular industry or set of investors. Still, all of them should at least be considered, even if more weight is ascribed to a specific approach at the end of the process. Diving into each of these will paint a picture of how a valuation is crafted by a professional.
The Income Approach is most commonly used for established businesses with profitable – or nearly-profitable – operations. Why? Because it is entirely oriented around cash flows. The Income Approach considers three key characteristics of a business: the level of cash flows, the timing of cash flows, and the risk associated with those cash flows.
If a business is not cash flow positive nor soon-to-be cash flow positive, you can see why the Income Approach is not an optimal fit.
The Theory Behind It
The Income Approach is based on the premise that equity holders are investors, and they view their ownership as they would any other investment. Financial theory holds that an investment is a current commitment of money to an endeavor that will (hopefully) result in future payments to the investor that are greater in value. The Income Approach is thus “forward-looking.” Further, it discounts those future payments back to their present-day value, incorporating the risks and opportunity costs inherent in any future project into the discount rate. The emphasis on future cash flows is a unique attribute of this approach that distinguishes it from the other approaches.
When to Use the Income Approach
The Income Approach could be appropriate for a business when the future cash flows have the following characteristics:
- Future cash flows are positive
- Future cash flows are relatively stable – not highly volatile
- Future cash flows can be reliably forecasted for several years into the future
- Focused on future cash flows which are of utmost importance to investors
- Unlike the Market Approach, the Income Approach is not as reliant on similar past transactions or comparable companies which can never truly match the unique characteristics of the subject company
- Unlike the Cost approach, the Income Approach considers value derived from both tangible and intangible assets
- Not as relevant when valuing businesses that are years away from achieving positive cash flow
- Potential to become highly complex and involve many underlying assumptions
The Market Approach establishes a value for a business by comparing it to similar companies that have a value attached to them that is publicly known. The premise is that an investor (a willing buyer) would look at the values of what is referred to as the “comparable companies” or “comps” and would price the subject company according to the values of these similar companies.
Thus, the Market Approach relies on publicly available data for pricing data which can arise from three primary sources:
- Sales transactions of similar companies
- Publicly-traded similar companies
- Sales of interests in the subject entity
Notice that the first two sources rely on pricing data for other companies whereas the last source relies the subject company itself. Neither is a perfect apples-to-apples comparison given the present-day subject company will have unique qualities that aren’t necessarily replicated in comparable companies or weren’t present in its prior stages. Moreover, it’s possible that relying on more than one of these methods within the Market Approach would result in a more accurate value for the subject company.
The following is an expanded version of the bulleted list that includes the widely accepted industry names for each of these methodologies:
- Guideline Company Transaction Method – Sales transactions of similar companies
- Guideline Public Company Method – Publicly-traded similar companies
- Guideline Sales of Interests in Subject Company – Sales of interests in the subject entity
The Theory Behind It
The underlying theory of the Market Approach is that a rational financial buyer will only be willing to pay the market rate for a company, and this market rate is based on the pricing data of companies with highly similar qualities to the subject company.
When to Use the Market Approach
The Market Approach could be appropriate for a business when the following characteristics are present:
- The pricing data for comparables is robust and readily available
- In situations where future cash flows are negative or highly unpredictable
- The Market Approach is “forward-looking” because market prices reflect investor expectations about the future
- Assumptions, adjustments, and third-party data are required, but the overall analysis is typically less complex than the Income Approach
- The value derived considers all of the operating assets, including tangible and intangible
- Insufficient or low-quality market data can limit the accuracy of the Market Approach or render it unsuitable
- Key assumptions are often excluded; an example would be the growth expectations for the comparables which can be available for public companies but rarely for private comparables
The Cost Approach (also referred to as the Asset Approach) is used to ascertain the value of a business from a balance sheet perspective. In other words, a valuation expert will determine the overall enterprise value based on the underlying value of the business’s assets net of its liabilities.
As you might expect, the Cost Approach is the least reliant on forward-looking projections. Instead, the Cost Approach typically begins with the book-basis balance sheet and “builds up” or “restates” the assets and liabilities to fair value (financial reporting) or fair market value (tax and other purposes). This build up exercise is performed because balance sheet values rarely reflect market values. Over time, this separation between historical cost and market value tends to grow wider, particularly for illiquid assets.
The Theory Behind It
The underlying theory to the Cost Approach is that – despite its historical bias and limitations – it can be more suitable for certain businesses versus the Income Approach or Market Approach. For example, when a holding company or asset-intensive business (like a real estate company) is being appraised, the valuation expert could conclude that the Cost Approach is suitable because the underlying assets make up most of the value and can be separately appraised. In this case, a greater weighting is placed on this approach than the others.
When to Use the Cost Approach
As previously discussed, the Cost Approach is typically used only in specific situations. Those may include but are not limited to the following:
- For use in valuations for financial and tax reporting purposes when minimal progress has been made on a company’s business plan
- For tangible asset-intensive businesses
- For investment, holding, and real estate companies where cash-flowing operations tend to contribute less of the value than the underlying assets
- For small businesses where there is little or no goodwill
- Does not rely on the challenging process of forecasting future cash flows
- Simple to understand and relatively straightforward to execute
- Rarely applicable to operating companies because an earnings-based approach is likely more relevant
- Does not directly value intangible assets so the valuation expert still needs to assess their value separately or use an additional Cost Approach, such as a cost to recreate, to value the intangible assets
Which Valuation Approach is the “Right One”?
To recap, we have three widely recognized valuation tools in our toolbox: the Income Approach, the Market Approach, and the Cost Approach. Each approach provides a framework for better understanding the total value of our subject company, no matter the industry.
However, certain approaches are more suitable for certain industries and companies. The Cost Approach could be well-suited for something like a storage facility where most of the value is in the real estate itself and goodwill is minimal or for an early stage life science pharmaceutical company that is years away from commercialization. On the other hand, more mature, high-growth biotech companies may fit well within the Market Approach given their significant intangible assets, the availability of comparable companies or transactions, and their financials which tend to show strong revenue growth but lagging earnings.
There is no “right” approach for all circumstances, which raises a relevant point on valuation. While we have introduced you to the three most common valuation approaches, these are only techniques. It is just as important to understand the business and industry as it is to understand the valuation techniques.
At Redwood Valuation, we have conducted thousands of valuations of venture-backed companies and private equity backed companies as well as public companies. We have gleaned insights from executives across all industries. If there’s one thing we’ve learned, it’s that our clients can provide the best insight into their industry and company. These are insights our valuation techniques and models can’t capture without our clients’ input. As a result, it is the combination of an entrepreneur’s or CFO’s perspective with a rigorously applied valuation approach that results in the best possible valuation outcome.
What business valuation method is best for your company? Let Redwood Valuation help you assess your business today. Contact us here.