Business valuation is an important part of any business and could be used to understand a business’ worth. It could be used as a measure of growth to understand how aligned the business is to its short and long-term goals. Most business valuation case studies have, however, pointed out other common reasons for doing business valuations to include divorces, business exit strategies, estate planning, tax purposes, and litigation proceedings, to mention a few.
While valuation is important to measure a business’s finances and growth, the method used can affect the overall outcome. Before you contact a business valuer, it may be best to brush up on some of the commonly used valuation methods. This knowledge can help you sift through potential business valuers while connecting you to the perfect professional for your valuation needs.
Business Valuation Approaches
The three commonly used business valuation approaches are;
- The income approach
- The market approach
- The cost approach
Each of these approaches has formed the foundation of business valuation for years. It is important to note that not all of the approaches can be used to value all businesses. Some approaches are better suited for businesses in certain industries.
The income approach
The income approach to business valuation is perhaps the commonest valuation method used by professionals. This approach is most suitable for established businesses with a trend of profitability or income over the years.
The income approach is perfect for established businesses with operational and financial structures because it considers their cash flow. For a typical income approach valuation, three important factors are considered;
- The business’s cash flow level
- The cash flow timing
The risks associated with the cash flow. This approach is based on the premise that business equity holders are investors who view their ownership/shares as an investment.
When to use: The income approach can be used when the business’s future cash flows are positive, relatively stable, and can be reliably forecasted for several years.
Pros
- The income approach focuses on future cash flows, which are the most important investment factor
- Does not rely on past transactions or the results from similar companies as with the market approach
- Does not consider the value of tangible and intangible assets as with the cost approach.
Cons
- Not recommended for businesses that are years away from a positive cash flow
- It can become highly complex and require many assumptions.
The Market Approach
This approach values a business by comparing it to several other companies of similar size and within the same industry. This approach is premised upon the assumption that investors will likely invest in companies with similar growth or comparable characteristics and would be willing to pay at the same level or slightly higher to invest.
Unlike the income approach, the market approach weighs the company’s visibility in relation to publicly available data from similar businesses. The data collected can be from sales transactions of similar companies, valuation of publicly-traded yet similar companies, or sales of interests in the subject entity.
When to use: The market approach is recommended for businesses with readily available industry pricing data as well as those in situations where the future cash flows are negative or unpredictable.
Pros
- This forward-looking approach reflects market prices and future expectations from investors.
- The overall analysis is less complex compared to the income approach. However, several assumptions, adjustments, and reliance on third-party data are needed.
- The business value is derived based on the total of its tangible and intangible operating assets.
Cons
- This may be difficult in industries with insufficient data or low-quality market data
- Often excludes key assumptions like business growth expectations.
The Cost Approach
The cost or asset approach focuses on knowing the value of a business based on its balance sheet. This approach determines the overall liabilities and profitability of a business based on its inflows and outflows.
Also a forward-looking projection like the income approach, the cost approach starts by looking at the business’ books, identifying the assets and liabilities, determining fair value for financial reporting purposes or a fair market value for taxation, estate planning, exit strategy, or other purposes.
When to use: The cost approach is typically confined to specific valuation situations like financial and tax reporting, estate planning and related concerns, and small businesses without goodwill.
Pros
- Does not require forecasting of future cash flows
- It is simple to understand and relatively straightforward, especially as it relies on the company’s financial books.
Cons
- It cannot be adopted for use in operating companies because their earnings are a better valuation approach.
- Does not truly consider the value of intangible assets, which may further impact the overall value ascribed to the business.
With the three primary approaches known, you can determine which is best for your company as well as use this information when selecting a valuation company for your needs.
