Business Appraisal Approaches

Asset Approach

The Asset Approach assumes that an asset’s value can be determined by the cost of reproducing or replacing it, less an allowance for physical deterioration or obsolescence. The asset values can also be determined by the price that the same or similar assets, with similar age and condition, have recently sold for on the open market. In general, this approach applies to companies with little value beyond the value of their tangible assets. It is also used when valuing the subject’s tangible assets when a company is converted from a C Corp to an S Corp, and when valuing individual components of a business for certain purposes, such as financial reporting.

Market Approach

The Market Approach for business valuations assumes that value can be estimated by analyzing recent sales of reasonably comparable businesses. Pricing multiples for the subject are determined from the pricing multiples of businesses sold that are in the same or similar industry as the subject. Typical pricing multiples are Price/SDE, Price/Revenue and Price/EBITDA. Many inexperienced and even experienced business appraisers misuse this data. They do not realize that all multiples are not relevant as calculated. The Price/SDE is relevant as SDE is the only parameter used to determine the subject’s value. The Price/Revenue multiple is obviously not relevant unless the comparable companies and the subject have the same profitability, which is not usually the case. A similar situation is true for Price/EBITDA multiples.

In other words, The Price/Revenue multiple will value a high profitability company the same as a low profitability company, if they both have the same revenue. The Price/EBITDA multiple has a similar problem. EBITDA can be written as SDE – Owner’s Compensation. In M&A transactions, which are priced based on EBITDA, a key factor is “carefully normalizing Owner Compensation”. In most comparables sold databases used by business appraisers for business under $10,000,000 or so, it can easily be shown that Owner Compensation is not normalized. Therefore, the Price/EBITDA multiple as written is not relevant. In fact, if the correct pricing equations are used for Price/Revenue and Price/EBITDA, all three multiples will give the same value indication. This means that only one pricing multiple is required for each database used. Appraisers of larger companies can also use the guideline public company method, which is in general, not applicable to smaller private companies.

The Income Approach

This approach is the closest to the basic valuation principle, i.e., “The Value of a business is equal to the present value of the future benefits of ownership”. The term income does not refer to income in the accounting sense, but to future benefits accruing to the owner. Under the income approach, the appraiser forecasts future owner benefits, e.g., net cash flow to equity, and discounts those benefits to present value using a discount rate suitable for the risks associated with realizing those benefits. A shortcut method under the income approach is to capitalize a normalized level of ongoing benefits, assuming that future growth will be stable in the full period immediately following the effective valuation date and into the future.

Under Each Appraisal Approach there are two or more potential methods

  • The Primary Methods under the Income Approach include:
    • Discounted Net Cash Flow
    • Capitalization of Net Cash Flow
  • The Primary Methods under the Market Method include:
    • Price/Seller’s Discretionary Earnings (Price/SDE)
    • Guideline Public Company Method
  • The Primary Methods under the Asset Approach include:
    • Net Asset Value Method – The value of all assets, including intangible assets are appraised to determine the total value of tangible and intangible assets.
    • Liquidation Value – The value of all tangible assets are determined in an orderly (assets sold over a reasonable time to maximize proceeds) or forced liquidation (assets sold as quickly as possible, such as at an auction).