3 Approaches to Business Valuation Methods

Even the smartest people in the room can be easily distracted by shiny, pretty things during a business valuation proceeding. Just look at what happened at JPMorgan with its $175 million purchase of Frank.

Frank was a sparkling young company with a 28-year-old wunderkind founder and a mission to assist in student loan relief. It had all the ingredients for a concoction too powerful for even titans in finance to ignore.

Unfortunately, sensational headlines on massive fraud soon overwhelmed any feelings of optimism. As the New York Times reported in 2023:

“[L]ast month, the biggest bank in the country did something extraordinary: It said it had been conned.

In a lawsuit, JPMorgan claimed that Frank’s young founder, Charlie Javice, had engaged in an elaborate scheme to stuff that list of five million customers with fakery.

[…]

JPMorgan’s legal filing reads like pulp nonfiction, with jaw-dropping accusations. Among them: that Ms. Javice and Olivier Amar, Frank’s chief growth and acquisition officer, faked their customer list and hired a data science professor to help pull the wool over the eyes of the bank’s due-diligence team.”

The Frank scandal is just one example of the dangers involved in fuzzy valuations. The reality of a competent valuation is that it involves a variety of challenges from assets and collateral matters to value disputes across business entities, cash-flow streams, and stakeholder claims. Overcoming these challenges is often what stands between a good and a bad investment.

Why Business Valuations Matter

Business valuations are used for a wide variety of purposes. This includes everything from transactions to financial and retirement planning, taxation, bankruptcy or restructuring, and litigation.

These valuations can be a ‘back of the envelope’ calculation or a formal opinion rendered by a third-party valuation expert. In all instances, even when using tried and tested methodologies, landing on an appropriate valuation requires a recipe of  ‘part science, part art.’

Most sellers seek an expert business valuation opinion. In some cases, that’s not necessary. You probably don’t need to know exactly how valuations are done, but having basic knowledge of different valuation approaches is important. It will help you determine the best path forward for you and your company.

We start by breaking down the three approaches to business valuation: the market approach, the income approach, and the asset approach.

The Market Approach to Business Valuation

The principle of substitution forms the foundation of the market approach to business valuations. It relies on the theory that the fair market value of a closely-held company can be estimated based on the prices investors are paying for the stocks of similar companies.

This estimation is based off ratios that relate the stock prices of such public companies to their earnings, cash flows, or other measures. The appraiser analyzes the financial statements of similar companies and compares their performances to the subject company. This allows them to judge what price ratios are appropriate for estimating the market value of the closely-held entity.

The market approach may be applied as a sanity check to values derived from other methodologies, such as the income approach. It also allows you to examine how the marketplace reacts to companies in the same or similar industry, based on varying levels and types of economic incomes. This helps to give a perspective on the types of buyers, demand, and rates of return for a given entity in a given industry.

The approach determines value using market multiples of either publicly-traded or privately-held companies. These multiples are ratios of specific financial metrics (e.g. share price/sales per share), which allow businesses to compare financial information across similar companies.

Business Valuation Methods Using the Market Approach

There are four primary business valuation methods applied under a market approach. Each comes with its own benefits.

The Guideline Company Method

This business valuation method uses financial and market information gleaned from publicly traded securities of other companies with similar business pursuits. It assumes that prevailing investor attitudes and expectations can be used to ascertain value for the subject company.

Differences in the comparable companies are noted, and adjustments are made to develop appropriate market multiples. These multiples are then applied to the subject company’s income and cash flow streams to develop value indications.

Guideline Merged & Acquired Company Method and the Transaction Database Method

These methods are different flavors of the guideline company approach. Instead of looking at investor sentiment regarding the future, analysts look at historical data. Market multiples from transactions involving privately-held companies in the same or similar industry are applied to the subject company’s level of economic income.

The Dividend-Paying Capacity Method

This method hones in on dividends and is perhaps best viewed as an extension of the methods discussed above. This typically involves extrapolating a company’s value from an analysis of the average dividend yields of five comparable companies.

This method does not seek to weigh the dividends a company has paid in the past. Instead, it looks at the ability of a company to pay dividends.

The Income Approach to Business Valuation

The income approach is based on the economic principle of expectation. In theory, enterprise value is derived from either historical earnings or future cash flows. This approach assumes that the value of the business is equal to the present value of its expected economic income. Expected returns are then discounted or capitalized at an appropriate rate of return to reflect investor risks and hazards.

Business Valuation Methods Using the Income Approach

The Capitalization of Excess Income Method

This method is also known as the Internal Revenue Service (IRS) Treasury Method. It assumes that the total value of a closely-held business is the sum of the net assets and the value of its intangible assets.

This is a hybrid approach methodology. It can be considered an asset method or an income method. It relies on the idea that a company’s value may be defined by both its adjusted book value and its earnings capacity. The value of the company’s intangible assets is determined by capitalizing the earnings of the business, which exceed a ‘reasonable’ return on the business’s net assets.

The Capitalized Economic Income Method

This method is widely used to value small- to medium-sized, closely-held businesses. Depending on the valuation’s purpose, you can also apply it to some larger entities.

The method assumes a company’s historical results are expected to continue into the future with a relatively stable growth rate.

Particularly in the case of a smaller, closely-held business, plans for expansion and growth either do not exist or are not formally documented. In these cases, the future mimics the past. Shareholder expectations are more focused on day-to-day operations and less on future financial performance or return on investment.

The Discounted Cash Flow Method (DCF)

This is also sometimes referred to as the Discounted Economic Income Method. It identifies the total value of a business as the present value of its anticipated future earnings. This includes the present value of a terminal value (when an indefinite stable growth rate is expected) in a specified period.

This method hinges on the time value of money. A dollar today is worth more than a dollar tomorrow because it can be invested. Forces such as inflation or interest rates may further impact that value.

The DCF Method looks to the present value of anticipated future cash flows and ‘discounts’ that value at a present worth factor. This is done to reflect the risk inherent in the investment. It is often used to value companies for sale and acquisition, and may also be applied when seeking a capital infusion.

The Method Determines the Purpose

A forward-looking valuation like the DCF Method is especially relevant when valuing a company that’s projected to experience significant growth or one with a finite life. This includes start-ups, companies anticipating growth based on a strategic plan, and businesses in a transitional phase.

In contrast, a historical performance analysis may be required for purposes of taxation. This may include consideration of estate and gift taxes. It may also be used for purposes of divorce or shareholder litigation.

The Capitalization of Excess Income Method typically assumes a controlling ownership if applied. Depending on the level of economic income, both the Capitalized Economic Income Method and the DCF Method can be used for either a minority/non-controlling or a majority/controlling equity interest.

The Asset Approach to Business Valuation

The asset approach may be applied when the benefits of operating a business do not outweigh the value that could be derived from the orderly liquidation of assets. Methods under this approach assume a controlling premise of value.

Financial analysts may assume that an investor would evaluate the company based on its earnings and cash-generating potential, and thus avoid adopting the asset approach. They may argue that underlying assets do not reflect the intangible value or economic obsolescence inherent in the company.

This does not mean an asset approach is necessarily wrong. Its applicability depends on your circumstances. You usually see it used when the level of ownership being valued is that of a controlling shareholder, as only a majority equity ownership (or a 50-plus-one vote) could dictate the company’s capital structure. This is crucial to the orderly liquidation of assets.

Business Valuation Methods Using the Asset Approach

Net Asset Value (NAV) Method

This method simply subtracts existing liabilities from the value of its assets. It is used most commonly for a controlling interest and when valuing securities of businesses involved in developing and selling real estate, investment holding companies, and certain natural resource companies.

The Adjusted Net Book Value Method

This method involves adjusting a company’s tangible assets and liabilities to their current fair market values. The value derived here represents the going concern value and assumes no expectation of intangible value or commercially transferable goodwill.

This method may also be applied when valuing an investment or real estate entity. It is also helpful when all business income is attributable to personal goodwill of the owner or key person, or when the value of the net tangible assets exceeds the company’s value as a going concern.

Knowledge Is Key in Business Valuations

A business valuation method using one or more of the three valuation approaches can help you confirm the integrity of the final value. The purpose of the business valuation ultimately determines the process and the best method to use.

Working with an expert is great, but it’s also not enough. When weighing up a valuation report, you should be knowledgeable enough to ask informed questions and ascertain meaningful information in return. Arming yourself with the proper knowledge might just help you avoid the sorts of humiliation JPMorgan suffered.

We think you’ll also like:

1. Determining Value — Choosing a Business Appraiser
2. How to Conduct Due Diligence Before Buying a Business
3. Beware Venture Capital Unicorns- Risks Look Greater than Potential Rewards

[Editors’ Note: To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can view at your leisure, and each includes a comprehensive customer PowerPoint about the topic):

1. Selecting the Right Valuation Expert
2. Opportunity Amidst Crisis- Buying Distressed Assets, Claims, and Securities for Fun & Profit
3. Real Estate Investing 101

This is an updated version of an article originally published in March 2015 and updated on March 22, 2023. This article was most recently updated by the Financial Poise Editors.]

©2025. DailyDAC^TM, LLC d/b/a/ Financial Poise^TM. This article is subject to the disclaimers found here.