The International Valuation Standards (IVS) provide some very helpful guidance on the three key Valuation Approaches and the application of those approaches to the valuation of businesses and business interests.
Guidance is provided in both the specific Business Valuation and Business Interest asset standard IVS 200 and also in the general standard IVS 103, Valuation Approaches.
Market Approach
According to IVS 200, the Market Approach is frequently applied in the valuation of businesses and business interests.
Per IVS 103, the Market Approach indicates value by comparing the subject business with identical or similar businesses for which price information is available (IVS 103, para 20.01).
The appendix for IVS 103 sets out the two key Market Approach methods:
- Comparable Transaction Method (IVS 103, A10.01 to 10.08)
- Guideline Publicly-Traded Comparable Method (IVS 103, A10.09 to A10.14)
The appendix also provides the key steps for each method (A10.06 and A10.12):
- identify units and metrics of comparison
- identify relevant comparable transactions and guideline comparables and calculate valuation metrics
- perform a consistent quantitative and qualitative comparative analysis
- adjust for difference between subject and comparable
- apply adjusted valuation metric to subject
Where adjusted difference often relate to Discounts for Lack of Marketability, Control Premiums and blockage discounts.
Income Approach
Per IVS 200, the Income Approach is also frequently applied in the valuation of businesses and business interests (IVS 200, para 60.01
However, the Income Approach should be applied and afforded significant weight under the following circumstances (IVS 103 para 30.02):
1. the income-producing ability of the asset is the critical element affecting value from a participant’s perspective; and/or,
2. reasonable projections of the amount and timing of future income are available for the subject asset, but there are no relevant and reliable market comparables.
Methods under the Income Approach are effectively variations of the Discounted Cash Flow Method (DCF) (IVS 103, para A20.01).
Under the DCF method the expected future cash flows are discounted back to the Valuation Date, resulting in a present value for the business (IVS 103, para A20.02).
Discount rate and cash flows
Per IVS 103, the the common methods to establish the discount rate required under the DCF method include (IVS 103, para A 20.31):
- the Capital Asset Pricing Model
- the Weighted-Average-Cost-of-Capital
- inferred rates
- Build-up-Method
IVS 103 also provide guidance on the types of cash flow to consider, for example, free cash flow to firm v to equity, pre tax v post tax, and real v nominal (IVS 103, para A 20).
If a forecasted cash flow is expressed in nominal terms, a discount rate consistent with expectation of future price changes due to inflation or deflation should be used (IVS 200, para 60.09).
Cost Approach
According to IVS 200, the Cost Approach is rarely applicable in the valuation of businesses. However, the Cost Approach is sometimes used when (IVS 200, para 70.01):
- the business is in an early stage or start-up
- the business is an Investment or holding business
- the business does not represent a going concern
Per IVS 103, the three Cost Approach methods comprise of the:
- Replacement Cost Method, which replicates the utility of the asset (A30.02-A30.05)
- Reproduction Cost Method, which replicate the physical asset (A30.06-A30.07)
- Summation Method, which values each component of value (A30.08-A30.09)
IVS 103 provides guidance on other steps to consider when applying a Cost Approach, for example, including not only direct costs such as materials and labour but also indirect costs such as installation costs, professional fees, taxes, finance costs and profit margins.
Summary
If a business is generating cash flow then it seems that, per the Standards, the Income Approach may likely be an appropriate primary valuation approach. Further, as all Income Approaches are essentially variations of the Discounted Cash Flow Method (DCF), then the DCF Method may likely be an appropriate valuation method.
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About the Author
Simon specialises in wrestling with and attempting to pacify often complex valuation problems. He is a Business Valuation Specialist with Chartered Accountants Australia and New Zealand (CA ANZ). He chairs the CA ANZ Business Valuation group for Queensland, is a member of the CA ANZ Trans-Tasman Business Valuation Committee and likes running long distances.
