Approaches to Valuation
Valuation literature typically describes three approaches to valuation: market, income, and asset-based. Each of these approaches is defined below using language from the International Glossary of Business Valuation Terms.
The market approach is a general way of determining a value indication of a business, business ownership interest, security, or intangible asset by using one or more methods that compare the subject to similar businesses, business ownership interests, securities, or intangible assets that have been sold. The market approach may rely on comparisons to publicly traded stocks or to sales of similar companies.
The income approach is a general way of determining a value indication of a business, business ownership interest, security, or intangible asset using one or more methods that convert anticipated economic benefits into a present single amount. Examples include the capitalization of earnings method and the discounted cash flow method.
The asset-based approach is a general way of determining a value indication of a business, business ownership interest, or security using one or more methods based on the value of the assets net of liabilities. These assets may be valued using the cost approach, which quantifies the amount of money required to replace the future service capability of that asset. The asset-based approach is used in situations where a company relies heavily on its tangible assets, and the value of those assets may exceed the value of the business as a going-concern.
Appraisers are expected to consider all three approaches to valuation, but they are not required to use all three. The most appropriate approach depends on the nature of the interest to be valued. When valuing business interests on a going concern basis, appraisers are more likely to apply the income or market approach than the asset based approach. If sufficient data is available, appraisers may use more than one approach. Different approaches and methods tend to yield different values. Reconciling these differences is a matter of judgment, and when appraisers' judgments differ, it doesn't necessarily mean than one value is right and the other wrong.
Appraisers often apply methods that combine different approaches. For example, discounted cash flow analysis may convert future cash flows to present value (the income approach) but estimate a future terminal value based on a multiple of earnings (the market approach). Likewise, the appraiser may value equity based on a comparison to guideline public companies (the market approach) but allocate value between preferred and common shares using an option-pricing model (the income approach).