BUSI 534 Week 3 Valuation Approach Paper Example

Three Roads to One Value: Comparing the Income, Market and Asset Approaches to Business Valuation

Valuation Approach Paper

Any business can be valued in three ways. An appraiser can estimate the cash the business will produce and discount it to the present, find out what investors have paid for similar businesses or their shares, or add up what the business's assets are worth and subtract what it owes. Hitchner (2017) calls these the income, market and asset approaches, and professional standards expect an appraiser to consider all three before relying on one or more. The three approaches rarely give the same answer, and the differences between them are not errors to be averaged away but information about the business. They reveal what each approach assumes about the business. This paper compares the approaches, examines what research shows about their accuracy, explains how appraisers reconcile them and considers what Scripture says about the task of setting a price.

Standards and Premises That Frame the Choice

The choice of approach starts before any number is calculated. Hitchner (2017) explains that the standard of value, such as fair market value, investment value or fair value, defines whose price is being estimated, and the premise of value, going concern or liquidation, defines what is being sold. Fair market value imagines a sale between an informed buyer and an informed seller, neither under any compulsion, so it points toward evidence of what buyers in general would pay. Investment value is the value to a particular buyer and may rest on that buyer's synergies. A going-concern premise favors the income and market approaches, which value the business as an operating whole, while a liquidation premise points to the asset approach.

The Income Approach

The income approach values a business by the economic benefits it is expected to produce. Its two main methods are the discounted cash flow method, which forecasts cash flows for several years and adds a terminal value, and the capitalized cash flow method, which divides a single normalized cash flow by a capitalization rate equal to the discount rate less long-term growth (Hitchner, 2017). The approach is grounded directly in finance theory: a business is worth the present value of what it will pay its owners.

Its strength is that it can capture what is unique about a business, its growth plans, its margins and its risks, rather than assuming it resembles other companies. Its weakness is that it depends on forecasts and on a discount rate, both of which require judgment and both of which can be shaded toward a desired result. The research is more encouraging than that weakness suggests. Kaplan and Ruback (1995) compared the values implied by the cash flow forecasts behind 51 large debt-financed buyouts and recapitalizations with the prices actually paid and found that the discounted forecasts came within 10 percent of the transaction values on average. Their discounted forecasts also did no worse than pricing the same deals off comparable companies or comparable transactions. When the forecasts are made carefully by people with money at stake, the income approach can be remarkably accurate.

For a private company, much of the work in the income approach happens before any forecast is made. Hitchner (2017) describes normalization adjustments that remove items a buyer would not expect to continue: owner compensation above or below market rates, one-time legal settlements, rent paid to an owner's related company at a non-market rate and personal expenses run through the business. An appraiser who skips this step may discount the wrong cash flow precisely. Normalization also links the income approach to the standard of value, because a hypothetical buyer would pay for the earnings the business can sustain under typical management, not for the earnings shaped by the current owner's preferences.

The Market Approach

The market approach values a business by reference to prices paid for comparable businesses or their shares. The guideline public company method applies multiples, such as price to earnings or the ratio of invested capital to EBITDA, observed for similar public companies; the guideline transaction method applies multiples from sales of entire companies (Hitchner, 2017). Its appeal is that it rests on actual prices, which courts and clients often find more persuasive than a model.

Its accuracy depends almost entirely on the choice of comparables and of the value driver. Liu et al. (2002) examined a long list of multiples for U.S. public companies and found that multiples based on forward earnings priced stocks remarkably well, with errors within 15 percent of price for about half of their sample, followed by historical earnings, then cash flow and book value, with sales performing worst. Alford (1992) studied how comparable firms should be chosen for price-to-earnings valuation and found that selecting companies from the same industry produced reasonably accurate valuations, about as accurate as selecting them by risk and earnings growth, while choosing by size alone was less effective. For a small private company, however, the market approach faces a practical obstacle: truly comparable public companies may not exist, and private transaction databases often report only a few multiples with little detail about the terms of each sale.

The Asset Approach

The asset approach values a business by restating its assets and liabilities to market value. Its main method, the adjusted net asset method, adjusts each balance sheet item from book value to fair market value, including intangible assets not recorded on the books (Hitchner, 2017). For most operating companies, the asset approach sets a floor rather than a value, because a profitable business is usually worth more than its separate assets. It becomes the primary approach for holding companies, real estate and investment entities, asset-intensive businesses with low returns and companies facing liquidation.

Research shows that asset values matter even for going concerns. Berger et al. (1996) tested whether investors value a firm's option to abandon its business and sell its assets. They found that, after controlling for expected cash flows from operations, firm value increased with the exit value of the assets, and more so when the assets could be used by other businesses. The asset approach therefore measures something real: the value of an exit that the owners could choose if operations disappointed.

Levels of Value Produced by Each Approach

Comparing the approaches requires attention to what level of value each one produces, a subject Hitchner (2017) treats with discounts and premiums. The guideline public company method starts from prices of small blocks of freely traded shares, so it produces a marketable minority value. The guideline transaction method starts from prices paid for whole companies, so it produces a control value, often including synergies a particular buyer expected. The income approach can produce either level, depending on the cash flows used: cash flows adjusted for the excess compensation or perquisites a controlling owner could eliminate yield a control value, while cash flows as the business is currently run yield a minority value.

These differences mean that the results of the approaches cannot be compared until they are brought to the same level. A minority interest in a private company valued by the transaction method would need a discount for lack of control, and one valued by the guideline public company method would need a discount for lack of marketability. Many disputes between appraisers turn out to be disputes about levels of value rather than about the business itself. Hitchner also cautions that control premiums observed in acquisitions often reflect synergies specific to the buyer, which belong to investment value, not to fair market value, so a control value drawn from transactions may need adjustment before it fits a fair market value assignment.

Comparing the Approaches

The approaches differ in what they assume about the future. The income approach makes those assumptions explicit, the market approach borrows them from the market's pricing of other companies, and the asset approach largely avoids them by focusing on what exists today.

Reconciling the Approaches

Hitchner (2017) cautions that the final value should come from a reasoned reconciliation, not a mechanical average of the results. Two composite companies show why. A software company with recurring subscription revenue, rapid growth and few physical assets would be valued mainly by the income approach, supported by a market approach if growth-adjusted multiples of similar companies were available; its adjusted net assets would understate its value badly. An equipment rental company with a large fleet and thin, cyclical earnings might show an income value close to or even below its adjusted net asset value. In that case the asset approach would carry heavy weight, since a buyer could sell the fleet if the business remained unprofitable, which is exactly the abandonment option that Berger et al. (1996) found investors value.

Large differences between approaches should prompt investigation. If the income approach gives a value far above the market approach, the forecast may be too optimistic or the comparables may not be comparable. The appraiser should explain the weight given to each result in words a reader can follow.

A Biblical Perspective on Valuation

Scripture contains a striking example of an income approach. In the law of the jubilee, land in Israel returned to its family every fiftieth year, so a sale of land was really a sale of its harvests until the jubilee. The buyer was to pay according to the number of years remaining: more if many years remained, less if few, "for it is the number of the crops that he is selling to you" (English Standard Version Bible, 2001/2016, Leviticus 25:16). The price was to reflect the stream of benefits the buyer would receive, which is the principle of the income approach. The same passage commands, "You shall not wrong one another" (Leviticus 25:17), placing the calculation inside a moral obligation of fairness.

Proverbs 20:14 observes the buyer who says the goods are bad and then boasts of the bargain afterward. Market prices are formed by people with interests, and an appraiser using the market approach must remember that a reported price may reflect bargaining skill, pressure or special motives rather than value. For a Christian appraiser, the three approaches are tools for telling the truth about value, and their reconciliation is an exercise of honest judgment for which the appraiser is accountable.

Conclusion

The income, market and asset approaches answer the same question from three directions. The income approach is the most complete in theory and, when forecasts are made carefully, surprisingly accurate in practice. The market approach brings the discipline of real prices but is only as good as its comparables. The asset approach sets a floor and becomes decisive when value lies in assets rather than earnings. A sound valuation considers all three, explains why it relies on some more than others and arrives at a value that a fair-minded buyer and seller could both accept.

References

Alford, A. W. (1992). The effect of the set of comparable firms on the accuracy of the price-earnings valuation method. Journal of Accounting Research, 30(1), 94-108. https://doi.org/10.2307/2491093

Berger, P. G., Ofek, E., & Swary, I. (1996). Investor valuation of the abandonment option. Journal of Financial Economics, 42(2), 259-287. https://doi.org/10.1016/0304-405X(96)00877-X

English Standard Version Bible. (2016). Crossway. (Original work published 2001)

Hitchner, J. R. (Ed.). (2017). Financial valuation: Applications and models (4th ed.). Wiley.

Kaplan, S. N., & Ruback, R. S. (1995). The valuation of cash flow forecasts: An empirical analysis. The Journal of Finance, 50(4), 1059-1093. https://doi.org/10.1111/j.1540-6261.1995.tb04050.x

Liu, J., Nissim, D., & Thomas, J. (2002). Equity valuation using multiples. Journal of Accounting Research, 40(1), 135-172. https://doi.org/10.1111/1475-679X.00042