From 'The Client's Handbook on Business Valuation'
Authors: Blake Allen, CPA/ABV, and Greg Light, CFA, ASA
“How exactly do you value a company?” This is a common question that we receive from business owners and other professionals who engage us to value a business. On the surface, this is a simple question with an equally simple answer; the value of any company is one of two numbers:
1. What the owner would receive from selling the business.
Or...
2. The present value of the cash flow the owner expects to receive in the future.
While this is the conclusion of the business valuation analysis, how we determine the appropriateness of each of these two premises and arrive at an estimate of value is much more complicated. There are three common valuation methodologies that are considered in determining which valuation method(s) is (are) most appropriate to determine how the business should be valued and ultimately relied upon in establishing value: the income approach, the market approach, and the asset approach. The following sections provide further detail on each of these approaches.
The Income Approach
The income approach determines the value of a company based on the economic benefits generated by the business factored by the required rate of return based on the company’s risk profile. Economic benefits are the after-tax cash flow or earnings generated by the company. The required rate of return is based on the company and industry-specific factors that seek to quantify how much risk exists in the business versus other investments available in the market.
When valuing a company under the income approach there are two methods commonly used methods: valuing a single year of economic benefits into perpetuity (the income capitalization method) or a varying stream of projected future economic benefits with a final year (once the company has reached a point of stability) being projected into perpetuity (the discounted cash flow method). Both methods rely on analyzing historical cash flows to forecast projected future cash flows factored against the estimated risk of the company. The combination of these components, cash flow, and risk, are used to estimate the value of the business’s operations.
The Market Approach
The market approach determines the value of a company based on the sales of comparable businesses or interests in comparable businesses based on data derived from public and private markets. This data is then applied to the subject company’s reported financial information to estimate the value of the company. Two common methods under the market approach are the comparable market transaction method and the guideline public company method. Both methods utilize key metrics derived from either the price at which the company was acquired (under the comparable transaction method) or the price at which a comparable public company is trading on a publicly traded exchange market (under the guideline public company method). Commonly used multiples under these approaches are Enterprise Value (“EV”)/revenue (enterprise value divided by revenue), EV/earnings (enterprise value divided by earnings), and EV/EBITDA (“Earnings Before Interest, Taxes, Depreciation, and Amortization”) (EV divided by EBITDA) among other multiples. Enterprise value in this case refers to the purchase price of an acquired company or the total value of a publicly traded company. These methods utilize the multiples observed in comparable transactions or public market data multiplied by the company’s historical or projected metrics resulting in the company’s enterprise value under the market approach.
The Asset Approach
The asset approach determines the value of a company based on the market value of its assets and liabilities. This approach is quite simply the concept of what is “owned” less what is “owed.” The most common method for valuing a company under the asset approach is the adjusted book value method (or the net asset value method). Under the adjusted book value method, the analyst reviews the company’s assets and liabilities and adjusts the various items from the reported value on the balance sheet to the market value as of the valuation date. The difference between the market value of the company’s assets and the market value of the company’s liabilities results in the value of the company under the asset approach.
In summation, the value of any business is commonly estimated by the economic benefits or cash flow analyzed under the income approach, the market value of the company based on relevant metrics from comparable publicly traded companies and/or mergers and acquisitions transactions of comparable companies, or the market value of the company’s assets subtracted by the market value of the company’s liabilities. There are various methodologies and intricacies within the application of each valuation approach which we dive into in the next segment of this series.