Business Valuations: 3 Approaches to Business Valuation

There are three Approaches that a business appraiser may use to valuate a business:

The Income Approach

The income approach is probably the most widely used approach in business valuation. In the income approach, the value of the business is based on the company’s earnings, or the future earnings that the business is expected to produce. The company’s earnings stream or future benefits is converted to a present value. This is done by either capitalizing the current benefits using an appropriate capitalization rate, or by discounting the future benefits using an appropriate discount rate. The capitalization of earnings method derives the company’s value by looking at a single period of normalized earnings stream. The discounted future earnings method is derived by looking at the company’s normalized earnings stream to be received over a number of years in the future. Using an income approach, there is a direct relationship between the amount of earnings or benefits the company will generate and its value.

The Market Approach

Using a market approach, the business is valued based upon reference to other transactions – in real estate referred to as comparable sales. Each of the following market approach methods uses the concepts of “multiples.”  Valuation multiples are the quickest way to value a company, and are useful in comparing similar companies. They attempt to capture many of a company’s operating and financial characteristics in a single number that can be multiplied by some financial metric to yield a value. A common multiple is Price-to-Earnings Ratio (P/E).

Publicly Traded Guideline Company Method: In this method of valuation the valuator finds comparable publicly traded companies. The valuator examines the multiples from the prices and financial data of the guideline companies and applies these multiples to the financial data of the business being appraised.

Comparative Transaction Method (Mergers and Acquisition Method): In this valuation method the appraiser finds companies that have been sold which are comparable. The valuator examines the multiples from the prices and financial data of such companies and applies these to the business being appraised.

Past Transactions Method: This method of valuation is often significant in divorce valuations because it uses any past transactions of the company’s own stock. Similarly, “buy-sell agreements” are often considered by the divorce courts in fixing the value of a business — especially when they are negotiated when a divorce is not contemplated.

The Asset Based Approach

Using an asset based approach, a business is valued on the basis of its assets and liabilities. Under this method of valuation, the company’s assets and liabilities are adjusted to their current fair market value. Under this method the valuator in a divorce valuation is generally valuing the business on the basis of a going concern value, meaning a business that will keep operating as opposed to closing down and liquidating assets. Occasionally, a business will be in the process of liquidation and, if so, the valuator will adjust the assets and liabilities to their fair market value (not as a going concern) but based upon the premise that the business will be liquidated.

The method of business valuation your valuator will use depends on the type of business, revenues, and type of tax and business structure. Business Valuations should be done if the spouses cannot agree on a value or if they are uncertain as to the value. Finding the right expert is important in preparing a business valuation. While it is common for one spouse to want the valuation and for the other to refuse, business valuation is money well spent because it can reduce divorce litigation fees and the total cost of a fully litigated divorce.