By Leslie Harrison
Delve into the strengths and limitations of valuation approaches and discover when to apply them effectively.
Various valuation approaches exist to estimate the value of an asset or business. Each of these approaches has its own strengths and weaknesses, and understanding when and how to apply them effectively produces a value that is defensible.
Exploring the valuation approaches
Valuation approaches can be broadly categorized into three main approaches: income, market, and cost approaches.
Income approach
The income approach pays particular attention on the earnings potential of the asset or business. The timing, steadiness, and duration of the earnings of the asset are important factors in estimating the value of that asset under this approach. This approach assumes that the value of an asset is solely derived from its ability to generate income over time.
The income approach is often used to measure the value of businesses, intangible assets, income producing instruments, and assets that are unique and/or that don’t have readily available data for comparable assets.
Several methods exist to estimate the value of an asset under the income approach, namely – in the case of valuing a business – the discounted cash flow method, the capitalization of earnings method, and the residual income method.
In general, the process of the income approach revolves around estimating the future earnings of the asset and calculating the present value of the asset through the discounting of those future earnings. The appropriate discount rate, or capitalization rate, applied to the earnings should reflect both the time value of money and the risk profile of the future earnings of the asset.
Market approach
The market approach, sometimes called the comparative approach, is the most straightforward valuation approach to understand. It involves comparing the subject asset or business to similar assets or businesses that have recently been sold or valued. This approach assumes that the market has already determined the value of identical or comparable assets, and, therefore, the information – generally, in the form of a market multiple or a capitalization rate – can be used to estimate the value of the subject asset.
The market approach is often the primary valuation approach to value assets when information for identical or comparable assets is readily available. For example, this approach is frequently used to value real estate assets using transaction details of recently acquired comparable real estate. Using the matrix pricing method, this approach is also aptly used in the valuation of debt securities, such as corporate bonds, sovereign debt, and municipal bonds. Lastly, practitioners often use the market approach as a secondary approach to qualify or support the value derived from other valuation approaches.
The process begins with the selection of a set of comparable assets or businesses along with their respective financial information, such as stock price, purchase price, revenue, and earnings. The selection of comparable assets or businesses should generally match the subject asset in terms size, industry, growth prospects, and other relevant factors. Multiples, such as EV/EBITDA or EV/Revenue, are calculated from the financial information of comparable businesses, and the calculated multiples are applied to the subject company’s respective financial information. While simple in application, there may be differences between the comparable assets and the subject asset and require adjustments to the financial data to account for the variations.
Cost approach
The cost approach, also called the asset-based approach, focuses on the value of individual assets and liabilities held by the company. At a high level, the cost approach estimates how much it would cost to acquire or construct a substitute asset of similar utility. This approach assumes that the value of an asset would not exceed the price that a market participant would pay to obtain a comparable asset.
The cost approach is typically used to value assets that can be easily replaced or reproduced, such as property, plant, and equipment. In other use cases, such as in valuing businesses, the cost approach can be used to determine the minimum price that an asset could command in the market.
The process of valuing an asset or business using the cost approach varies depending on the nature of the asset. Different types of assets may require different methods to be properly evaluated. For example, the replacement cost method tends to be used on plant, property, and equipment; the reconstruction cost method is usually considered for real estate property; and the liquidation value method is sometimes contemplated for companies that are in distress or are facing potential bankruptcy.
Every approach has its strengths and limitations
Given the focus on earnings and cash flows, the income approach is applicable to a wide range of assets and businesses. And since it takes into account the future potential of the asset or business, it is particularly suitable for businesses that expect material near term growth or decline, such as in the case of startups or mature companies in decline. However, since the income approach requires forecasting, it is inherently complex and is subject to numerous assumptions about the future performance of the company.
EXHIBIT
While the income approach may be complex and is based on a multitude of assumptions, the market approach is simple and is based on actual market transactions. From this vantage point, the market approach may be viewed as credible and reflective of current market sentiment. What is not in plain sight, however, is that the market approach is equally, if not more, susceptible to judgement. The market approach requires not only a careful selection of comparable assets or companies, but also adjustments to financial data to ensure comparability and accuracy. More crucially, the market approach is particularly sensitive to market sentiment, yielding high estimates of value during peak market conditions and low estimates of value during trough market conditions.
Lastly, the cost approach is typically considered the most conservative approach, often yielding the lowest value of the three approaches. The approach is also quite intuitive to understand. However, because the asset approach relies on the existence of assets for the calculation of a value, the approach is not well suited for asset-light businesses such as law firms and other service-based businesses.
When to apply each approach
The choice of which valuation approach to apply depends on various factors, since every asset and situation is unique. But here's a general guideline for when to apply each approach:
- Income approach. Apply this approach when valuing businesses with strong growth prospects or when you need to account for future earnings potential. It's also valuable for startups and companies with unique characteristics that make them difficult to compare to others.
- Market approach. Use this approach when you have access to a sufficient number of comparable assets or businesses with similar characteristics. It's most suitable for publicly traded companies or industries with well-established benchmarks. The market approach is often used as a sanity check in conjunction with other approaches.
- Cost approach. Choose this approach for asset-intensive businesses, such as manufacturing plants or real estate holdings. It's useful when the company's value is primarily derived from its tangible assets. Additionally, the asset-based approach may be used to determine the minimum value of an asset or business.
In practice, combining multiple valuation approaches and considering their results together can provide a more comprehensive picture of an asset's worth. For example, the cost approach could be used to provide a lower-bound value for the asset or business. In another case, the value from the market approach– if materially different from the other approaches – could be used to evaluate the differences driving the discrepancies in value between the competitors and the subject company.
Conclusion
Choosing which valuation approach to use involves understanding the strengths and limitations of income, market, and cost approaches. By carefully considering the nature of the asset or business and the purpose of the valuation, as well as seeking expert advice when necessary, you can choose the most appropriate approach that aligns with your specific circumstances.