Business Valuation Approaches
Generally accepted ways of determining the value of small businesses and professional practices.
What It Means
There are three broad approaches used for small business valuation. Each approach serves as a foundation for a group of methods used to determine the business value.
- Income approach
- Asset approach
- Market approach
A comprehensive business valuation model should include a choice of several methods under the above approaches.
Income approach to business valuation
The Income approach methods determine the value of a business based on its ability to generate desired economic benefit for the owners. The key objective of the income based methods is to determine the business value as a function of the economic benefit.
The economic benefit such as the seller’s discretionary cash flow or net cash flow is capitalized, discounted or multiplied to perform the valuation. Key to the effective use of the income-based business valuation methods is the proper selection of the capitalization rate, discount rate, and valuation multiples. The well known methods under the income approach are:
- Discounted cash flow method
- Capitalization of earnings method
- Multiple of discretionary earnings method
Asset approach to valuing a business
The Asset approach methods seek to determine the business value based on the value of its assets. The idea is to determine the business value based on the fair market value of its assets less its liabilities. The commonly used valuation methods under this approach are:
Market-based business valuation
The Market approach based valuation methods establish the business value in comparison to historic sales involving similar businesses. The business valuation methods under the market approach that are typically used in professional business appraisals include:
- Comparative transaction method
- Guideline publicly traded company method
These methods rely on the so-called pricing multiples which determine a relationship between the business economic performance, such as its revenues or profits, and its potential selling price.
Sales of businesses which closely resemble the business being valued are most commonly used to estimate the pricing multiples. Statistical analysis of such actual business sale data is used to establish the business valuation Market Comps.