Three Approaches Used in Calculating a Business Valuation

Business valuation software

There are several reasons you could be considering a business appraisal valuation. Small business valuations determine the amount you can get when you sell you business. The valuation of a business is the greatest determining factor behind the price tag you are subject to when you are acquiring an established business. A business valuation puts a price tag on equity you gain when you are investing in a business or and the amount of capital you can raise in exchange for equity in your business you own.

However, business valuations use a large number of assumptions and calculations according to the purpose the valuation serves; they are not a hard and fast science. The exact same business could be sliced and diced several different ways, and several different (accurate and appropriate) valuations can be determined, depending on the information being drawn from the valuation. One of the initial factors that determines the valuation of a business is the valuation approach used. Essentially, there are three main categories of business valuation approaches, each approach uses a different set of factors in determining a business’s value and answers a different question. Each valuation approach is an umbrella category for a different set of valuation methods, and — you guessed it — each method also creates its unique valuation. People dedicate entire careers to the subject of business valuations, and it is impossible to cover everything here, but we have provided a basic overview of the three valuation approaches and when you would use each in order to calculate the value of a business:

  • Valuation Income Approach

    The valuation income approach is based on earning power of the business. You most commonly use the valuation income approach when you are selling a viable business that will remain in operation by the next owners, or gathering investments for a business that is achieving the revenue goals set for it. Basically, the calculation uses the power of the business has to draw money in, rather than just the assets that the business owns or the earning power of comparable businesses.

    The valuation income approach uses income statements and cash flow reports to create a valuation. In order for it to be successful, the correct discount rates capitalization rates and valuation multiples must be used. Valuation methods that fall under the valuation income approach include:

    • Discounted cash flow method
    • Capitalization of earnings method
    • Multiple of discretionary earnings method
  • Valuation Market Approach
    The valuation market approach compares similar businesses in the sales that they make. The valuation market approach is used to determine the health and worthiness of a business based on the industry it is in, as the earnings and value of other similar businesses can be a good indication of the future earnings of the business. This is commonly used to determine the value of new businesses that do not have established cash flow reports and income statements. Of course, in order for it to be successful, the nature of the business has to be something that closely resembles other businesses with established value.

    The factors used in the valuation market approach include the revenue or profits of the business and comparable market calculations. Methods under this umbrella approach include:

    • The comparative transaction method
    • The guideline publicly traded company method
  • The Valuation Asset Approach

    The valuation asset approach is based on the idea that the value of the business is tied to the value of the assets the business owns, less its liabilities. This approach is generally used when the business is being liquidated, and the assets are being converted to cash to pay off debtors, rather then any earning potential the business has going forward.

    You might be wondering how the value of assets are determined, since it is the skeleton of this approach. The valuation asset approach is based on the fair market value of the assets, which is a set of calculations in and of itself. Valuation methods that fall under this umbrella approach are:

    • The asset accumulation method
    • The capitalized excess earnings method

Those are the three umbrella valuation approaches and their appropriate uses. In some cases, business appraisal services will evaluate a business by more than one approach and then use a weighted average to determine the final number. Understanding the difference helps you understand the meaning of the valuation itself.