There are three generally accepted Approaches to value which can be used to value almost any asset: businesses, real estate, vehicles, personal property, etc. The three most common Approaches are:
- The Asset Approach,
- The Income Approach; and
- The Market Approach.
The Asset Approach is based on the principle of substitution meaning if you were to recreate your business or any other asset, across the street from your current location, what would it cost to do so? The major flaw with this approach is it captures only tangible value. Any asset that includes intangible value will typically be very difficult to value using this Approach and will require consideration of at least one of the other approaches.
The Income Approach determines the price a knowledgeable investor would be willing to pay to obtain the cash flow stream produced by the asset being valued. For example, in simplified terms, in the case of a business, the income approach attempts to isolate the cash flow stream specific to the business being valued by considering all revenue from operations less all necessary business expenses required to produce that income stream with adjustments made for risk, non-operating assets, excess inventory, working capital, long-term debt, anticipated revenue growth, profitability, etc.
The third and final Approach, The Market Approach compares the asset being valued or sold to similar or comparable assets. This Approach assumes that if two duplicate products or assets were sitting side by side a prudent investor would be willing to pay a similar price for each if they are substantially the same in all material respects. The difficulty with the Market Approach arises when data regarding similar assets or similar transactions is not readily available. As a result, you may find that this Approach will work great in valuing certain assets yet challenging when valuing others. One of the markets famous for their use of the market approach is the real estate market as this data is public and often times plentiful. Within each of these three “Approaches” to value are several different “Methods” of valuation. We will discuss each Method and the corresponding Approaches in greater detail in future blog postings.