Business valuation is often the first step in valuing private company securities, intangible assets or financial instruments. Both income and market-based approaches are important valuation tools, while practitioners find plenty of technical, philosophical and mythological reasons to emphasize one over the other.
The focus of the Income Approach is on cash flows associated with the subject property. This approach estimates the present value of future cash flows that the business or asset generates. The present value of future cash flows comes from discounting earnings based on business and economic risks associated with the forecast. The cost of capital determines present value discounts. The most common income-based methods include:
◊ Discounted cash flow (“DCF”),
◊ Risk adjusted net present value,
◊ Multi-period excess earnings method,
◊ Various derivative pricing methods.
The Income approach is the only tool consistent with the concept of intrinsic value. Expected cash flows and required rate of investment return are the only two factors that determine value. Every other valuation method is a shortcut.
In principle, valuing a start-up is no different than choosing a bond for your IRA. You estimate future cash flows, define required rate of return in comparison to other investment options and chose the price (aka value) that will produce the return commensurate with the risk of achieving projected cash flows. In case of US Treasury bonds, the risk is low so we may pay $98 to receive $100 a year later. In case of a start-up the risk is high so we may pay only $50 for the chance of the same $100.
Income-based approaches rely on uncertain financial forecasts and subjective cost of capital (aka “rate of return”) estimates. These valuations can be volatile and easy to manipulate. Therefore, as a stand-alone measure, the income approach may not always be reliable.
Situations that require the income approach include intangible asset valuations, valuations of companies with significant projected changes in cash flows, and pre-revenue companies such as those in life-science industries.
Accurate valuation point-estimates are almost irrelevant in many important use cases. Income approach shines in capital budgeting, choosing investment alternatives, or tracking investment returns on privately held securities or business interests. This is where relative, not absolute, values matter. DCF models are used as the backbone of strategic planning process where 100-page presentations can be condensed into a single, quantifiable and actionable measure of project’s success or failure.
The Market Approach relies on recent transactions where similar types of businesses, assets or securities changed hands. Transaction prices help us develop valuation metrics such as market multiples that represent the relationship between financial performance and business value. Comparable security prices, with or without adjustments, can also help estimate the value of a subject instrument. The most common market-based methods may rely on the information obtained from:
◊ Guideline public companies,
◊ Guideline transactions,
◊ Transactions in company’s own securities.
The market approach may appear more intuitive as it is commonplace in our professional and personal lives. It is common to talk about business valuations as multiples of EBITDA or real estate values in terms of price per square foot.
While commonly reduced to seemingly trivial multiplication of two simple numbers, neither the multiple nor the financial measure are certain. Accurate implementation requires substantial analytical procedures:
◊ identifying maximally comparable transactions,
◊ calculating appropriate multiples for each comparable company or transaction,
◊ selecting and blending most applicable multiples (e.g. revenue, EBITDA, book value),
◊ calculating financial measures of a subject company, e.g. revenue or EBITDA, in a manner consistent with guideline companies financial reporting standards (not straightforward),
◊ adjusting for any financial attribute of a subject company that was not captured by multiples (e.g. NOLs or excess cash).
The Market approach works well for established businesses in steady financial markets. Yet, it is rarely appropriate for fast-growing start-ups, can’t be used in valuing intangible assets or most Level 3 financial instruments. One of the biggest concerns comes from the fact that market approach can be as volatile as markets themselves. It does not protect against pricing bubbles, and can move in the direction opposite the subject company’s business performance.
DCF vs. Market Approach
The biggest concern with DCF is that it needs an uncertain financial forecast and therefore is not reliable. The method can be easily manipulated with a myriad of subjective assumptions such as discount rates, terminal growth rates or cash flow adjustments. While true, many of these issues can be mitigated by good valuation policy.
The market approach may provide a false sense of security. As illustrated above, its accurate implementation is complex, especially for companies that grow fast or pursue new business models. There is just as much subjectivity in the market approach as in the income approach.
Selecting multiples for companies such as Uber (should we apply transportation or technology company multiples) or PayPal (should we apply technology or lender multiples) is highly subjective and just as unreliable in producing valuation point-estimates.
In most valuations the preference is to use both methods. Traditionally, we implement each method independent of one another. Practitioners weigh different value conclusions based on the relative strengths and weaknesses of the underlying analysis. A small biotech company may give greater weight to an income approach, while an established electronics manufacturer is likely to emphasize the market approach.
Reconciling different valuation approaches is important. In situations where methods produce highly disparate valuations, the common view is that one or both valuations are wrong. It is typically up to a valuation specialist to identify and correct the issue to arrive at the consistent values.
Just as with most things, greater effort (within reason) produces better valuation, but improvement is not gradual. For the valuation to be meaningful it has to cover all relevant issues and factors to a sufficient depth. Numbers can change dramatically in the eleventh hour.