Basic Business Valuation Approaches
There are three primary approaches to the financial valuation of businesses: the asset approach, the market approach and the income approach. Generally, the asset approach addresses a firm's balance sheet; the market approach compares the firm's historical financial performance to similar public, private, or acquired businesses; and the income approach identifies the present value of expected future cash flows.
Asset ApproachMarket Approach
Income Approach
Asset Approach
The Asset Approach involves identifying the significant assets of the business and estimating the individual fair market values of these assets. The price at which a business entity changes hands can be influenced by the values of the assets employed in the business, net of liabilities. In a favorable economic and industry environment, the “net asset value” is less important to overall value than the resulting earnings. Tangible assets are often perceived as providing a valuation “floor” when earnings are absent or have declined significantly. Most operating companies' tangible assets are primarily financial. Certain identified “excess assets” may be considered within the valuation approaches noted below. Typically, the tangible assets do not reflect the going-concern potential qualities of an operating company.Market Approach
The Public Company Method and the Recent Transaction Method are applications within the market approach.
In the Public Company Method, consideration is given to market price multiples derived from operating data of comparable or guideline publicly held companies. This method requires the identification of comparable or guideline companies, and analyses of operating data and rates of return and growth as experienced in this industry at the present and intermediate past. Market prices of the common shares of the guideline companies at the valuation date provide the basis for market price multiples which incorporate investor expectations of prospective growth and profitability. Selected multiples are applied to the target company operating data to arrive at indications of fair market value. Customarily in the application of market multiples, greater company size, greater anticipated growth, and lower risk imply higher multiples, while smaller size, lower growth, and higher risk imply lower multiples.
The Recent Transaction Method is based on actual prices paid for acquisitions of similar private or public companies. Ratios (market or valuation multiples) of total purchase price paid to earnings and sales are generally developed for each comparable transaction if the data are available. These multiples are then applied to the earnings and sales of the subject Company, if applicable.
Income Approach
The Income Approach to value calculates the present value of the future free cash flows expected to accrue to the owner of an asset during its remaining economic life.
The Debt-Free Discounted Cash Flow Method is an application within the income approach. Here, based on management’s forecast over a five-year period, future debt-free cash flows available for distribution and the terminal value (value of the target company at the end of the forecast period) are discounted to the present at an appropriate rate (generally the weighted average cost of capital) to derive an indication of fair market value on an enterprise basis. The value of total interest-bearing debt, if any, is then subtracted to derive an indication at the equity level.
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