Valuation Approaches: Asset, Income and Market Approach

Understand Valuation Approaches: Asset, Income and Market

Key rules to remember

Net asset value (asset approach)

Net asset value = Fair value of assets − Liabilities

Exclude fictitious assets such as preliminary expenses. Use adjusted values where the question gives them. Divide by number of equity shares for value per share.

Value under income approach (DCF)

Enterprise value = Σ [FCFt ÷ (1 + r)^t] + Terminal value ÷ (1 + r)^n

FCF is free cash flow, r is the discount rate and n is the final forecast year. Equity value = enterprise value − debt + surplus cash.

Terminal value (constant growth)

Terminal value = FCFn × (1 + g) ÷ (r − g)

Valid only when r is greater than g. Growth g must be sustainable.

Capitalisation of earnings

Value = Maintainable earnings ÷ Capitalisation rate

Use normalised earnings, not one-off peaks or troughs.

Market approach using a multiple

Value = Comparable multiple × Subject metric

Example: equity value = P/E multiple × earnings. For EV/EBITDA, subtract net debt to reach equity value.

Weighted value

Weighted value = Σ (Value by each method × Weight), with weights adding to 100%

Weights are a matter of judgement and must be justified.

How to solve Valuation Approaches: Asset, Income and Market questions

1. 1Identify the purpose and date: merger, demerger, sale, buyback or liquidation. Purpose decides the basis of value.
2. 2Note the nature of the business: asset-heavy or asset-light, going concern or not, stable or fast growing, listed or unlisted.
3. 3Check the data given: balance sheet, cash flow forecasts or comparable multiples. The data often points to the intended approach.
4. 4Pick the approach and give a reason linked to the facts. Say which approaches are less suitable and why.
5. 5If numbers are given, apply the matching formula step by step and show each line.
6. 6Cross-check with a second approach where data allows, and note any large gap.
7. 7Where several values result, assign weights with reasons and state the final value.
8. 8Conclude with a clear statement of the value and the key assumptions.

Quickest way: Match business type to approach

Common mistakes in Valuation Approaches: Asset, Income and Market

• Using the asset approach for a profitable service or technology business.

  Book values are easy to find and students stop there.

  Fix: Say that the asset approach misses earning power and goodwill. Prefer income or market approach for asset-light going concerns.

• Calling price-to-earnings or EV/EBITDA multiples part of the income approach.

  Both use earnings figures.

  Fix: If the multiple comes from comparable companies or deals, it is the market approach. The income approach discounts or capitalises the business's own future benefits.

• Forgetting to deduct debt when moving from enterprise value to equity value.

  DCF gives a value for the whole business and students treat it as the shareholders' value.

  Fix: Equity value = enterprise value − debt + surplus cash. Check which one the question wants.

• Using a terminal growth rate equal to or above the discount rate.

  Students pick a high growth rate without checking the formula.

  Fix: Terminal value needs r greater than g. Use a modest long-term growth rate.

• Including fictitious assets or ignoring contingent liabilities in net asset value.

  Students copy the balance sheet total.

  Fix: Remove assets such as preliminary expenses and discount balance, then adjust for items the question flags.

• Giving a list of approaches without linking to the facts in a case question.

  Students memorise definitions only.

  Fix: Name a fact from the case, state the approach it points to, and conclude.

Worked examples