How to value a business? According to the International Valuation Standards there are three Valuation Approaches to value a business: Market Approach, Income Approach and Cost Approach. Within each Valuation Approach there are Valuation Methods.
Market Business Valuation Approach
The Market Approach is frequently applied in the valuation of businesses and business interests. The Market Approach indicates value by comparing the subject business with identical or similar businesses for which price information is available (IVS 103, para 20.01). The Market Approach is what Professor Damodaran calls pricing.
There are two key Market Approach methods:
- Comparable Transaction Method (IVS 103, A10.01 to 10.08)
- Guideline Publicly-Traded Comparable Method (IVS 103, A10.09 to A10.14)
The key steps for each method include (A10.06 and A10.12):
- identify units and metrics of comparison, for example EBITDA or revenue
- identify relevant comparable transactions and guideline comparables and calculate valuation metrics
- perform a consistent quantitative and qualitative comparative analysis (how different is the subject company to the comparables)
- adjust for difference between subject and comparable
- apply the adjusted valuation metric to the valuation subject
The key issues in applying the Market Approach to privately held business is identifying publicly listed companies that are comparable or relevant transactions. An alternative application of the Market Approach is to use business listed for sale (Comparable Listings Method), but is only appropriate when combined with other methods.
Income Business Valuation Approach
The Income Approach is also frequently applied in the valuation of businesses and business interests (IVS 200, para 60.01).The output under the Income Approach is what Professor Damodaran calls intrinsic value.
The Income Approach is afforded significant weight under the following circumstances (IVS 103 para 30.02):
1. the income-producing ability of the asset is the critical element affecting value from a participant’s perspective; and/or,
2. reasonable projections of the amount and timing of future income are available for the subject asset, but there are no relevant and reliable market comparables.
Methods under the Income Approach are effectively variations of the Discounted Cash Flow Method (DCF) (IVS 103, para A20.01).
Discounted Cash Flow Method (DCF)
Under the DCF method the expected future cash flows are discounted back to the Valuation Date, resulting in a present value for the business (IVS 103, para A20.02). Consequently, the two key inputs in valuing a business are estimating future expected cash flows and estimating a discount rate.
According to Professor Damodaran, the valuer’s focus should be on estimating the future cash flows, rather than the discount rate. Estimating future cash flows requires analysing past financial performance and forecasts, assessing the operations and the outlook for the business and the industry.
The common methods to establish the discount rate required under the DCF method include (IVS 103, para A 20.31):
- the Capital Asset Pricing Model
- the Weighted-Average-Cost-of-Capital
- inferred rates
- Build-up-Method
Cost Business Valuation Approach
The Cost Approach is rarely applicable in the valuation of businesses. However, the Cost Approach is sometimes used when (IVS 200, para 70.01):
- the business is in an early stage or start-up
- the business is an Investment or holding business
- the business does not represent a going concern
Per IVS 103, the three Cost Approach methods comprise of the:
- Replacement Cost Method, which replicates the utility of the asset (A30.02-A30.05)
- Reproduction Cost Method, which replicate the physical asset (A30.06-A30.07)
- Summation Method, which values each component of value (A30.08-A30.09)
IVS 103 provides guidance on other steps to consider when applying a Cost Approach, for example, including not only direct costs such as materials and labour but also indirect costs such as installation costs, professional fees, taxes, finance costs and profit margins.
Summary
If a business is generating cash flow then the Income Approach is likely the appropriate primary valuation approach. Further, as all Income Approaches are essentially variations of the Discounted Cash Flow Method (DCF), then the DCF Method is likely the appropriate valuation method. This requires estimating future cash flows and an appropriate rate of return.
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About The Author
Simon is the owner of Lotus Amity Business Valuations and specialises in wrestling with and attempting to pacify often complex valuation problems. He is a Business Valuation Specialist with Chartered Accountants Australia and New Zealand (CA ANZ). He chairs the CA ANZ Business Valuation group for Queensland, is a member of the CA ANZ Trans-Tasman Business Valuation Committee and likes running long distances.
