Business valuation experts must undertake a series of preliminary steps to set the groundwork for determining the worth of a business. Once those steps are complete, valuators must consider three very distinct approaches to valuing a business.
In earlier postings, David Anderson, principal of David Anderson & Associates, a Philadelphia forensic accounting firm that provides a full range of business valuation and other forensic accounting services in Philadelphia and the Delaware Valley, explained the first three steps of the business valuation process — determining the standard of value, deciding on the premise of value and normalizing financial statements.
In this fourth installment in a series of articles on business valuation, Anderson reviews the three most commonly used approaches to valuing a business: the Income Approach, the Asset-based Approach and the Market Approach.
“Professional business valuators are required to consider all three approaches,” said Anderson, a business valuation expert in Philadelphia and the Delaware Valley. “In the end, a business valuation expert must use his or her judgment to determine the best approach or combination of approaches to arrive at a business valuation that is as fair and accurate as possible.”
The most common approaches a business valuation expert will consider are the three noted below:
Income Approach – Income Approach values a business by using one or more methods to convert anticipated economic benefits (earnings or cash flow) into a single present amount. There are two primary methods under this approach: Capitalization of Earnings/Cash Flows Method, which is used when there has been a steady level of historical growth, and the Discounted Earnings/Cash Flow Method, which is used when there have been fluctuations in historical growth and when the company can reasonably project earnings for the next five or more years.
Asset-based Approach – Asset-based Approach values a business by calculating the value of net assets, which is the difference between total assets and total liabilities. There also are two primary methods under this approach: the Book Value Method, which calculates the net asset value as shown on the books of the business – typically at historical cost, and the Adjusted Net Asset Method, which adjusts the value of assets and liabilities to the fair market value as of the valuation date.
Market Approach – Market Approach values a business by comparing it to sales of similar businesses. There are four primary methods under the Market Approach: analyze transactions of comparable publicly held companies; analyze transactions of comparable privately held companies; analyze prior transactions involving shares of the company itself, and lastly, analyze the ability of the company to pay shareholder dividends and compare that to dividends paid by comparable companies.
“The specific methods used depends on the facts and circumstances surrounding the business being valued,” Anderson said. “For example, if there are no comparable market transactions or an insufficient number to be meaningful, the Market Approach may not be useful.”
Once the value of the business has been set under each of the approaches, the business valuation expert must determine whether one of the values is the best representation of the true value of the business or if a weighted blend of the values provides a more accurate final business value, Anderson said.
Anderson gives the example of valuing a startup business with little profitability. The Income Approach might yield a very low value because the startup hasn’t had time to show historical growth, while the Market Approach might result in a considerably higher value based on the sale of comparable businesses.
“Under this scenario, some valuators would select the Market Approach as being most indicative of value and others might choose a blend of the Income Approach and Market Approach with a higher weight on the Market Approach,” Anderson explained. “It all comes down to the professional judgment of the business valuator, based on his or her experience and knowledge about the business being valued.”
At this point, the complex process of business valuation is nearing the end. But there is still one major step remaining before a final determination on the worth of a business can be made: consideration of certain adjustments for non-operating assets as well as control, marketability and other adjustments. Anderson will explore these adjustments in his next installment of “Understanding Business Valuation.”
If you require the services of a business valuation expert in Philadelphia or any other forensic accounting services in Philadelphia and the Delaware Valley, please contact the Philadelphia forensic accounting firm of David Anderson & Associates by calling David Anderson at 267-207-3597 or emailing him at firstname.lastname@example.org.
About David Anderson & Associates
David Anderson & Associates is a Philadelphia forensic accounting firm that provides a full range of forensic accounting services in Philadelphia and the Delaware Valley. The experienced professionals at David Anderson & Associates provide forensic accounting, business valuation, fraud investigation, litigation support, economic damage analysis, business consulting and outsourced CFO services. Company principal David Anderson has more than 30 years of experience in financial and operational leadership positions and is a Certified Public Accountant, a Certified Fraud Examiner, a Certified Valuation Analyst and a business valuation expert in Philadelphia.