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Valuation approaches & methods

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Valuation Approaches and Valuation Methods

According to the Accounting & Ethical Standards Board 225:

  • “Valuation Approach(es) means a general way(s) of determining an estimate of value of a business, business ownership interest, security, intangible asset, or other asset or liability using one or more Valuation Methods.”
  • “Valuation Method(s) means, within Valuation Approaches, a specific way(s) to determine an estimate of value of a business, business ownership interest, security, intangible asset, or other asset or liability.”

Valuation Approaches

Per the International Valuation Standards (IVS), there are three main Valuation Approaches:

  • Market Valuation Approach
  • Income Valuation Approach
  • Cost Valuation Approach

Each Valuation Approach has different methods of application.

Which Valuation Approach do we adopt?

According to the standard on Business and Business Interests (IVS 200):

  • the Market and Income Valuation Approaches are frequently applied in the valuation of businesses and business interests;
  • the Cost Valuation Approach cannot normally be applied in the valuation of businesses and business interests; however, certain exceptions include where the value of assets in liquidation may exceed the value of the business as a going concern.

In selecting the appropriate Valuation Approach, issues that we consider include:

  • the Basis of Value adopted
  • the purpose of the valuation report
  • the respective strengths and weaknesses of the Valuation Approaches
  • the appropriateness of each Valuation Approach to the valuation subject
  • the availability of reliable information upon which to apply the Valuation Approach

Income Valuation Approach

The Income Valuation Approach provides an indication of value by converting future cash flow to a single current value.

According to the IVS, the Income Valuation Approach should be applied and afforded significant weight if:

  • the income-producing ability of the subject asset is the critical element affecting value from a participant’s perspective; and/or,
  • 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.

Often, the incoming producing ability of a subject business is the critical element affecting value, and consequently we adopt the Income Valuation Approach as the primary Valuation Approach.

Projections of the amount and timing of future income are often not available and so we prepare cash flow projections. These cash flows are usually projected under difference scenarios.

Per the IVS, although there are many ways to implement the Income Valuation Approach, methods under the Income Valuation Approach are effectively variations of the Discounted Cash Flow Method (DCF). Consequently, Lotus Amity typically adopts a DCF Valuation Method.

Under the DCF Valuation Method expected future cash flows are discounted back to the Valuation Date, resulting in a present value of the asset.

The key steps we take in applying the DCF Valuation Method include:

  • modelling granular cash flow forecasts for a projected period (five to ten years)
  • modelling and applying a relevant discount rate to the forecasted future cash flows
  • modelling and applying an adjustment for lack of liquidity (if applicable)

Market Valuation Approach

Per the IVS the Market Valuation Approach provides an indication of value by comparing the asset with identical or similar assets for which price information is available.

Per the standards there are two key Valuation Methods under the Market Valuation Approach:

  • the Guideline Publicly Traded Comparable Valuation Method– the Valuation Method relies on identifying relevant and comparablepublicly traded company metrics
  • the Comparable Transactions Valuation Method – the Valuation Method relies on identifying recent and relevant transactions involving assets that are the same or similar

Under the Market Valuation Approach, we:

  • research and identify publicly traded prices and actual prices paid for the same or similar companies and use the available date to develop key valuation metrics
  • make a comparison between qualitative and quantitative factors between the comparable companies and the subject asset
  • adjust the valuation metrics to reflect differences
  • apply the adjusted valuation metrics to the subject asset

A key factor we adjust for in relation to valuing private companies is that we adjust public company metrics to reflect firm specific risk.

Cost Valuation Approach

The Cost Valuation Approach provides an indication of value by assuming that a buyer will be pay no more for an asset that the cost an asset of equal utility.

According to the IVS, the Cost Valuation Approach is rarely applicable in the valuation of businesses and business interests, but maybe applied if the subject business:

  • is an early stage and cash flow cannot be readily determined and comparisons with other businesses are impractical or unreliable
  • is an investment or holding business
  • does not represent a going concern

There are three Cost Valuation Approach methods:

  • Replacement Cost Valuation Method-involves identifying the costs to replicate the utility of the subject asset
  • Reproduction Cost Valuation Method – involves identifying the costs of replicating the subject asset
  • Summation Valuation Method– involves identifying and valuing the each component of the subject asset

Our assessment of costs includes both the direct material and labour costs and the indirect costs, for example, installation costs, professional fees, commissions, finance costs and profit margins.

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