Definition - What does Valuation Approach mean?
A valuation approach is the methodology used to determine the fair market value of a business.
The most common valuation approaches are:
- The Income Approach - quantifies the net present value of future benefits associated with ownership of the equity interest or asset. The estimated future benefits that accrue to the owner are discounted or capitalized at a rate appropriate for the risks associated with those future benefits. Common methods within the income approach include the capitalization of earnings (or cash flow) methodology and the discounted cash flow methodology.
- The Market Approach - determines fair market value by reviewing actual transactions of comparable companies and assets. Both M&A activity and stock market activity are considered in deriving various value measures to apply to the subject entity.
- The Asset-based Approach - uses the current value of a company’s tangible net assets as the key determinant of fair market value. This approach is typically used where a business is not a going concern, or where a business is a going concern but its value is tied directly to the liquidation value of its underlying tangible assets and investments. The asset-based approach also provides a useful reasonableness check when reviewing the value conclusions derived under the income or market approaches.
Divestopedia explains Valuation Approach
Some valuation approaches are more appropriate than others, depending on the circumstances. The market approach is the most commonly used by business owners to determine the fair market value of their business. This approach may be misleading because the comparables used may be public companies or other private transactions that have altogether different characteristics and may not relate at all. As well, the market approach isn't applicable in circumstances where the company is experiencing rapid growth. In this instance, the discounted cash flow approach would be more appropriate.
The valuation of a private company is a complicated process since it is "part art, part science." Our advice is for the seller to hire a business valuator with practical transactional experience or an M&A professional to provide either a full valuation or an indication of the company's value.