The value of a business is generally recognized to be the present value of the future benefits of ownership. This is a basic premise of business valuation. It is assumed an informed buyer will base an offer to purchase on what he believes the returns to be generated by the asset will amount to. These returns take the form of current yield and growth in value.

Conversely, it is assumed an informed seller will not sell a business for anything less than the present value of the future benefits. Consequently, in valuation theory (and generally proven in practice), businesses are sold and bought at a price which each party believes is fair to themselves.

This does not mean that the buyer and seller must, in their hearts, believe the price paid or received is fair to the other party. To the contrary, each party to the transaction generally wants the most value at the lowest cost or risk. This is what makes a market.

As mentioned above, a company’s value is based upon future benefits anticipated to be derived by the ownership. However, since many assumptions must be made in the valuation process, and no two companies are exactly alike, many factors are considered in the determination of the Fair Market Value of an entity. It is for this reason no set formula can be derived to determine the value of a business. However, the valuation community, along with the various professional business valuation organizations, recognizes there is a methodical approach to determining the Fair Market Value of a business.

The above use of the words “methodical” and “approach” is not random. Before a method (or multiple methods) of valuation can be applied to a company, one of the below three recognized approaches must first be determined:
Income Approach
Market Approach
Asset Approach

Income Approach
This approach determines value based upon future benefits accruing to the owners. Generally, future benefits are based upon historical or prospective data, subjected to adjustments to normalize actual or anticipated results. The result is then either discounted to a present value, or capitalized.

This concept assumes some normalized level of ongoing benefits can be determined based upon historical information.

Market Approach
This approach assumes value can be determined by analyzing recent sales of comparable assets or through development of valuation multiples of guideline or comparable companies. Consequently, if comparable market data are not available, this concept cannot be used.

The market concept is useful for valuation of public companies, and other large companies where comparable sales data are available.

Asset Approach
This approach assumes an asset value is indicated by the cost of replacing or reproducing it, less an allowance for physical deterioration and obsolescence. This approach is commonly used for assets not sold on an active market.

For businesses, this concept generally applies only to companies with little value beyond the value of their tangible assets.

Once the approach is selected for the valuation, a method, or methods applicable to the approach must be decided. This is where the valuator’s experience and judgment are of great importance. While there are several methods and iterations of those methods available under each approach, the most common are:

Income Approach
Discounted Future Returns
Capitalized Returns

Market Approach
Guideline Public Company Multiples
Guideline Company Transaction Multiples

Asset Approach
Underlying Assets Methods
Excess Earnings Method

Next month we will explain in detail the various methods used in business valuation and discuss which one is most appropriate for your or your client’s business.