Business valuation methods fall into three broad approaches: income, market, and asset. Each asks a different question about value. The income approach asks what economic benefits the business is expected to produce. The market approach asks how comparable businesses or interests have been priced. The asset approach asks what remains after assets and liabilities are measured.
An approach is not selected because it is familiar or because it produces the most favorable result. Its usefulness depends on the purpose of the valuation, the standard of value, the characteristics of the company and ownership interest, the valuation date, and the evidence available. A supportable valuation considers the applicability of the relevant approaches and explains the relevance and reliability of the indications ultimately relied upon.
The income approach to business valuation methods
The income approach estimates value from the future economic benefits expected from the business or ownership interest. Those benefits may be measured as cash flow, earnings, or another economic stream that fits the assignment. Two methods commonly associated with the approach are capitalization methods and discounted cash flow.
A capitalization method converts a representative level of expected benefit into value using a capitalization rate. It may be informative when the company has stable operations and a sustainable level of earnings or cash flow. A discounted cash-flow method projects benefits over a defined period and discounts them to the valuation date. It can be useful when expected performance, capital needs, or growth are expected to change materially over time.
The approach depends on the quality of the underlying economic measure and the assumptions used to convert it into value. Historical results may need context when they include unusual items, owner-specific compensation, nonoperating activity, or conditions that are not expected to continue. The selected discount or capitalization rate is also consequential because it reflects the risk associated with the expected benefits and, for a capitalization method, the relationship between required return and expected long-term growth.
The market approach
The market approach estimates value by reference to pricing evidence from comparable companies, transactions, or ownership interests. Common methods include guideline public-company analysis, which examines market pricing of publicly traded companies, and guideline transaction analysis, which examines acquisitions or other transactions involving businesses.
Market evidence is most useful when the comparison is genuinely informative. Size, products or services, customers, geography, growth, profitability, capital structure, and risk can all affect whether another company is comparable. A transaction may also differ in ways that matter: a buyer may have paid for control, synergies, strategic assets, or terms not present in the subject interest.
A multiple derived from the market is therefore a starting point for analysis, not a substitute for judgment. The relationship between the selected companies or transactions and the subject business must be evaluated before their prices can inform an indication of value.
The asset approach
The asset approach estimates value from the assets of the business less its liabilities. Depending on the assignment, it may begin with the recorded balance sheet and adjust assets and liabilities to values appropriate to the valuation date and standard of value. It can also require separate attention to assets not fully reflected in the financial statements, such as identifiable intangible assets, nonoperating assets, or contingent obligations.
This approach may be particularly relevant for holding companies, investment entities, asset-intensive businesses, companies with limited earnings, or a business whose value is tied more closely to its underlying assets than to its ongoing operations. It may be less informative as a stand-alone measure for a profitable operating company whose value depends chiefly on expected future earnings and intangible business attributes.
The asset approach does not assume that book value equals fair value. Accounting amounts are prepared for financial reporting and may not reflect current values, unrecorded assets, or the economic effect of particular rights and obligations.
Choosing appropriate methods
The available approaches are considered in light of the valuation assignment rather than applied mechanically. The nature and history of the business, its expected performance, financial condition, industry conditions, ownership rights, and the evidence available as of the valuation date all affect which methods may be useful.
Where an income method is used, the selected discount or capitalization rate can materially affect the resulting indication of value; how to define discount rate in a business valuation sets out what that rate represents. For example, stable and predictable earnings may make a capitalization method informative, while reliable transactions involving comparable companies may support a market method. A company with substantial underlying assets and little operating income may warrant particular attention to the asset approach. The same business can present facts that make more than one of these observations relevant.
For a broader description of the circumstances in which an independent valuation may be needed, see our business valuation services. That page describes the firm's work; this page is limited to the methods used to develop and evaluate indications of value.
Reconciling indications of value
Different methods can produce different indications of value because they rely on different evidence and assumptions. That difference is not necessarily an error. One method may place greater weight on expected future performance, another on observed market pricing, and another on the current value of the company's assets and liabilities.
Reconciliation considers the methods that were applied, the quality of the supporting data, the comparability of market evidence, the reasonableness of the economic assumptions, and each method's fit with the subject interest and assignment. A valuation may give greater weight to one indication, or may use multiple indications to develop a conclusion. It should not average results merely because more than one method was used.
The facts considered in that judgment commonly include the company's history, financial condition, earning capacity, assets, industry conditions, and the characteristics of the ownership interest.
A related framework, Revenue Ruling 59-60, identifies factors to consider in valuing closely held stock for estate and gift tax purposes, including the nature and history of the business, financial condition, earning capacity, dividend-paying capacity, goodwill and other intangible value, prior sales of the interest, and market evidence from comparable companies.
