When valuing a business there are a few approaches or methods that could be taken. Let’s have a look at those approaches and in which circumstances they would be most appropriate.
There are generally three approaches: the market-, income- and cost approach.
Market approach
This method of business valuation applies certain valuation metrics of a business or businesses (benchmark information) to value another business. This method is normally preferred as the primary business valuation method where:
- the business being valued is a going concern and is expected to remain a going concern in the foreseeable future, and
- the current earnings can be regarded as sustainable, and
- there was a market transaction that had occurred a short period before the current valuation for the same business being valued; or
- accurate and timeous benchmark information is available; and
- the business being valued is identical or substantially similar than the business(es) on which the benchmark information is based.
This approach may often not be the best to use as a primary business valuation method as few businesses are identical or even substantially similar. It is, however, a particularly good sense check and as a minimum it is recommended that the benchmark information (such as earnings multiples) is used to assess the reasonableness of values calculated by following the Income approach.
Income approach
There are two methods than can generally be considered when following the Income approach: the Discounted Cash Flow method (“DCF”) and the Discounted Dividend Method (“DDM”).
The DCF business valuation method is based on the rationale that the enterprise value of a business equates the net present value of free cash flows over the long term. The free cash flows are discounted at the weighted average cost of capital (“WACC”), which is a weighted return expected by all providers of capital considering the risks and capital structure of the business over the forecast period.
A critical element required when using this method is the ability of the business to produce income and positive cash flows. The business being valued would also reasonable projections based on assumptions that can be realistically applied. The DCF method is typically applied where a majority stake is valued but it can also be used where a minority shareholding is valued and the DDM method is not feasible. The value derived should be compared to the values calculated using the market approach and cost approach (NAV) for reasonableness.
The DDM is based on the net present value of forecast dividends and perpetuity of dividend flows to the investor. The discount rate applied is based on the cost of equity (i.e. required return for investors). This method is most appropriate when a minority shareholding is valued. It is important that a sustainable and stable dividend stream is be expected. Normally the value from the DDM is compared to the equivalent value for a similar shareholding when applying both the DCF and NAV methods.
Cost approach
The Cost approach reflects the current cost to replace the assets and liabilities of a business. This cost should also be considered within the context of the circumstances of the business being valued and the fair value of the underlying assets and liabilities.
This approach is best used for entities with the predominant purpose of holding assets such as properties, investments or even subsidiaries in a group. It is also the most appropriate method where there is uncertainty whether the business being valued will continue to operate as a going concern, in which case the realisable values of assets and liabilities will need to be considered.
Finally, the cost approach is also a particularly important reasonableness check when assessing values derived from other valuations methods. This is because, if a business will be sold and the NAV yields the highest value, owners will mostly prefer to sell off the assets, settle the liabilities and distribute a final dividend. Think of it as the minimum value.
In summary, factors or circumstances to consider when choosing the most appropriate valuation approach are generally as follows:
- the type of organisation,
- whether or not it is a going concern,
- the existence of similar businesses or recent substantially similar market transactions,
- the expectation of sustainable earnings in the long-term,
- the portion of the shareholding is being valued,
- whether or not there is a stable dividend policy and,
- any other factors or circumstances which could materially affect the outcome of the valuation.
The simplified flowchart below can provide guidance on which approach to use in your business valuation:
