There are several analytical methods commonly used in valuation. The financial theories behind these methods were developed over several years of research and enhancement by the biggest names in finance and financial economics. Valuation, however, is an art and not a science. These methods are only a framework, and inputs into these frameworks are critical assumptions that can affect concluded value greatly. Because of the significance of inputs to the valuation process, it is critical that the inputs reflect reality. Understanding the industry and its minutiae can only come with years of experience in the industry.
The three generally accepted primary techniques used to determine the fair value of a business or business interest are the Market Approach, Income Approach, and the Cost Approach.
The Market Approach is based upon the principles of competition and equilibrium. Competition among buyers and sellers in the marketplace often results in equilibrium prices for various assets. Based on the prices established for competing investments, a value for the subject investment can be developed. In business valuation, the Market Approach can be based upon pricing information in the public securities market (guideline company method) or in the mergers and acquisitions market (guideline transaction method).
The Income Approach equates the value of any asset with the total present value of anticipated future income from that asset. The discounted cash flow method typically utilizes the cash flow measure free cash flow to the firm, and discounts back future operating earnings at a market derived discount rate. The discounted economic profit method takes a different approach to measuring profit than the DCF method. To value profit, takes the net operating profit less adjusted taxes (NOPLAT) and subtracts required return in dollars for the period (or the invested capital X WACC). If used correctly, the value indications of the discounted economic profit method and the DCF method will yield the same results. The direct capitalization approach (usually used in real estate valuation) typically utilizes the cash flow measure net operating income, and capitalizes this measure by a market derived cap rate. Finally, an LBO analysis is a discounted cash flow analysis that takes into consideration the debt used to finance a transaction.
The Cost Approach is based upon the principle of substitution. This principle states that an investor will pay no more for an asset or investment than the cost of obtaining another asset of similar utility. Under the Cost Approach, the value of a Reporting Unit is equal to the aggregate value of the financial, tangible, and intangible assets comprising the unit. Within the cost approach the analyses depends on the purpose of the valuation. In a liquidation analysis, the analyst will use liquidation values of balance sheet assets. Under a going concern analysis, the fair market value of the asset will be used. However, in the context of appraising a going concern, the Cost Approach is seldom used because of the difficulties in estimating the intangible asset values as a separate element.