Business valuation approaches: strengths and weaknesses
Ask any professional business appraiser about the choice of valuation methods and you will hear that there are quite a few. By convention, the methods fall under three major categories, known as approaches. And you have three of those: market, asset, and income.
No one approach to business valuation is bullet proof. If you choose just one method or approach, you may face criticism from a discriminating reader.
Challenges with the market approach
Business people tend to pick the market approach as their first choice. It is simple and direct, easy to explain and implement. All you have to do is compare your company to a number of similar firms that have sold recently. The selling prices, when related to the companies’ financial performance, give you a way to measure the business value, provided it is similar enough.
But here is the rub. The similarity of businesses is more often imagined than real. No two companies are exactly the same. Plus business conditions change, sometimes rapidly, affecting what a given business is worth on the market. No two parties to a business sale are ever the theoretical willing buyer and seller. There are always special circumstances that make each deal unique.
So if you use market approach methods to value a company, be prepared to handle objections that comparisons may be misleading.
Asset approach gotchas
The asset approach relies on the assumption that business assets do not become obsolete too quickly and that their condition and fitness for service can be reliably established. But consider the fact that a set of business assets on hand is not something you would want to invest in for the future. Perhaps the company needs to upgrade its aging asset base to pursue future opportunities. Thus the business assets may not represent what the business is worth going forward.
Handling income based valuation
Methods under the income approach let you focus on valuation from an investment perspective. The advantage is that you focus on the actual company being valued, not other firms or a set of assets. The idea is that business value is revealed by the company’s ability to generate earnings at an acceptable level of risk. In this sense, the income valuation methods help you focus on the essential reason to be investing in any business.
The downside is that you need to come up with reliable representation of business earnings and risk assessment for the future. Since no one has the crystal ball, any prediction of future earnings can be off the mark. So while the income approach framework is powerful and elegant, the actual results you get in your valuation are as good as your assumptions.
In summary, any business valuation is an expression of opinion. If you trust your analysis, then you can rely on the answer. If you have doubts, it is time to review your assumptions and revise your business valuation.
Business valuation – three approaches
Using more than one approach in your business valuation is best. Various methods let you assess business value from different perspectives. The result is a well rounded conclusion that stands up to the most exacting scrutiny.