This article examines, compares, and contrast the different valuation approaches in determining business valuations.
There are three valuation methods that the valuation analyst may use to value an asset. The asset approach focuses on determining the value of an asset by the cost of replacing the asset. The market approach centers on examining an asset by comparing it with other identical or similar assets. And the income approach deals with analyzing future economic benefits or cash flows based in today’s dollars. Each approach is unique to the asset that is being valued, thereby, the analyst needs to determine what’s the best approach for each asset.
Introduction to the Three Valuation Methods
Valuations have significant relevance in many different areas, e.g. mergers and acquisitions, legal and tax purposes, corporate finance, portfolio management, and even real estate investments. No two valuations are exactly the same. Valuation reports are the measuring guide to those who need it. Value is the firm value that consists of shareholder value and fundamental value (Kumar, 2016). There are three primary approaches to valuations; asset approach, market approach, and the income approach. Each approach may have a different assumption, based on its characteristics. And each approach will carry different insights into the valuation.
The Asset Approach of the Three Valuation Methods
The asset or cost approach centers on the replacement cost of the company. “The asset approach presents the value of all the tangible and intangible assets and liabilities of the company” (Hitchner 343). The asset approach is based on an entry price or cost to buy, rather than, an exit price or the price that it can be sold. The asset approach is determined by a replacement cost that is estimated based on what it may cost to replace the asset as new, that is, it “requires an estimate of the cost to reproduce or replace existing improvements” (Hitchner 369).
Asset Approach Example 1
For instance, suppose an analyst needs to estimate the fair value of a car mechanic business. In the asset approach, the car mechanic business involves the land, the building, the machinery, among other assets. In one of the assets, there’s a car lift that still is operational. Since the car lift system is tied to the specific business operation, there’s not a direct determination for a particular selling price. However, the analyst may determine through an estimate of what it would cost to replace the car lift and have it newly installed.
Let’s assume that a commercial grade car lift cost is $23,000 with a life of 30 years with a 15 percent salvage value (metal scrap, etc.). The previous car lift has been in use for 3 years. Therefore, the salvage value is $3,450. Furthermore, we can determine the depreciation value per year at $23,000 – $3,450/30 years = $652 per year. And since the car lift has been in service for 3 years, we calculate that the depreciation value after 3 years is $1,955. Therefore, this will give us adjusted replacement cost of $21,045 ($23,000 – $1,955). The asset approach works because the calculation of the asset can be determined and replaced with what it would cost new, in this case, $21,045.
Asset Approach Example 2
“Business valuation analysts often rely upon the work of other professionals during the process of a valuation engagement” (Hitchner 364). In commercial real estate, assume that a piece of real estate property entails the land, the building, and the parking lot. The asset approach would estimate the cost of purchasing similar real estate (land) and then the cost of the building construction with the parking lot. It would estimate the land value to the building of depreciated value (Sirmans and Jaffe).
By this, the reproduction cost of improvements would be estimated. That is the cost of constructing the improvements of the building, pavement, and other assets. Then you would calculate the estimate of loss in value to the improvements. That is the value of the building due to deterioration or depreciation value. Once that is complete, you will subtract the loss in value from the production cost (Sirmans and Jaffe). Lastly, add the depreciated building to the estimated land value which will give you the asset approach to property.
The asset approach requires that an estimate is performed of the cost to replace or reproduce the existing improvements (Hitchner).
Market Approach of the Three Valuation Methods
The market approach takes data from market prices and compares with other similar or identical assets. The market approach relies heavily on company sales transactions and companies that are publicly traded (Hitchner). The concept entails the determination of comparables or “comps.” That is, one company is compared to another or multiple companies that are similar or one transaction is compared to other transactions. The value of these companies is known because either they are publicly traded or recently sold (Hitchner). The market approach among corporate finance is the methodology mostly used (Nesvold, Nesvold, and Lajoux).
Further, the market approach is the principle of substitution, that is, a buyer would not pay more for an asset than they would pay for one that is similar in the marketplace (Hitchner).
For instance, by determining the share of a stock’s fair value, we would look at the most recent selling price of comparable shares of that stock. And because the shares of ownership are identical for the same company, the current selling price of each share shows a solid indication of fair value for the other shares.
The market approach uses data-driven stock prices to drive the process of publicly traded stock. This is due to the transparency that public companies provide. For instance, the value of Microsoft stock, as of Friday, March 29, 2019, quoted a share price at $117.94 per share. This is a very good fair value through the market approach. In contrast, privately owned businesses do not have transparency since their financial reporting is not published, therefore, not producing much data and trading in the stock market. Therefore, the market approach works extremely well with publicly traded companies that publish their financial data. Further, the valuation of a privately held company through the market approach will still use publicly traded companies for valuation. This is because of the transparency of financial data, thereby, comparing with identical or similar companies. Therefore, for assets that are traded in a public or a transparent market, the valuation through the market approach works well.
However, companies or assets presents a small proportion globally. In other words, through most valuations, there will be better valuation approaches than the market approach. For instance, in private small businesses or underdeveloped real estate where similarities are not traded, the market approach cannot be used. When the market approach cannot be used, the income approach or asset approach may be used to estimate the value of an asset.
Market Approach in Real Estate
In real estate, the market approach “is an estimate of value based on a process of comparing recent sales of similar in the surrounding or competing areas to the subject property” (Hitchner). There are five major categories of adjustments that reflect a market approach valuation, time, location, financing, conditions of sale, and physical characteristics (Sirmans and Jaffe).
Time. Sales are historical, in that, the comparables should reflect based on how things may have changed. For instance, has there been any new construction in the area? Or are there any other factors that would influence the value, e.g. inflation (Sirmans and Jaffe).
Location. Location is very important and can impact the value. Adjustments may be necessary based on the comparables of whether the asset is in a certain location, e.g. based on different neighborhoods. These adjustments should reflect value.
Financing. There are different methods of financing an asset. Understanding the behavior of the buyer may impact the prices on the market. Fair market value is determined by a willing buyer and a willing seller and any compulsion may impact that estimated value.
Conditions of sale. Essentially, this is asking the question of how motivated are the buyers and sellers? Motivation can play a factor in market price.
Physical characteristics. This involves many components, e.g. building size, rooms, lot size, etc.
Overall, the market approach is very adaptable and is considered a great way to value an asset that has transparency, financial data, and other resources available for the analyst. Otherwise, if the asset is private or data is not accessible, e.g. privately own business. The income approach may be more suitable to value the asset.
Income Approach of the Three Valuation Methods
The income approach is considered the most widely recognized when valuing a privately held business (Hitchner). It is considered the most common and the most appropriate valuation to use in most situations and it is considered to be the most difficult, in that, with the least amount of certainty. The income approach essentially is analyzing the future economic benefits of an asset in income based on today’s dollars, or present value (Holton and Bates). The income approach is basically a mathematical fraction, thereby, consisting of a denominator and a numerator. Where the numerator “represents the future payments of an investment, and the denominator represents a quantification of the associated risk and uncertainty of those future payments” or rate of return (Hitchner 118). The income approach tries to determine the future cash flow through the means of financial data to its current operations and future plans for those business operations. There are three commonly used methods within the income approach; discounted cash flow (DCF), capitalized cash flow (CCF), and excess cash flow (ECF).
Each method requires a numerator and a denominator, that is, a future cash flow (numerator) and the rate of return (denominator) (Hitchner). And each method is dependent on the present value. The DCF method uses a series of fractions, whereas, the CCF uses only a numerator and denominator. Moreover, the ECF is a hybrid, whereby, “the ECF is the “amount of cash flow available to all intangible assets” (Hitchner 119).
Discounted Cash Flow (DCF) Method
Essentially, the DCF method calculates the present value of future cash flows utilizing a discount rate. These adjustments may be applied, for instance, a business may be growing exponentially. According to Hitchner (2017), there are five categories of adjustments, ownership characteristics, GAAP departures and extraordinary, nonrecurring, and unusual items, nonoperating assets and liabilities and related income or expenses, taxes, and synergies from mergers and acquisitions. Further, each business’s individual cash flows are discounted to the present value through the discounted rate over a certain period of time. At that point, the asset that is being valued to determine the overall cash flow.
The income approach compared to the market approach or the cost approach requires more estimates and there is more uncertainty within the valuation of the asset. This is mainly due to future predictions. In other words, it is difficult to predict anything in the forthcoming years that the asset will operate. For instance, there is no coming of what the interest rates will be or any future for that matter.
The Conclusion to the Three Valuation Methods
Valuations play a significant role in many financial interests. Analyst faces many challenges as assets change with the ongoing economy. Overall, there are three valuation methods. The asset approach, whereby, the valuations are determined by the replacement of the asset. The market value approach, that is, retrieving data from public or through transparency measures and comparing the asset with similar or identical assets. And the income approach, which is, analyzing future economic cash flows in today’s present value. The income approach is the most difficult based on its uncertainty due to its futuristic predictions, however, the widely used approach. Each approach brings to the table a different toolbox for the analyst to determine a valuation.
Hitchner, James R. Financial Valuation: Applications and Models. Hoboken, New Jersey: John Wiley & Sons, Inc., 2017.
Holton, Lisa, and Jim Bates. Business Valuation for Dummies. Hoboken, NJ: Wiley Publishing, Inc., 2009.
Kumar, Rajesh. Valuation: Theories and Concepts. New York, NY: Academic Press, 2016.
Nesvold, Peter H, Elizabeth B Nesvold and Alexandra R Lajoux. Art of M&A Valuation and Modeling: A Guide to Corporate Valuation. New York, NY: McGraw-Hill Education, 2016.
Sirmans, C. F., and Austin J. Jaffe. The Complete Real Estate Investment Handbook. New York, NY: Prentice Hall Press, 1988.