When a business appraiser provides an opinion of value, they rely on three different approaches to derive a value. The approaches are widely recognized and used by business appraisers, equity analysts, investment bankers, and various other industry professionals and are supported by robust financial theory. I won’t bore you with the theory.
Below are the three approaches to valuation:
• Income Approach;
• Market Approach; and,
• Cost Approach.
This article provides a brief introduction to the different approaches. Feel free to contact us for a deeper explanation and discussion.
I believe the three approaches to valuation are intuitive. First, appraisers look internally at the economics of the business by valuing the actual cash flows the business is estimated to generate going forward (income approach). Second, appraisers look externally, by valuing the business based on how similar companies transact in the marketplace (market approach). Lastly, we determine value be estimating the cost to recreate the business from scratch (cost approach). All three approaches cast a wide net over the available ways to value a business.
The Income Approach
The Income Approach to valuation focuses on the income the business generates and flows through to the respective stakeholders. The income approach can be summarized as, “the present value of all future economic benefits.” In layman’s terms this means we look at all the future free cash flow the business will generate between now and Judgement Day, and we value those cash flows in today’s dollars.
‘Economic benefit’ is a term used by professionals to mean the actual benefit the stakeholder receives based on their ownership stake. Appraisers may use free cash flow, earnings, or income to define economic benefit. This is determined on a case by case basis. We will use free cash flow for our discussion.
How do we use it?
There are two common methods within the income approach that we use to value a business:
1. Capitalization Method; and,
2. Discounted Future Cash Flows Method.
Other methods exist, but these are two common methods used by appraisers today.
The Capitalization Method uses a single cash flow number to value the business. Appraisers can use historical results or expected future cash flows to estimate business value.
This approach is used when businesses expect to grow at their long-term sustainable growth rate which will be similar to the economies overall long-term growth rate. Well established businesses expecting stable growth can be valued using the capitalization method.
XYZ, Inc. is well established business and management believes the company will continue to grow its free cash flow 3% annually, on average. After reviewing historical cash flows, and incorporating management’s future expectations, the appraiser values the company as follows:
Capitalization Method – XYZ, Inc.
Mathematically the formula divides the expected free cash flow by the capitalization rate. How the capitalization rate is determined is beyond the scope of this article.
The Discounted Future Cash Flows Method, commonly referred to as the DCF method, requires the appraiser to estimate the individual cash flows for each successive future period. It is common for appraisers to estimate the free cash flow by year for as many years as necessary until the growth in the annual free cash flows eventually stabilize.
This method is used when management believes free cash flow growth will be materially different than the company’s long-term growth rate. Companies in the start-up and expansion phase will apply this method.
Management of XYZ, Inc. has decided to grow their business over the next five years. Management plans to increase free cash flow by 10% annually over the next five years because of investments in a new operating division. Using the assumptions provided by management, the appraiser will determine the value using the DCF method as follows:
The value we determine for XYZ, Inc. using the DCF method is approximately $5.9 million, much higher than the $5.0 million valuation using the capitalized cash flows method. Growth is the primary reason for this difference in this scenario.
The DCF method allows an appraiser to focus on the individual cash flows for each particular year in the future. This gives the appraiser greater flexibility to make assumptions during the future. The terminal value is the sum of all future value beyond year five. This is used by the appraiser as a mathematical short-cut so that they do not need to estimate cash flows going into perpetuity.
The Market Approach
The Market Approach is a way of determining the value of a business by comparing the subject company to similar businesses that have been sold. The market approach is also referred to as the relative value approach, meaning the value of the business is relative to how similar businesses transact.
How do we use it?
There are two common methods within the market approach:
1. Guideline Public Company Method; and,
2. Private Transaction Method.
The Guideline Public Company Method uses valuation statistics of publicly traded companies that are in the same or similar business as the business being valued.
Once the appraiser finds similar businesses to the subject company, than they will gather pricing multiples which are statistical ratios of the company’s market price versus a fundamental metric such as revenue, pre-tax earnings, net income, cash flow, or book value.
The pricing multiples can than be applied to the subject company’s same fundamental metric. For example, the average publicly traded company in your industry has a Price-to-Earnings (P/E) ratio of 15 times. The appraiser can use the average P/E ratio as an indicator of value once it is applied to your company. Using this method, if your company has $1,000,000 in earnings, we can apply the 15x P/E ratio which suggests a value for your business of $15,000,000 (15 times $1,000,000).
The Private Transaction Method is applied using the same method under the Guideline Public Company Method, however, as the name implies, this method uses data from recent sales of privately held companies to derive pricing multiples.
An appraiser can review recent market transactions in the private market and find multiples such as the Price-to-Earnings ratio of those transactions and apply it to the subject company.
There are limitations to using data from private transactions. Such limitations include a general lack of information on a company’s background and we don’t know the motivations of the buyers or sellers. Sometimes sellers are under duress and must sell, which would depress the pricing multiple.
The Cost Approach
The Cost Approach requires the appraiser to value each component of the balance sheet of the business, which includes every asset and liability. The values of the assets are summed together and then the total liabilities are subtracted to arrive at a value of the equity.
How Do We Use It?
There is one common method used under the cost approach:
1. The Adjusted Book Value Method.
The Adjusted Book Value Method adjusts the assets and liabilities of the company to reflect their fair market values. The fair market value of the equity will be determined when the adjusted liabilities are subtracted from the adjusted assets.
This method of appraisal is generally used in situations where the company has very little or negative earnings or may be capital intensive. Such companies include not-for-profit organizations, holding companies, and manufacturing companies.
Real estate partnerships generally hold real estate assets in an entity structure, such as a limited liability company. Many times these entities will be valued using the Adjusted Book Value method.
I hope you enjoyed our brief overview of the three different approaches to valuation. These three approaches require a deep understanding of theory and practical experience to apply them effectively. Please don’t hesitate to contact us with any questions.