3 Approaches to Business Valuation Methods

It’s surprisingly easy to get distracted by shiny, pretty things during business valuation proceedings. Even the “smartest people in the room” are vulnerable to such seductions. Just look at what happened at JPMorgan. 

The combination of student loan relief, a 28-year-old wunderkind, and a sparkling young company provided the ingredients for a concoction too powerful for even titans in finance to ignore. But sensational headlines about massive fraud soon overwhelmed any feelings of optimism. As the New York Times reported:

[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 offers just one example of the dangers involved in fuzzy valuations. The reality of a competent valuation involves a variety of challenges. It involves assets & collateral matters, value disputes across business entities, cash-flow streams, and stakeholder claims. Overcoming these challenges stands between a good and 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 professional business valuation expert. But even when utilizing sound financial and time-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. Although you probably don’t need to understand  “how the sausage is made,” basic knowledge of different valuation approaches will help you determine the best path forward for you and your company.

Market Approach Methods

The principle of substitution forms the foundation of the market approach to business valuations. It is predicated 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, publicly traded (or private) companies. 

This is done through ratios that relate the stock prices of such public companies to their earnings, cash flows, or other measures. By analyzing the financial statements of analogous companies and comparing their performances with those of a subject company, the appraiser can judge what price ratios are appropriate for estimating the market value of the closely-held entity. 

Market methodology may be applied as a sanity check to other derived values, such as those from an income approach methodology. It also allows you to examine how the marketplace reacts to companies within the same or similar industry as the subject company based on varying levels and types of economic incomes. For example, examining market multiples may give a perspective on the types of buyers, demand, and rates of return for a given entity in a given industry.

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

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. The premise of this data assumes that prevailing investor attitudes and expectations can be applied 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 can be 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 options 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 within the same or similar industry are applied to the subject company’s level of economic income.

The Dividend-Paying Capacity Method

Perhaps best viewed as an extension of the methods discussed above, the dividend-paying capacity method hones in on dividends. Typically this 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.

Income Approach Methods

The income approach is based on the economic principle of expectation. Theoretically, 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 the expected economic income generated. Expected returns on an investment are then discounted or capitalized at an appropriate rate of return to reflect investor risks and hazards. 

The Capitalization of Excess Income Method

Also known as the Internal Revenue Service (IRS) Treasury Method, this method starts from the assumption 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 business valuation 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. It 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 do not exist or are not formally documented. In these cases, the future mimics history. Shareholder expectations are less focused on future financial performance or return on investment than on day-to-day operations.

The Discounted Cash Flow Method

 Sometimes referred to as the Discounted Economic Income Method, the Discounted Cash Flow Method (DCF) 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. That means 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 method looks to the present value of anticipated future cash flows and “discounts” that value at a present worth factor that reflects the risk inherent in the investment. This method is often utilized when valuing companies for sale and acquisition. It may be applied when seeking a capital infusion, too. It is especially relevant when valuing a company projected to experience significant growth or one with a finite life.

Start-ups, companies anticipating growth based on a strategic plan, and businesses in a transitional phase may all warrant a forward-looking valuation analysis. Conversely, 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. 

Asset Approach Methods

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

Financial analysts who buck the asset approach to business valuation assume that an investor would evaluate the company based on its earnings and cash-generating potential. Underlying assets, they argue, would not reflect the intangible value or economic obsolescence inherent in the company.

This does not mean the approach is necessarily wrong. Its applicability depends on your circumstances. You usually see its application 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.

Net Asset Value Method

The Net Asset Value (NAV) Method subtracts existing liabilities from the value of its assets. This simplistic approach 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 final method involves adjusting a company’s tangible assets and liabilities to their current fair market values. The value derived from this method represents the going concern value and assumes no expectation of intangible value or commercially transferable goodwill.

The Adjusted Net Book Value Method also may be applied in other situations. It can be especially useful when valuing an investment or real estate entity. It is similarly helpful if all business income is attributable to personal goodwill of the owner or key person, or when the value of the net tangible assets exceeds that of the company’s value as a going concern.

Valuation Purpose Determines Valuation Method

Utilizing business valuation methods under one or more of the three valuation approaches helps  confirm the integrity of the final value. The purpose of the business valuation ultimately determines the process and the methodology applied. 

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

Business valuation is a complex endeavor. While this article gives you a solid starting point, you can enhance your education on the subject through our on-demand Valuation webinar series. It covers topics like:

• Valuing Lost Profits for Litigation Purposes
• Selecting the Right Valuation Expert
• Valuing Your “Brand” and Other Soft Assets

For more information about our other on-demand webinar series, click here.

This is an updated version of an article published in March 2015. ©2023. DailyDACTM, LLC d/b/a/ Financial PoiseTM. This article is subject to the disclaimers found here.