Valuation methods can be classified into several categories, each of which can be used to calculate a fair and defensible value for a business or its assets. The first step in determining the value of a business or its assets is to determine the best method of valuing the business or assets.
Types Of Valuation Methods
Market, cost, and income valuation methods are the three main types of valuation methods that are commonly used to determine the economic value of businesses; each method has its own set of advantages and disadvantages. In the following sections, we'll go over each of these valuation methods, as well as the situations in which they're most appropriate. We will also look at examples from the power industry to demonstrate how each method could be applied to the valuation of a specific type of business asset in the future.
Market Valuation Methods
When it comes to determining the value of a company, there are essentially two market approaches.
The first method is based on identifying comparable companies, analyzing price/earnings ratios and other value indicators, establishing an average, and then applying that average to the subject corporation. This is, without a doubt, a very imprecise method of determining a company's worth, due in part to the fact that markets can under- or overvalue a company. Furthermore, it is difficult to determine how much of the difference in multiples among similar companies is due to factors unique to each individual company.
The second market valuation approach is similar to the use of comparable real estate sales in determining market value. This approach is based on a sales analysis of similar properties, and it determines the full cash value of a property by analyzing recent sales or offering prices of similar businesses. It is necessary to adjust the selling price of comparable property if similar transactions are not identical to the subject business in order to account for the differences between them and the subject business.
Market valuation can be used to determine the value of a power generation plant in our hypothetical situation. In some cases, taking a market approach may entail looking at a recently constructed plant in the same market rather than looking for transactions, which are likely to be few and far between in the first place. Alternatively, if there are no comparable assets available on the market, a plant that is currently under construction or that has been approved for construction could be used as a point of comparison.
There are several disadvantages to taking a market-oriented approach. There are many situations in which the market is not active enough to provide sales data on comparable properties, and there are many situations in which there are no credible sources that can provide independent verification of value. A thorough analysis of similar transactions for the valuation of large, complex, income-producing properties is complicated because not only are there fewer of these transactions, but information related to the economic factors that influenced the decisions of buyers in those transactions is not available through public records. Intangible assets such as trademarks, patents, favorable contracts, trade secrets, and customer relationships are frequently purchased in these types of transactions. An outsider who was not involved in the sale would be unable to determine the actual fair value of these assets.
If a comparable company's sale price is to be useful for comparison purposes, it should identify the value components that make up the company's value: tangible versus intangible assets, real versus personal property, and taxable versus non-taxable assets. Even if the appraiser is able to assign value to the various components of the sale, the complexity of the factors involved may make the sale a less reliable indicator of the enterprise's value. And even in the case where everything is available, the process of making value adjustments to the comparable and subject company is subjective, resulting in a valuation that is not as well-supported by the evidence as one derived using a different valuation technique, which is a problem.
The market valuation method may therefore provide some useful information about the "going rate" for a similar business at any given point in time, but it will almost always fail to provide an accurate assessment of the company's actual fair value in most cases for these reasons. The market approach, on the other hand, is occasionally employed as a merger and acquisition (M&A) valuation technique. A common scenario in a merger and acquisition transaction is that the acquiring company anticipates achieving some type of business synergy as a result of its acquisition of the subject business, and as a result, the acquiring company is less concerned with determining the exact value of the subject company when negotiating the acquisition. In addition, the market valuation approach is one of the most widely used valuation techniques in the financial industry.
The Cost Valuation Method
In the cost approach, the logic of the substitution principle is used to guide the decision-making process. A prudent investor will not pay more for a property than they would pay for a substitute property of equivalent utility, according to this concept. For a cost-based approach to valuation, there are two possible starting points: the reproduction cost and the replacement cost. This is similar to the market-based approach.
The estimated cost, at current prices, to create an exact replica of the subject asset, using the same materials, construction techniques and standards, design, and quality of workmanship, and incorporating all of the subject asset's deficiencies, over adequacies, and obsolescence's into this exact duplicate is referred to as the reproduction cost. The cost of replacing an existing property with a new one of equivalent utility as of a specific date is referred to as the replacement cost. In terms of the substitution principle, the replacement cost is more meaningful because a prudent investor would not choose to replicate an existing property and incorporate obsolete, redundant, or unused features. This is for obvious reasons.
It is advantageous to use the cost approach in capital asset valuation because it is a very solid method that is supported by current market prices as well as the operating environment. It provides a clear value for tangible property because the value of the tangible property has been clearly separated from the value of all other assets in the account. The cost approach, when used in conjunction with the income approach, allows intangible assets to be valued indirectly rather than directly. The value of tangible assets determined through the cost approach is subtracted from the enterprise value determined through the income approach; the remainder is the value of intangible assets determined through the cost approach.
Limitations include the need for a large amount of reliable data to be used in the cost approach. It entails calculating the costs of materials, equipment, and labor, as well as developing information about the most efficient way to service those 100,000 customers in our hypothetical example. Finding and developing this information requires a significant amount of data and time.
The Income Valuation Method
The income approach is predicated on the premise that a property's current full cash value is equal to the current value of future cash flows that it will generate over the course of its remaining economic life, which is the case for most real estate. It is a traditional approach to valuation, but it necessitates a great deal of detail and analysis. Given the large number of assumptions made by the income valuation method, it carries the highest model risk (the possibility that your model will turn out to be incorrect). Even though it takes more time and effort to use the income method, it will usually result in a more accurate appraisal, especially when combined with other valuation methods. This approach allows for the forecasting of value based on a variety of scenarios, and it can also be used to perform a sensitivity analysis on the value forecasted.
There are several steps involved in putting this approach into practice:
Calculation of the annual cash flows that a prudent investor would expect to receive from the subject property over a specified period of time.
Estimated cash flows are converted to current value equivalents using a rate of return that accounts for the relative risk of the projected cash flow and the time value of money.
If there is a residual value at the end of the defined projection period, an estimate of it is provided.
Conversion of residual value, if any, to the present value equivalent of that residual value.
The addition of the current value of estimated cash flows from the defined projection period to the residual value, if any, in order to arrive at the enterprise value of the company.
Subtracting the value of working capital, intangible property, and other excluded assets from the enterprise value in order to arrive at an estimate of the value of the subject company's tangible assets.
If the goal is to arrive at a fair and defensible enterprise value, then the income approach should be considered. However, in situations such as determining the value of tangible property for tax purposes, tangible property must be valued separately because the income approach does not allow for the separation of assets by type of asset. In addition, the calculated value is extremely sensitive to assumptions about the forecast period, the cost of capital, and the terminal growth rate derived; even minor changes in these key assumptions can have a significant impact on the assigned value.
For example, as previously stated, the income approach can be combined with the cost approach, allowing for the direct valuation of tangible assets while also allowing for the indirect valuation of intangible assets. The value of intangible assets can also be modelled separately, and the value of those assets can then be compared to the residual intangible value that results from the business enterprise income approach. It is anticipated that this combined approach will provide a defensible fair value for the majority of purposes for which a business valuation is required, in addition to providing values for a variety of different asset types.
Making accurate, defensible estimates of the worth of businesses and/or business assets, regardless of the reason for the valuation, can be an extremely difficult and complicated process that requires the expertise of a qualified valuation professional with extensive experience. A business valuation expert has the knowledge and experience necessary to determine the most appropriate valuation method for your specific needs and to calculate a fair and accurate value for your company or organization.