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Weighting Different Methods To Determine Value

Posted in Business Valuation, on Sep 2016, By: Mark S. Gottlieb

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Unity Technologies, a previously nondescript software development company, has grown significantly in value over the past few months with the release of the viral mobile app, Pokémon Go, which was created using Unity’s software.

The company has recently been valued at around $1.5 billion. This consensus comes from an amalgamation of different data including the company’s past financial performance, trends in the market, and the company’s owned resources. In performing this or any other valuation one needs to decide the relevancy of each type of data. For instance, Unity’s past performance may be a good prediction of the company’s potential but does not account for the growing market for programs that produce augmented reality, an area in which Unity specializes. These considerations are an important aspect of business valuation.

In a typical business valuation, the analyst will often use three general valuation approaches: (1) the income approach, (2) the market approach, and (3) the asset approach. Each of these approaches uses different data to estimate the value of the subject company, which inevitably results in slight disparities between the outcomes. In order to come to a consensus on value, the analyst must decide how to weight each outcome.

There is no official formula for calculating weights in business valuation. In fact, Revenue Ruling 59-60 of the Internal Revenue Code states:

“Because valuations cannot be made on the basis of a prescribed formula, there is no means whereby the various applicable factors in a particular case can be assigned mathematical weights in deriving the fair market value. For this reason, no useful purpose is served by taking an average of several factors (for example, book value, capitalized earnings and capitalized dividends) and basing the valuation on the result. Such a process excludes active consideration of other pertinent factors, and the end result cannot be supported by a realistic application of the significant facts in the case except by mere chance.”  

Given this, the analyst must give thought to the process of weighting the results found.

The Income Approach

The Income Approach uses a company’s past or future performance to predict future earnings and places a value on the company based on this result. The two most common methods under the Income Approach are the capitalization of earnings and discounted cash flow methods.

Advantages of the Income Approach:

  • This approach attaches value to a company’s ability to generate cash flow, forming a relationship between the value of the company and its earnings.
  • The Income Approach can be used for companies of various types and stages.
  • This approach simulates a market price even if there is no active market.
  • This approach places a value on the company’s tangible and intangible assets.

Disadvantages of the Income Approach:

  • It can be difficult to calculate sustainable benefit streams that will be used for this method, especially for smaller and/or newer companies.
  • It can be difficult to choose the capitalization and discount rates necessary to calculate the benefit stream because this requires subjective professional judgement.

The Income Approach is Most Appropriate When:

  • It is the only method able to calculate the company’s intangible assets.
  • There is a large amount of data regarding past and future earnings.

The Market Approach

The Market Approach uses data regarding the performance of companies similar to the subject company and relevant transactions. The four most commonly used methods under this approach are (1) the guideline public company method, (2) the merger and acquisition method, (3) sales of the company’s own stock method, and (4) the industry method. Each of these methods uses market data to estimate the value of the company in question.

Advantages of the Market Approach:

  • The Market Approach is a direct approach for establishing the fair market value of a company.
  • This approach is grounded in real public data and does not rely on subjective forecasts.

Disadvantages of the Market Approach:

  • It can be difficult to find suitable companies and transactions to make comparisons, especially for smaller, private companies.
  • It can be difficult to ascertain what market data is accurate and consistent.

The Market Approach is Most Appropriate When:

  • There is a sufficient number of comparable companies and transactions.
  • The available market data is consistent and reliable.
  • There are instances of market trends that may affect the value of the subject company in ways that are not reflected on the company’s own balance sheets.

The Asset Approach

The Asset Approach (a/k/a the Cost Approach) places a value on a business based on the value of business’s assets net of liabilities, adjusted to fair market value.

Advantages of the Asset Approach:

  • The Asset Approach values net tangible assets more reliably than the other two approaches.
  • This approach most accurately reflects the economic balance sheet of the subject company.

Disadvantages of the Asset Approach:

  • The Asset Approach is not readily applicable to intangible assets.
  • This approach tends to be more time consuming than the other approaches.

The Asset Approach is Most Appropriate When:

  • The subject company is no longer operating as a going concern and is preparing for liquidation.
  • The valuation is based on assets rather than earnings.
  • The valuation analyst needs to test the reasonableness of the concept of highest and best use.

Weighting Valuation Results

The final indication of value, on a going concern basis, is generally one number computed from a variety of analytical procedures and one or more of the three methods discussed above.  In many instances the asset approach will be considered the floor and not the highest and best use of the company’s assets. The remaining values from the income and market approaches are weighted, often based upon the reliability of the data used to formulate their conclusion or the industry itself.

Mark S. Gottlieb, CPA/ABV/CFF, CVA, CBA is a credentialed business valuation and forensic accounting expert.  If you would like more information about this or any other topic regarding business valuation or forensic accounting please feel free to contact him at 646-661-3800 or by email at msgcpa@msgcpa.com.