Question

Name three broad approaches to business valuation and provide pros and cons for each approach.

Answer 1

Following are approaches to business valuation:

i)The Assets Approach:

The value determined under the asset approach is the value of business's assets less any liablities.The assets and liablities of the business could be valued under a number of different methods(Fair value,Liquidation value etc) based on the purpose of the valuation.

Pros and Cons:

The main advantage of this approach is the simplicity of its application,since the calculation of values is relatively straight forward and does not require any significant forecasts of future business activity or estimation of discount or capitalization rate.However,the approach can require costly appraisals of business assets and ignores the current and future earning power of the company.

ii)The Income Approach:

Under this approach,the valuation is based on the economic benefit stream(net income or cash flows) produced by the business.This benefit stream is either capitalised or dicounted to a present value,and this amount becomes the foundation for the valuation of the company.Two common valuation methods under this approach is capitalization of earning method and the discounted cash flows method.

Pros and Cons:

The major advantage of this method is that it utilizes in the valuation calculation the benefit streams produced by an enterprise.Since a business's value is commonly considered to be the present value of its future earning or cash flows,these methods emphasize the elements that are generally valued by the investors in business.

Significant downside of this approach is the degree of estimation involved in the calculations.The forecasting of future benefits streams and determination of a capitalization or discount rate often involve a high degree of professional judgemnt,which can subject the valuation to debate from other parties.

iii)The Market Approach:

Under this method,data from sales transaction of comparable businesses are used to determine a reasonable valuation for a company.

Pros and Cons

The market approach is favourable since it is easy to apply and makes use of real world transactions to drive a value.However the major challange with this approach is finding suuficient private company market data to reach a valid valuation conclusion.