When valuing a privately-held entity, there are typically three commonly-accepted methodologies employed by valuation professionals: the Income Approach (which consists of the application of either a capitalized or discounted cash flow method), the Market Approach (which includes both the guideline public company and guideline transaction methods), and the Asset Approach (although this approach is not typically used in the valuation of profitable operating companies). Many valuators rely heavily on an income-based approach as a preferred valuation method, as it relies on management’s estimation of future performance to determine value (and nobody is better positioned to be in-tune with a company’s future prospects than management).
However, projecting future performance can be difficult depending on several factors, including the nature of the subject company’s industry (i.e., highly cyclical), and prevailing market conditions. Additionally, projections by management are susceptible to various cognitive biases that can potentially limit their accuracy. In these cases, valuators often rely on the use of market-based approaches to provide additional indications of value. Similar to income-based approaches, however, market-based approaches have inherent benefits and weaknesses, as discussed below:
Guideline Public Company Method
The guideline public company method (“GPCM”) uses current pricing multiples of publicly-traded companies in the subject company’s industry.
Guideline Transaction Method
The guideline transaction method (“GTM”) uses pricing multiples based on actual transactions involving companies (private or public) in the subject company’s industry.
Given the pros and cons of the various valuation methodologies outlined above, a comprehensive valuation analysis should include some combination of income and market-based approaches. Similar conclusions reached based on the application of multiple methods using different valuation approaches serves to bolster valuation conclusions and should give the user a greater degree of confidence in the accuracy of the concluded value.