Three Conventional Approaches to Company Valuations

New York-based finance professional Kate Merli serves as chief financial officer of New 2ND Capital, a private equity fund focused on investing in middle market companies. Possessing more than a decade of experience, Kate Merli has a strong understanding of valuations.

There are three conventional approaches to valuing a company: the cost approach, income approach, and market approach. To properly value a business, professionals may use any of these approaches individually or combine them. Each is briefly described below:

Income approach
Focused on a company’s future, the income approach to valuation converts predicted returns on investment to a current dollar amount, based on estimates of future cash flow. These estimates include future revenue growth, operating profitability, working capital requirements, and capital expenditure needs. To account for the risks associated with achieving the projected cash flow, the current valuation amount is often lower than the predicted income.

Cost approach
This approach determines valuation from a company’s current asset value, compared to the estimated value of liabilities. In many cases, this amount represents the floor value of the company, or the value a company can generate if its assets are entirely liquidated. Since cost approach valuations do not reflect future value, they are primarily used in the valuation of a holding company or capital-intensive business.

Market approach
Unlike income and cost approaches to valuation, a market approach focuses largely on the valuation of a business’ competing companies. The idea of this approach is that current stock market data of recently sold companies can provide an accurate idea of the value of a business with similar revenue, transactions, and growth.