Guide
The three business valuation approaches, and how to choose
Updated
There are three approaches to value and everything else is a method inside one of them. Getting that structure straight first makes the rest of the subject much smaller, because most of the disagreement people have about business valuation turns out to be disagreement about which approach applies.
Where the three come from
They are not a convention invented by advisers. The IRS Business Valuation Guidelines at IRM 4.48.4, which govern the IRS's own valuation personnel, identify the asset-based approach, the market approach and the income approach, and state that consideration should be given to all three.
That instruction is the useful part. Not that all three will produce a sensible answer for every business, but that a valuation which never looked at two of them has not explained why it did not.
Asset-based
It asks what the assets would fetch, less every liability. The work is restating a balance sheet from book values to current values, and the hardest half is the liability side: accrued leave, deferred revenue, lease obligations and warranty exposure are all real and several of them are not shown.
It is the right approach for a loss-making or asset-heavy business and for a wind-down. It is the wrong approach for a business whose value sits in customer relationships or contracted revenue, because a balance sheet has no line for either.
Market
It asks what buyers paid for businesses like this one. Two method families: completed private transactions, and guideline public companies.
The whole approach rests on comparability, and comparability is where it breaks. A multiple from a business ten times the size is not evidence about yours, because size itself carries a premium. And a multiple has to be applied to an earnings figure computed the way the comparable set computed theirs, or the numerator and denominator do not belong together, which is the most common error in amateur valuations.
Income
It asks what the future earnings are worth today. Capitalisation of earnings converts one sustainable figure at a single rate. Discounted cash flow projects the flows and discounts them.
It is the only approach that can value something whose worth is mostly ahead of it, which is why it leads for growth businesses and for fundraising. Its weakness is arithmetic honesty: the answer is very sensitive to the discount rate and the terminal growth rate, so a valuation using it without a sensitivity table has hidden its most important assumption.
Reconciling them
Two approaches that disagree by a third or more are giving you information. Usually it is a growth assumption the accounts do not support, or a comparable set that is not comparable.
The reconciliation is the part a reader who did not commission the report will look at hardest, and it is the part most often missing. Writing down why one approach was weighted above another is what turns three calculations into a valuation.