An Arbitrator’s Overview of the Approaches to Value

When determining the value of a business interest the business valuator must consider each of the three valuation approaches: (i) asset-based approach; (ii) the income approach; and (iii) the market approach. Within each of these three approaches, there are several methods available to be considered based upon the facts and circumstances of the valuation assignment.

The asset-based approach is based upon the entity’s value of its underlying assets and is most suitable in situations where the entity has significant tangible assets, negligible intangible value and is not labor intensive. Although the asset approach can be used in almost any valuation, it is seldom used in the valuation of operating companies.

Two common methods under the asset approach are the net-asset-value method and the liquidation value method. Both methods begin with the assets and liabilities on the book basis balance sheet and are then restated to their fair market value.  When utilizing the net asset value method, the entity is assumed to continue to operate as a going concern. This method is most applicable when the entity has significant tangible assets, and where its products and services from labor add little or no added value. In contrast, the liquidation value method assumes that the entity is not a viable going concern. Thus, this method restates the entity’s balance sheet items to their net realizable values in a liquidation.

The income-based approach to business valuation embraces the premise of a forward-looking concept that calculates the value based upon the assumption that the entity’s value is comprised of the sum of its present values of expected future economic benefits. In adopting this approach, the business valuator initially projects the entity’s future expected economic benefits, and then must determine a discount rate applicable its level of risk.

Two often used methods under the income approach are the capitalized cash flow method and the discounted cash flow method. Whereas both methods discount a projected future economic benefit stream to a present value, the capitalized cash flow method requires a projection for only one future period while the discounted cash flow method necessitates a projection for two or more periods into the future.

The third approach to consider is the market approach which is based on the principle of substitution. This concept states that the economic value of something tends to be determined by the cost of acquiring an equally desirable substitute in an arm’s-length-transaction. Thus, the value of an entity can be determined by analyzing sales transactions of comparable companies that have taken place in either the public or private marketplace. 

Two widely use methods using the market approach are the guideline public company method and the guideline company transaction method. Applying the guideline public company method, the business valuator selects comparable companies in the marketplace of publicly traded companies. The guideline company transaction method is based upon transactions of appropriate comparable private entities utilizing data obtained from one or more published databases of transactions.

The business valuator should consider all three approaches when determining the value of an entity. For any of the approaches not utilized there should be an explanation provided as to why they were not appropriate for this specific valuation.