Business Valuation – It Involves Both Science AND Personal Judgement
Any business acquisition follows standard methods and associated applications to arrive at an estimated market value. These methods and applications, however, are often influenced by personal judgments that can vary when analyzing the current economic and industry-related environment.
In the context of business valuation, three approaches are used:
Income Approach: The concept of the income approach is to consider the future earnings and cash flow capacity of the business and to discount those future cash flows to a present value. The period used to determine discounted cash flow (DCF) is often 5 years. This discrete period cash flow is then discounted using an appropriate cost of capital. Added to this calculation is a terminal value which reflects the value of the business after the discrete forecast period.
Market Approach: This approach considers market price of either similar publicly traded companies or similarly acquired companies and apply that pricing to the subject company through the use of multiples (e.g. EBITDA).
Cost Approach: Here, the value of all of the underlying assets and liabilities of the business are considered. This approach is not typically used in the valuation of an operating business where it is often difficult to discretely value the various intangibles of the company.
The income and market approach – they are influenced by judgment
It is the income and market approach where areas of judgment play out resulting in differences of opinion among the parties involved.
Under the income approach, the discreet period forecast, cost of capital, and terminal value are all subject to personal judgment by the valuation practitioners.
In the market approach, “guideline” companies are identified that are most similar to the subject company and analyzed for financial measurements that would correspond to the business. The selection of the “guideline” companies is where judgments often vary.
The application of the income and market approaches is always going to be subject to practitioners’ personal judgments. Using multiple approaches is the only way to gain confidence in valuation conclusions. In the end, it is a process that involves both judgment and science.
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