Business valuation approaches and methods

There are three major commonly used business valuation approaches: income approach, market approach and asset approach. Under each approach, the value of a business can be determined by a number of methods.

​Income approach
​
Income approach to business valuation determines the value of a business by converting anticipated future returns of a business into a present single amount. The methods available under this approach include:

• Discounted Cash Flow method establishes a business value by discounting the future business earnings for time and risk using an appropriate discount rate.
• Capitalisation of Earnings method (also referred to as Capitalisation of Future Maintainable Earnings) converts sustainable future earnings of a business into a value by dividing them by an appropriate capitalisation rate.
• Multiple of Discretionary Earnings method establishes the business value as a multiple of its earnings. The multiple is derived analysing the subject business performance across a variety of internal and external factors affecting the business.
• Capitalisation of Dividends (also referred as Dividend Discount Model, DDM) method establishes the business value by capitalising the sustainable future dividend payments using an appropriate capitalisation rate.

Market approach 

Market approach to business valuation determines the value of a business by comparing the business being valued to similar businesses. The methods available under this approach include:

• Comparative Transaction method refers to comparable market transactions of either public or private companies.
• Recent Transactions method refers to previous sales of a share or the whole of the business being valued.
• Market-driven Rules of Thumb method refers to business selling prices in the same industry.

Asset approach

Asset approach to business valuation determines the value of a business based on the value of its assets net of liabilities. The methods available under this approach include:

• Net Tangible Assets (also referred as Net Assets Value, NAV) method determines the value of a business as the value of its normalised tangible assets net of the liabilities. Normalised tangible assets are assets adjusted for factors that distort the true reflection of the business (e.g. excess assets or non-operating assets). The method may use book values (as recorded in the financial statements) or fair values (book values adjusted to the market).
• ​Net Realisable Value (NRV) method determines the value of a business as the value of its net normalised tangible assets upon orderly (not forced) realisation.
• Liquidation Value method values a business based on the net amount that would be realised if the business is terminated and the assets are sold over a limited time period (forced realisation).
• Replacement Cost method calculates the business value as the replacement costs of all assets necessary for the business operations.
• Cost to Create (also referred to as Cost to Duplicate, Entry Costs) method calculates the business value based on how much it would cost to build a similar business from scratch.
• Capitalised Excess Earnings method calculates the business value as the sum of the net tangible assets at fair market value and the business goodwill (determined through the capitalisation of the excess earnings). Unlike most asset-based methods, Capitalised Excess Earnings does not ignore the value of the intangible assets and endeavours to assign a value to it. This method is not a pure asset-based valuation method but rather a hybrid of the asset and income valuation approaches.

By Julia Podgorbunskaya, CPA, Senior Business Valuer at Professional Business Valuers
March 2017
​
(61) 02 4295 0079
Julia@ProfessionalBusinessPlans.com.au
www.ProfessionalBusinessValuers.com.au