01Three families of approach
Almost every business valuation method falls into one of three families. The income approach values a business by reference to the earnings or cash it is expected to generate. The market approach values it by comparison with prices paid for similar businesses or shares. The asset approach builds value from the business's net assets.
None is universally correct. The right choice depends on what drives value in the particular business, the purpose of the valuation and the quality of the evidence available. Valuers often use more than one approach and reconcile the results.
02The income approach
Capitalised earnings: a measure of maintainable earnings, such as EBITDA, operating profit or post-tax profit, is multiplied by a figure that reflects risk and growth. It suits established, profitable businesses with a stable record.
Discounted cash flow (DCF): forecast cash flows are discounted to present value at a rate reflecting their risk, with a terminal value for the period beyond the forecast. DCF suits businesses whose future differs from their past, such as those growing quickly, investing heavily or recovering from losses, but it is only as reliable as the forecasts behind it.
Dividend-based methods value a holding by the income it is expected to receive and are sometimes used for small minority interests that have no influence over the business.
03The market approach
Comparable company analysis uses the pricing of listed companies in a similar line of business. Precedent transaction analysis uses prices paid in acquisitions of similar businesses. Both derive multiples, such as enterprise value to EBITDA, that can be applied to the business being valued.
The difficulty is comparability. Listed companies are usually far larger and more liquid than private businesses, and transaction prices may include synergies specific to the buyer. Market evidence is valuable as a cross-check and sometimes as a primary method, but it must be adjusted thoughtfully.
04The asset approach
Net asset value adds up the business's assets and deducts its liabilities, adjusting book values to current values where they differ. It is most relevant to property and investment companies, holding companies, businesses being wound up, and loss-making businesses whose earnings do not support a higher value.
For a profitable trading business, net assets usually understate value because they ignore goodwill and other intangible assets created by the business's earnings.
05Choosing and reconciling
In practice the choice is guided by a few questions.
- Is the business profitable, and are its profits likely to continue at a similar level?
- Are there reliable forecasts, and does the business's future differ from its past?
- Is there credible market evidence for similar businesses?
- Does value lie mainly in the trade or in the assets held?
- What does the purpose of the valuation, such as a tax rule or a contract, require?
This guide is general information, not advice on any particular situation. The correct approach to a valuation depends on its purpose, the basis of value and the facts.
