Valuation Approaches and Methods
Three approaches, one conclusion
Every valuation draws from the income, market, and cost approaches. The income approach discounts expected future benefits to present value; the market approach derives value from comparable transactions or guideline public companies; the cost approach estimates replacement or reproduction cost less depreciation. Candidates must know when each applies and how to reconcile them into a single concluded value.
Income approach essentials: choose between capitalized cash flow (a single-year perpetuity: value = normalized cash flow ÷ capitalization rate) and discounted cash flow (multi-period plus terminal value). The capitalization rate equals the discount rate minus expected long-term growth. Terminal value uses either a Gordon growth model or an exit multiple. Match the discount rate to the cash flow: use WACC for enterprise free cash flow and cost of equity for equity cash flows - never mix them.
Market approach essentials: select and adjust comparables for size, growth, risk, and control. Know the difference between minority and controlling interests and the premiums/discounts (control premium, DLOM) that bridge them.
Traps: (1) Applying a growth rate exceeding the discount rate in a perpetuity. (2) Using a market multiple derived from minority, publicly traded shares to value a controlling interest without adjustment. (3) Double-counting risk by adding a premium after using a higher discount rate. (4) Forgetting mid-year convention.
Rule of thumb: If discount rate = 12% and sustainable growth = 3%, the capitalization rate = 9%, so value = normalized cash flow ÷ 0.09. A $900,000 cash flow yields $10 million.