Approaches in Business Valuations
Asset Based Approach:
The Asset-Based approach is often called the “Cost Approach” or the “Replacement Cost Approach”. In this approach, each component of the business is valued separately and the asset values are totalled. The Asset-Based Approach provides the valuer with the cost of duplicating or replacing the assets of the company and is based on the assumption that a prudent investor would pay no more for an asset than its replacement cost. The Asset-Based Approach can be a reliable method for valuing tangible assets; however, the Asset-Based Approach may not recognise the full earning power of the total business enterprise.
The income approach estimates the value of a business based on the anticipated risk and return inherent in the investment. When a buyer purchases a business, what is being bought is a stream of prospective economic income. Economic income can be defined as any cash flow or benefit accruing to a business enterprise in exchange for goods, services or capital. The forecasted economic benefit or cash flow is capitalised or discounted at an appropriate rate to determine the estimated value of the business. Time in business, asset utilisation, operating results and customer and supplier relationships all influence the amount of risk relative to a particular entity. Anticipated benefits are then converted to a value taking into consideration the expected growth, timing of benefits, risk profile and the time value of money. In determining the appropriate discount or capitalisation rates, the valuer should consider factors such as prevailing interest rates, expected rates of return required by investors on comparable investments and the specific risk characteristics of the subject business.
The use of comparable sales of similar sold businesses as a guide to business valuation is one of the most important techniques for valuing businesses. The purpose of the Market Approach is to compare the subject business with sales of similar businesses to estimate the value of the subject business relative to its peers. The timing of the sale, the size of the comparable business, industry and the structure of the transaction must be analysed and compared with the subject businesses financial data. The market approach emphasises the principle of substitution, which assumes that an investor would gravitate toward the business with the lowest price if all other financial fundamentals and risks were the same.