It is widely accepted that business value is derived from the stream of discounted future benefits to the owners. The primary difference among the various valuation approaches is attributable to the method in which those benefits are estimated. Controversy exists among valuation practitioners and academics as to which methods are most appropriate, as evidenced by, among other things, the substantial amount of litigation and other legal proceedings surrounding valuation issues. The importance of developing reliable valuation estimates cannot be overstated, especially considering their impact on matters such as estate tax liability, business acquisitions, buy-sell agreements, and the division of assets in marital dissolutions. Research on the theory and application of valuation methods often yields mixed results, which only exacerbates the debate.
Business valuation theory recognizes three broad approaches to estimating value: the income approach, the asset-based approach, and the market approach. The income approach uses an entity's estimated future income stream as a basis for value. The asset-based approach focuses on determining an entity's collective asset values. The market approach can be thought of as a derivative of the other two approaches (the application of some market multiple of assets or income). Because the income and asset-based approaches each demonstrate comparative advantages and weaknesses, it follows that some form of hybrid technique that utilizes a combination of income and assetbased data may be generally superior as a valuation model.
The most common methods of estimating value have traditionally involved the discounting or capitalizing of an income stream. In the income approach, variables such as earnings or cash flows are utilized as a proxy for the expected benefits to the owners of the business. Common examples of valuation methods under the income approach are the earnings capitalization model and the discounted cash flows model.
The effective implementation of any model with an income approach requires a reasonable estimate of the expected future benefit stream as well as an appropriate rate at which to discount the benefit stream. In a discounting model, a projection of income is estimated for a finite period, followed by a terminal value calculation that assumes a constant income growth rate from that point into perpetuity. The income stream is converted to present value by applying an appropriate discount rate. In a capitalization model, a representative level of income is capitalized into perpetuity at a capitalization rate determined by the difference between the appropriate discount rate and a constant, sustainable level of growth (i.e., a price-to-earnings multiple). The primary difference between discounting and capitalizing is the level of discretion afforded in controlling the growth of the income stream. In any case, reasonable growth assumptions and an appropriate discount rate are imperative for effective valuation.
Asset-based methods typically involve restating both assets and liabilities to their current values to arrive at a net asset value. The restatement can be done on an individual component level (discrete valuation) or collectively (collective valuation). Given the relative difficulty of individually valuing a variety of assets, such as real estate, machinery and equipment, and inventory, it is often necessary to employ valuation specialists. Collective valuation requires a single analysis, which identifies the collective value of the assets and liabilities over and above their recorded GAAP value (i.e., a price-to-book multiple). Even with asset-based models, value remains a function of expected benefits to the owners. The value of assets is generally derived from either future income-generating potential or liquidation value, depending on the circumstances at a given time.
The income and asset-based approaches to valuation have relative strengths as well as obvious limitations. …