In our previous post, we discussed whether Business Valuation Approaches. In our article today, we will be talking about the methods used in valuing a company.
Business valuation can be broadly categorised into three approaches. The methods are
- Income Approach
- Market Based Approach, and
- Asset Approach
The Income Approach determines the value of a company based on the income that the company is expected to generate in the future. This is done by assessing the present value of the firm’s forecasted future cash flows. Some methods under the income approach includes the discounted cash flow method (DCF) and the capitalisation of earnings method. This approach is typically used for firms that have an operating focus, such as a service company, rather than a firm that has an asset-focus, like a real estate firm.
Market Based Approach
The market based approach values a company by considering the price multiples of similar listed firms, or historical transactions of companies in the same industry. The company is valued by applying the multiplier on an indicator of the company’s performance, such as profits, sales, or net book value, depending on the industry. The idea behind this methodology is that the value of similar companies would serve as a good reference point for the company we are valuing.
The Asset-Based Approach determines the value of a company by assessing the market value of the company’s net assets. This usually gives the lowest valuation among the three methods as most firms that are a going concern would usually generate a higher cash flow from its assets than they would if it sold all its assets in liquidation. This excess value is referred to as “goodwill”. This approach may give the highest value for companies like real estate firms where the fair market value of the assets is higher than the value given in the expected discounted cash flow method.
A detailed valuation will employ a few of the methods above to determine the company’s value.
In our following post in our three Valuation Series, we will discuss the types of Data and Useful Sources Required for a Business Valuation.