There are three (3) distinct valuation approaches to be considered in doing a valuation of a closely held entity.  They are the asset approach, the income approach and the market approach.  Within each approach, there are different methodologies utilized in arriving at the fair market value of a closely held entity.  All three valuation approaches should be considered in a business valuation.  A brief summary of the different approaches and methodologies is discussed below. 

Asset Approaches

The asset approach assumes that the value of an entity is determined upon the value of the underlying assets of the entity.  Under this adjusted net asset value approach, there are different methodologies used in computing the respective adjusted net asset value.  Generally, the assets and liabilities are adjusted from the book value on the balance sheet to their respective market, replacement or liquidation values and unrecorded assets (library of maps & drawings) and liabilities (pending lawsuits) are taken into account as well.  The resulting excess of the assets value over that of the entity’s liabilities (or equity if you will) is the pre-discounted value based on an asset based approach.

The resulting value is a controlling interest marketable value.  This approach implies that the person has ownership and control over the underlying assets of the entity being valued.  This approach also results in a value for which there is a ready market for the interest being valued. 

Revenue Ruling 59-60 states this valuation approach is best used for entity’s that hold significant non-operating assets such as investments and real estate. 

Income Approaches

The income approach values an entity on the presumption that the true value of an entity is in the cash flows/earnings an entity generates and passes onto its owners.  Depending upon the whether the cash flow or earnings stream has been adjusted for owner’s discretionary items used the above methods the resulting value could result in a controlling or non-controlling marketable value.

Capitalization of Cash Flow/Earnings

The capitalization of earnings method values the entity based upon the recurring earnings the entity is expected to generate and capitalizing them using an appropriate capitalization rate.  This method uses historical earnings in predicting what the future recurring earnings of the entity will be.  The capitalization of earnings usually takes a five (5) year average or weighted average of the earnings and capitalizes them in computing the entity’s value. 

The use of historical earnings to predict the future earnings is in accordance with Revenue Ruling 59-60, which states, “Prior earnings records usually are the most reliable guide as to the future expectancy, but reporting arbitrary five-or-ten-year averages will not produce a realistic valuation.”  This method is employed where past earnings will be representative of future earnings.   

Capitalization of Excess Earnings

The capitalization of excess earnings method comes to a distinct value of the tangible asset and the goodwill (earnings) of the entity and adds them together in valuing an entity. The excess earnings methods are not the favored method to be used in valuing an entity.  This method does not work well when the value of the goodwill and that of the assets are not so easily separated and distinct from one another. 

Under the Treasury method, the recurring earnings amount is then compared to industry average earnings based upon the entity’s book equity level (not adjusted).  The excess of the entity’s earnings over that of the industry is then capitalized, using an appropriate capitalization rate. 

The Reasonable Rate method compares the expected recurring earnings amount to what a reasonable rate of return expected based upon the adjusted net assets value the entity has as of the valuation date.  The excess of the entity’s earnings over that of the expected earnings based upon a reasonable rate of return upon the adjusted net assets are the excess earnings of the entity. 

Discount of Cash Flows/Earnings

The other income approach method is the discount of cash flows/future earnings.  This method uses a projection or forecast in determining the future cash flow/earnings for the entity.  The projected future earnings and the terminal value of the earnings when a constant growth rate is expected to occur are present valued back to today’s dollar value to arrive at a value for the entity as of the valuation date. 

The discount of cash flows/earnings income approach method is a good method of choice when valuing start-up or companies or companies for which the past is not indicative of the future.  Start-up companies generally will not have generated cash flows or earnings in its early years due to product development costs and expansion plans etc.  Valuing such companies on past earnings will not be indicative of future earnings, and will vastly undervalue such companies. 

This approach relies heavily upon the projection of future earnings/cash flows done by management.  For this very reason, Revenue Ruling 59-60 tends to place more emphasis on methodologies that use prior earnings/cash flows in determining an entity’s value than on methodologies that employ a projection of the future that may never materialize.  

Market Approaches

The market approach values an entity based upon the premise that the value of the entity approximates that of similar companies that are publicly traded or by using comparable privately-held company sales transactions multiples.  This approach takes similar applies their respective value indicators (price/earnings, price/revenues, price/book value etc.) to the entity being valued.  This approach is the favored approach by the Internal Revenue Service Revenue Ruling 59-60.

A value multiple derived from the guideline companies information is applied to the entity being valued.  The resulting value is the fair market value of the entity under this approach.   

In applying this approach, careful consideration must be given in determining the guideline companies for a certain entity being valued.  Generally, this approach should be used with care as finding similar company’s is crucial in using this approach. 

Under the market approach, the resulting value is can be either a fully marketable minority interest value (non-controlling) and at other times a fully marketable control value depending upon the comparable company information used.