Business Valuation Approaches and Methodologies

If you are in the process of a business decision or transaction, you may be advised to seek professional services in the form of business valuation. Although this process can seem complicated or intimidating, understanding the approaches and methodologies that are likely to be used can provide you with a higher level of comfort with the business valuation process. There are three generally accepted approaches used in business valuation. Within each approach, there are generally accepted methodologies that appraisers may rely on as the basis for their valuation. By obtaining a greater understanding of the approaches and methodologies that are likely to be used, the business valuation process should become more exciting and less scary. Therefore, we have outlined all three valuation approaches as well as the standard methods used under each approach.‍

Income Approach

‍The income approach is a way of determining a value indication of a business, business ownership interest, security, or intangible asset using one or more methods that convert anticipated future economic benefits into a single present amount. The premise is that the value of the subject business/interest can be determined by looking at the expected future economic benefit that would accrue to the owner of the business/interest, discounted to present value using a discount rate that corresponds with the risk in achieving the expected economic benefit. Under the income approach, there are two generally accepted valuation methods, as follows.

Capitalization of Earnings Method

‍Under the capitalization of earnings method, a single period earnings stream that is representative of expected future maintainable earnings for the business is translated into value by capitalizing (dividing) the earnings stream by a discount rate adjusted for the expected long-term growth of the earnings stream.

The capitalization of earnings method is most appropriate for mature or slow-growing entities that have stable normalized historical earnings that can be used as a proxy for future expected earnings.

Discounted Cash Flow Method

‍Under the discounted cash flow method, cash flow is projected over a discrete projection period until the company’s earnings have stabilized. These cash flows are discounted to their present value using a discount rate commensurate with the risk of realizing the projected cash flows. In addition to the discrete projection period, consideration is given to the value created by all cash flows beyond the discrete period by estimating a terminal value, generally calculated by capitalizing the stabilized earning stream (as is performed within the capitalization of earnings method).

The discounted cash flow method is used when business operations are expected to change going forward, and it is necessary to capture the economic impact these changes are projected to have on the business’ cash flow.

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‍Market Approach

‍The market approach is a way of determining the value of a business, business ownership interest, security, or intangible asset regarding the prices paid at arms-length for similar businesses, business ownership interests, securities, or intangible assets. There are two primary methodologies under this approach.

Guideline Public Company Method

Under the guideline public company method, reference is made to the valuations of publicly traded companies that are comparable to the subject business you are valuing. From the implied value of the comparable publicly traded companies, multiples are derived based on each public company’s income statement and/or balance sheet. Typical multiples include revenue, EBIT, and EBITDA; however, various other financial metrics may be considered if they are relevant to the subject company’s industry.

Comparable Transaction Method

‍Under the comparable transaction method, reported financial information from consummated transactions are used to calculate valuation multiples, which are then applied to the subject business you are valuing. Like the guideline public company method, valuation multiples are derived based on each company’s reported financial metrics.

It is essential to consider that under the market approach, the concluded value is only as good as the underlying data being used. This consideration is vital in that to appropriately apply the market approach, you must not only have a statistically sufficient number of data points available to you (comparable publicly traded companies and/or comparable transactions), but you must also be able to understand the specific nuances associated with the data. For example, if you cannot know whether the reported deal price for a transaction excluded certain assets or included consideration for post-transaction synergies, it would be impossible to rely comfortably upon the underlying transaction.

Often within the healthcare industry there are both a limited number of comparable data points to review, and the available data is not in a format that would allow the user to understand the standard of value reported and/or any deal-specific nuances that would eliminate the comparability of the transaction to the subject business. For these reasons, the market approach is often shown but not relied upon within healthcare valuation assignments.

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‍Asset Approach

The asset approach is a way of determining a value indication of a business, business ownership interest, security, or intangible asset based on the value of the underlying asset(s). In business valuation, the asset-based approach may be analogous to the cost approach of other appraisal disciplines. It is also critical to consider that the asset approach should never be used as the sole valuation approach in the appraisal of a going-concern enterprise, as it will always result in the floor value of a business. As such, in order to conclude whether the asset approach also results in the highest and best use value of a business, it should be used in conjunction with the income and market approaches. Generally, the asset approach is most appropriate for asset holding companies or for distressed companies with marginal profitability.

However, in the healthcare industry, it is the most common approach for physician practices as it is typically for all earnings to be paid in the form of owner physician compensation. In this context, it is also paramount to consider the compensation for the practice physicians’ post-transaction in order to align the up-front purchase price based on the business valuation with the go-forward employment earnings (which should be supported by a separate compensation valuation). Under the asset approach, there is one primary method of valuation:

Adjusted Net Assets Method

Under the adjusted net assets method, all assets and liabilities of the business are restated to reflect their market values. The valuation must include both reported assets and liabilities (net working capital, fixed assets, other long-term assets, debt, and other long-term liabilities) and off-balance sheet assets and liabilities (intangible assets and off-balance sheet financing). Within a going-concern valuation, the adjusted net assets method concludes on the value of the assets and liabilities that will continue to be utilized in the ongoing operation of the subject business and does not contemplate their value in sale or liquidation.

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Key Takeaway

‍When considering the valuation of a business, the valuator must consider all three generally accepted valuation approaches in order to opine on the highest and best use value of the subject business or subject business interest. Further, when considering each of the three valuation approaches, the valuator must recognize the applicability of each approach and the underlying methodologies to the subject business or subject business interest. Without a full understanding of the technical theory behind each approach and the underlying methodologies, a valuator could easily derive a value opinion that is not supportable and/or provides a misrepresentation of value. Additionally, as a user of business valuation, the basic understanding of the approaches and methods will allow you to take a more significant role in the valuation process and have greater comfort in both the process and the outcome of the business valuation assignment.