• Asset Approach
• Income Approach
• Market Approach

As an indicator of the total value of the entity, the net asset value method, using the book value has the disadvantage of only considering the status of the business at one point in time. Additionally, book value does not properly take into account the earning capacity of the business or any intangible assets that have no historical cost. In many respects, book value represents the minimum benchmark value of an operating business.

Income Approach
There are two general methodologies under the income approach - the discounted future returns methodology (the multi-period model) and the capitalized future returns methodology (the single-period model). The three key variables needed to apply each of the methods are (1) the amount of the future returns, (2) the Company's cost of capital in generating those returns and (3) the timing of the future returns.

In transactions pertaining to closely held businesses, buyers generally are most concerned with the company's ability to generate profits or future returns and the risks associated with the continuation of those profits. The theory behind this method of valuation is that the purchaser of a business interest expects to receive a stream of future earnings, or more specifically, the cash generated from these earnings, adjusted for the cash required to provide the working capital and capital expenditures needed for future operations.

The income approach estimates value based on the earnings capacity of the company. This approach evaluates the present worth of the future economic benefits that accrue to investors of the business. These benefits, future earnings or cash flows, are discounted to present value at a rate of return that is commensurate with the company's risk. This present value determines the value of the operating component business.

Market Approach
Lastly, the market approach compares the Companies to companies in the same or similar industry. The approach involves the gathering of information and valuation multiples, based on recent sales of comparable business and using this data to develop an industry multiple to utilize as a proxy in developing an indication of value for the Companies.

The Guideline Public Company Method, is based on the underlying premise that market transactions of publicly traded stock for companies similar to a subject company, provide empirical evidence of value.¹ The advantages to using public comparables as a benchmark for value are the available of information regarding operations, industry risk, anticipated growth and observable valuation measurements. Additionally, this method is strongly advocated in Revenue Ruling 59-60.

In applying the Guideline Public Company Method, the appraiser searches for potentially comparable companies and identifies similar companies to the subject company. Once potential comparables have been identified, they must be analyzed to determine if they have similar risk characteristics, line(s) of business, markets served, types of products, geographic territory served, size and comparability of financial history. ²

If a sufficient number of suitable companies are identified, those companies' financial history is analyzed to determine if any adjustments are necessary for differences from the subject company. Value multiples are computed for each comparable company. Based on the unique aspect of the subject company, the appraiser selects one or more multiples to apply to a base to arrive at an indication of value. Throughout this process, the appraiser must also consider the standard of value, the ownership characteristics, any going-concern issues and the type of company in arriving at a conclusion using this method. ³

Methodology based on private transactions is based on using transactions as an indication of the market multiples. There are a number of databases which track private transactions including Pratt's Stats, BIZCOMPS® and the Institute of Business Appraisers Transaction Database. The methodology is based on principle of substitution, that the value of a business is no more than the cost of acquiring an acceptable substitute.

The Private Transaction Methodology is similar to the Guideline Company Method, but with an important difference. In the guideline company method, several publicly traded companies (usually a very small number) are selected as being similar to the target business and then a value is developed for the company based upon the current stock prices of these publicly traded companies. Using Private Transactions, all transactions for which market data is available are considered as a statistical ensemble that defines the market for businesses of the same general type. Based on the financial analysis that is a part of the valuation process, the appraiser benchmarks the company compared to the market in evaluating the appropriateness of the methodology and then selecting and applying one or more multiples.

The challenge of using the market approach is to find comparable companies or transactions, similar enough to the business being valued to provide an indication of value. If a business has non-operating net assets, they are added to the values resulting from the income and market approaches.

Once indications of value have been derived from applicable methods, considering the foundational concepts regarding the economy and industry and the characteristics of the business, the values are then reconciled to arrive at a either a single value or range of values for the business interest. In this process it may be appropriate to apply discounts for marketability (illiquidity), minority interests (lack of control) or key person discounts. In some cases premiums may apply for control.

Contact Florida Business Valuation Group for more information.

¹ Pratt, Shannon, P., Business Valuation Body of Knowledge, Second Edition, John Wiley & Sons, 2003, pages 144-143.

² Pratt, Shannon, P., Business Valuation Body of Knowledge, Second Edition, John Wiley & Sons, 2003, page 144.

³ Pratt, Shannon, P., Robert F. Reilly and Robert P. Schweihs, Valuing a Business, Fourth Edition, McGraw Hill, 2000, pages 234-236.