Valuation methods examples: six cases, three approaches

These valuation methods examples use six invented business scenarios to show why different evidence can point to different conclusions. No real company, owner or transaction is described: each case is built so that one method's blind spot shows clearly. Each case is worked in round illustrative figures, in any currency, and every capitalization rate, discount rate and multiple below is an assumption chosen to make the arithmetic visible, not a market benchmark.

Every case shows why the methods disagree and which disagreement to believe. The pattern is always the same: when two methods give different answers, the gap is information about the business, not an error in the arithmetic.

The methods sit inside the three approaches named in the IRS's own business valuation guidelines: the asset-based approach, the market approach and the income approach, with consideration to be given to all three. In the cases below, the adjusted net asset method belongs to the asset-based approach, the precedent transactions method and comparisons with listed businesses to the market approach, and capitalized earnings and discounted cash flow to the income approach. The same guidelines say historical financial statements should, where necessary, be analyzed and adjusted to reflect the appropriate asset value, income, cash flows or benefit stream for the method selected, which is the normalization at work in case five. The guidelines also say the appraiser selects discount rates, capitalization rates or multiples consistent with the benefit stream, after considering factors such as the nature of the business, the risk involved, the company's industry and the stability or irregularity of earnings. That last factor is the subject of cases three, five and six.

What to take away

One: the assets are worth more than the earnings

A business with a yard full of equipment, property it owns, and a thin trading result. A capitalized earnings method produces a modest figure. An adjusted net asset method, based on what the equipment and property would actually fetch, produces a larger one.

In figures: normalized earnings of 120,000 capitalized at a rate of 0.25 give 480,000. The equipment and property would fetch 900,000, less 100,000 of liabilities, for an adjusted net asset value of 800,000. The gap is 320,000.

Why they disagree. The capitalized earnings method values the business as a going concern, a machine for producing profit. The adjusted net asset method values what is left if the machine is switched off. When the asset figure exceeds the earnings figure, it raises the question of whether the assets are worth more outside the business than within it. The gap itself is a finding, and valuation methods mistakes often start right there.

What to believe. The asset figure, as a floor, and the question it raises: should this be sold as a business at all, or wound down and the assets sold separately? A buyer who wants the trade will pay the earnings figure; a buyer who wants the property will pay for the property and treat the trade as a nuisance. The owner has to decide which sale they are running.

Two: profitable on paper, short of cash

A business with a healthy profit line and a bank balance that never grows. The capitalized earnings method looks strong. A buyer's accountant, working through the cash, finds that customers pay slowly, stock sits for months, and the business funds the gap from an overdraft.

In figures: earnings of 300,000 capitalized at 0.25 give 1,200,000. But receivables and stock tie up 250,000 that the overdraft currently funds, and the buyer has to provide it at closing. To the buyer, the business costs 1,450,000 to own on day one, or the price falls to 950,000 if the seller leaves the working capital behind unfunded.

Why they disagree. Profit is measured on an accrual basis: revenue when earned, cost when incurred. Cash arrives later. The earnings method is not wrong about profit; it is silent about the working capital the business needs to produce that profit, and a buyer has to fund that working capital on day one.

What to believe. The earnings figure, adjusted for the capital the buyer must put in to keep the business trading. The price and the working capital target are settled together, and a seller who has not calculated the second will find the first reduced at closing.

Three: the same average, two directions

Two businesses whose earnings over several years average the same. One rose to that average; the other fell to it. A simple-average capitalization of earnings approach treats them identically.

In figures: business A earned 100,000, 150,000 and 200,000 over three years; business B earned 200,000, 150,000 and 100,000. Both average 150,000, and at 0.25 both are worth 600,000. Weight the years 1, 2 and 3, most recent heaviest, and A's base becomes 166,667 and B's 133,333: 666,667 against 533,333, a difference of 133,334 that the simple average hid.

A simple-average capitalization of earnings approach deletes the direction, and the direction is what a buyer is paying for. A stream of earnings that is rising is a different asset from one that is falling, however similar their past totals. A discounted cash flow (DCF) method can reflect a supported forecast rather than treating the average as the run rate. A buyer who wants the direction priced in should start with the requirements for valuation methods before choosing a family.

What to believe. The most recent period, weighted, and an honest account of why the trend runs the way it does. The falling business is not unsaleable; it is a different price, and a seller who presents the average as if it were the run rate will lose the argument in diligence and lose trust with it.

Four: the comparables that were never sold

An owner uses a market approach, treating asking prices of similar businesses currently listed as comparable evidence. The figure is reassuring. An intermediary with access to completed transactions applies a precedent transactions method and produces a lower one.

In figures: on earnings of 200,000, listings that ask 3.0 times earnings point to 600,000; completed sales of similar businesses at 2.4 times point to 480,000. The 120,000 difference is the gap between hope and payment.

Why they disagree. Listings are what sellers hope. Transactions are what buyers paid. The listed businesses may still be listed a year from now, at reduced prices, or withdrawn. And even completed prices mislead without their terms: a headline that included an earn-out that never paid is not the number it appears to be.

What to believe. Completed transactions with known terms, if you can get them. If you cannot, the precedent transactions method is unavailable to you and should be set aside rather than fed listings. The valuation methods guide sets out why this family is the one most often misused.

Five: the one large item

A business whose most recent year contains a single large receipt, a settlement or a one-off contract, that will not recur. A capitalized earnings method run on that year produces a figure well above the one run on the year before.

In figures: last year's earnings were 400,000, of which 150,000 was a one-off settlement. Capitalized at 0.25, the reported year gives 1,600,000; the normalized 250,000 gives 1,000,000. The settlement is worth 150,000 once, not 600,000 forever.

Why they disagree. The method assumes the earnings continue. A non-recurring item, by definition, does not. Left in, it inflates the base; taken out through normalization of earnings, the base returns to what the business ordinarily does.

What to believe. The normalized figure with the item removed and shown separately. The reverse also applies: a one-off cost taken out raises the base, and the buyer will want to see the document that proves it was one-off. Adjustments in either direction must survive the same test, and a seller who removes only the unflattering items is advocating rather than valuing.

Six: earnings that end on a known date

A business whose profit rests largely on a contract with a fixed remaining term and no assurance of renewal. A capitalized earnings method, run on the current result, produces a figure that assumes the contract continues indefinitely.

In figures: the contract earns 200,000 a year with three years left. Capitalized at 0.25, that is 800,000, as if it never ended. Discounted at a rate of 0.15 for its three remaining years, the contracted stream is worth about 456,600, before anything is added for a renewal that may not come.

Why the method fails. A capitalized earnings method values a continuing earnings stream, while a contract-bound stream has an end date. A discounted cash flow (DCF) analysis can model the contracted period and any subsequent cash flows separately; the second part is much less certain.

What to believe. A valuation that separates the contracted period from the uncertain one, and a deal structure that reflects the uncertainty: an earn-out tied to renewal, or a price that assumes it does not happen. A buyer will insist on one of these; a seller who understands why can negotiate which.

The pattern

In every case, the method that flattered the business ignored what a buyer cannot ignore. What would assets fetch, what cash does the trade consume, which way is it heading?

What did buyers actually pay, what recurs, and when does it end? Methods do not decide value; they make the argument about value precise enough to have.

Common questions