Income vs. Market vs. Asset: Comparing the Three Main Valuation Approaches

In Summary

• The Income Approach (Future-Focused): This method calculates value based on expected future economic benefits. It uses the Discounted Cash Flow (DCF) method for companies with fluctuating growth by discounting future projections to their present value, or the Capitalized Earnings method for mature, stable companies where past performance is a reliable proxy for the future.
• The Market Approach (Peer-Based): This relies on the “principle of substitution,” determining value by comparing the business to similar companies that have recently sold or are publicly traded. It utilizes multiples—such as Revenue, EBITDA, or Earnings—to align the business with current real-world investor behavior and industry trends.
• The Asset-Based Approach (Floor Value): Generally used for distressed companies or those being liquidated, this approach calculates the net value of all tangible and intangible assets. It often serves as a “valuation floor,” ensuring a business is never appraised for less than the sum of its parts during negotiations or buy-sell agreements.

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A business valuation provides more than a number; it offers insight into how your business creates value, where risk exists, and the steps you can take to strengthen its financial position. Whether you’re planning for an exit, transferring ownership, resolving a dispute, or satisfying tax or financial reporting requirements, an accurate and defensible valuation is essential. There are three primary methods of valuating a business: the market, income, and asset-based approaches, each with its own purpose. Below is an overview of each method and the circumstances in which they might be applicable.

Income Approach

The income approach to business valuation comprises two methods: the discounted cash flow method and the capitalized earnings method.

Discounted Cash Flow Method

The discounted cash flow (DCF) method involves forecasting your future revenues, cost of goods (sales), and operating expenses between five and ten years into the future, and a terminal value after that. You then discount them back to their present value using the Weighted Average Cost of Capital (WACC).

WACC is a company’s cost of equity and after-tax cost of debt that reflects the true risk and required return investors expect. It usually involves using a business’s Beta to determine the cost of equity. When dealing with private companies, we use a company-specific risk premium in its place, which captures a business’s unsystematic risks, such as poor management depth, key-person dependency, and company offerings, among other factors.

Terminal value is determined using the Gordon Growth Model. This model assumes cash flow will grow at a stable, long-term rate by using the formula for the final projected year cash flow, applying that perpetual rate, and dividing by the difference between the WACC and that long-term growth rate. Doing this, we discount the cash flow back to its present value, including the terminal rate, and add them up to determine the value. We will usually provide a range of values depending on possible changes in WACC and growth rate.

Capitalized Earnings Method

This method involves dividing normalized earnings by the capitalization rate to reflect the company’s risk profile and expected return to investors. The capitalized earnings method is usually used by a business that we assume will continue to generate earnings at a stable, sustainable level in the future, with no massive growth or significant, unexplained expenses projected. These are usually mature companies with consistent performance over the past four to five years.

The capitalization rate is typically found from WACC minus long-term growth expectations, as it converts a single period of earnings into an implied value (usually used as a range, as mentioned above, by using different capitalization rates and values).

Market Approach

The market approach involves comparing companies similar to the business you’re evaluating to determine a value based on the multiples given. For each multiple, you’ll use three values: low, middle, and high. Multiples are adjusted for differences in growth, profitability, risk, size, and capital structure to maintain comparability. This relies on the principle of substitution; a buyer won’t pay more for a company than the cost of acquiring a comparable alternative.

The market approach method is especially useful when there’s robust market data and when the subject company operates in an industry with active mergers and acquisitions or public comparables. This approach can follow the Guideline Public Company Method (GPCM) or the Guideline Transaction Method (GTM), depending on whether the data comes from public markets or private company sales. Market multiples reflect real-world investor behavior, making this approach a strong cross-check against income-based methods like DCF.

Revenue, EBITDA, and Earnings Multiples

The market approach uses three types of multiples: revenue multiples, EBITDA multiples, and earnings multiples.

• Revenue multiple: Compares enterprise value to total revenue. The multiple is derived as enterprise value divided by revenue for comparable companies and applied to the subject company’s revenue to estimate enterprise value. This method is commonly used when earnings measures are unstable or not representative of long-term performance.
• EBITDA multiple: Compares a company’s enterprise value to its EBITDA to assess operating performance without the effects of capital structure, taxes, or non-cash charges.
• Earnings (P/E) multiple: Compares a company’s equity value to its net income and is commonly used for valuing mature, profitable businesses based on after-tax earnings.

Asset-Based Approach

The asset-based approach is usually used when a company is more dead than alive. We typically see this when a business is not very profitable or not profitable at all, is experiencing financial distress, or is being valued for liquidation rather than as a going concern. The companies’ assets can be both tangible and intangible. These assets can be independently appraised and measured, making the balance sheet a more accurate indicator of the firm’s value than its future performance.

It’s also relevant to use the asset-based approach as a baseline or floor value for a business going through negotiations and buy-sell agreements to confirm that the company is, at a minimum, worth the value of its assets.

Identifying Opportunities With a Business Valuation

Business valuations serve many purposes, including determining the fair market value of a privately held business, establishing the per-share price for an Employee Stock Ownership Plan (ESOP), assessing whether a publicly traded share is overvalued or undervalued, and complying with gift and estate tax requirements when transferring ownership interests. Valuations also play a significant role in mergers and acquisitions by establishing a reliable baseline value for negotiations and deal structuring, and by assessing whether an offer reflects true economic worth.

Valuation work also has a consulting component: by analyzing financial performance, industry trends, operational efficiency, and risk factors, a valuation can help identify strengths, weaknesses, and opportunities for improvement. This insight positions the business to enhance its value over time and operate from the strongest possible strategic footing. If you have any questions or need assistance, please contact us using the form below.