By Judy Mason, CPA, CVA, CEPA – Partner
If you watch a television show like Dancing With The Stars or America’s Got Talent, it may seem that the judges’ scores are arbitrary. We may think a dazzling effort was made, but the performance receives low scores. How do these judges reach their results? What methods or factors do these judges consider?
In the world of business valuation, understanding the results of a valuation report can also be challenging. There are three general approaches to determining value: 1. income approach, 2. market approach, and 3. asset (or cost) approach. Each approach contains different methodologies based on varying factors. The valuation analyst’s role is to determine which of these valuation methodologies to consider and apply to determine the conclusion of value.
1. INCOME APPROACH
In general, income-based valuation methodologies convert an anticipated future benefit stream, such as cash flows or earnings, into a single amount by discounting that benefit stream to present value using an appropriate discount rate. In other words, any income approach is predicated on determining the present value of a future benefit stream. The income approach generally consists of two methods: single-period capitalization and multi-period discounting. The following summarizes these two most common forms of the income approach used to value businesses.
- Capitalization of Cash Flow Method: This method values a business based on a single expected cash flow stream, capitalized by a risk-adjusted rate of return. It is most appropriate to use this method when current or historical results are believed to be representative of future results, and the business is projected to grow at a sustainable or modest growth rate. In general, this approach is often used for companies that are mature in nature and are experiencing a relatively consistent stream of revenues and earnings.
- Discounted Cash Flow Method (DCF): This method is a multi-period discounting model that determines the value of a business based on the present value of its expected future benefit stream. Specifically, the DCF method is based on the theory that the value of a company is equal to the sum of both the present value of projected future benefits over a specific period of time plus the present value of a residual cash flow. The specific period encompasses the period of time extending through the point when future cash flows are expected to stabilize before growing at a constant rate into the future. The residual value represents the present value of all cash flows beyond the discrete period. The present value of both is determined using an after-tax, risk-adjusted cash flow rate of return. Distributable cash flow is used as the benefit stream in this analysis as it represents the earnings available to distribute to investors after considering the reinvestment required to fund a company’s future growth. Generally, this method is used by companies that expect varying levels of revenue and earnings growth in the future.
2. MARKET APPROACH
Valuation methodologies under the market approach calculate value based on the prices paid for ownership interests in companies similar to the business being valued. There are two principal methods used in the market approach.
- Guideline Transaction Method: This method values a business based on pricing multiples derived from the sale of companies that are similar to the subject company. The steps taken in the guideline transaction method include finding transactions involving the purchase of comparable companies. Then, selecting the transactions that closely mirror the company’s operations and which occurred in similar industry and economic conditions. Finally, the indicated pricing multiples from the representative transactions are applied.
- Guideline Public Company Method: This method values a business based on trading multiples derived from publicly traded companies that are similar to the subject company. The steps taken in the guideline public company method include identifying comparable public companies, adjusting the indicated multiples for differences in size and risk relative to the subject company, and then applying pricing multiples from the representative companies.
3. ASSET APPROACH
In business valuation, the asset approach is a valuation technique that determines the value of the business based on the market value of its assets and liabilities. The primary valuation methodology used in the asset approach is the Adjusted Net Asset Method, which is summarized below.
- Adjusted Net Asset Method: In applying this method, the value is calculated as the difference between the fair market value of the company’s assets and liabilities. Under this method, the assets are adjusted from book value to fair market value, and the total adjusted assets are then reduced by recorded and unrecorded liabilities. The application of the Adjusted Net Asset Method typically establishes a company’s “floor value,” which would be realized upon the sale of a company’s assets and the satisfaction of its liabilities. This methodology is appropriate in the case of holding companies or capital-intensive companies. It is also used when the business has underperforming earnings, and the other valuation methodologies indicate a value lower than its net asset value.
Reconciling Valuation Methodologies and Conclusions of Value
Ultimately, the valuation methodologies considered and utilized in a business valuation are based on the unique characteristics of the business. Every business is different and has different competitive markets, different history, and different future potential. All these factors, along with the past and future earnings of the company, ultimately determine which method reflects the value of that business.
A working knowledge of the common valuation methodologies applied during the course of a business valuation can prove vital in understanding the context and reasonableness of the conclusion within a valuation report, almost as if you were able to see the dancing show judges’ scorecards before they hold them up to the audience and contestants.
Do you have questions about valuation methodologies? Our business valuation team is here to help. Contact us at 847.982.0333.