Business valuation approaches are the generally accepted ways of determining the value of businesses and professional practices.
What It Means
There are three broad approaches used for business valuation. Moreover, 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 should include a choice of several methods under each of 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. In other words, the income-based methods seek to establish the business' value as a function of its economic performance.
For example, these methods can use capitalization, discounting or multiplication of the seller’s discretionary cash flow or net cash flow to perform the valuation. To use the income-based business valuation methods effectively, you must make a proper selection of the capitalization rate, discount rate and valuation multiples. The well-known methods under the income approach include:
Asset approach to valuing a business
The Asset approach methods seek to determine the business value based on the value of its assets. In other words, these methods measure the value of a business 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 valuation methods under the Market approach establish the business value in comparison to historic sales involving similar businesses. Professional business appraisals often include these market-based methods:
- Comparative transaction method
- Guideline publicly traded company method
These methods rely on the so-called valuation multiples. The multiples establish 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 serve as the comparison basis to come up with the valuation multiples. Moreover, such actual business sale data requires careful statistical analysis in order to develop and use the multiples in business valuation.