Approaches to Valuing a Business

Several methodologies to measure the fair market value of an asset are available and can be classified into one of three approaches: cost, market or income approach. All approaches must be considered in any fair market value analysis, and the approach or combination of approaches deemed most relevant will then be selected for use in the fair market value measurement of that asset.

Cost (Asset) Approach

The cost approach involves analyzing the economic worth of a company’s tangible and intangible assets net of its liabilities. It is based on the assumption that the value of an asset is equal to the amount that currently would be required to acquire, construct or replace the asset, less any adjustments for physical deterioration and functional or economic obsolescence.

The approach generally results in an upper limit of value in cases where the asset is easily replaced or reproduced as no prudent investor would pay more for an asset than the cost to create a like replacement.

Market Approach

The market approach is based on the idea that the value of a subject asset can be determined by comparing the asset to reasonably comparable transactions for which transaction values are known. These transaction values are derived either from publicly traded company transactions or private company transactions that have been disclosed. This is a general way of determining a fair value indication of a business, business ownership interest, security or intangible asset by using one or more methods that compare the subject to similar assets that have been sold.

Income Approach

The income approach is used when a factor being considered in the valuation includes the earnings capacity of a company. The methods under this approach are based on converting earnings, or some type of economic benefit stream, of a company to a single present value. There are several different income approaches that can be used. The focus is to determine a benefit stream that is attributable to the ownership of the asset. The benefit stream is then discounted to present value with an appropriate discount rate adjusted for appropriate risks. Risks factored into the discount rate generally include a riskless rate at the measurement date as well as other business and industry risks specific to the asset being valued.

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