The Three Approaches to Business Valuation
Asset, income and market. What each one actually measures, when each should carry the conclusion, and why a report that uses only one deserves a second look.
Where the three approaches come from
The framework is older than most of the businesses it gets applied to. IRS Revenue Ruling 59-60, issued in 1959, remains the foundational authority for valuing closely held stock, and it lists eight factors that have to be considered in a fair market value determination: the history and nature of the business, the economic outlook and the condition of the industry, book value and financial condition, earning capacity, dividend-paying capacity, goodwill and other intangibles, prior sales of the stock, and the market price of comparable publicly traded companies.
Two things about that list matter more than the list itself. It is expressly not exhaustive, and the ruling rejects rigid formulas and rules of thumb. A valuation that arrives at a number by applying a multiple someone heard was standard for the industry has not followed the framework; it has skipped it.
The eight factors map onto the three approaches used today, which is why the framework has survived: earning capacity and dividend capacity are the income approach, prior sales and comparable public pricing are the market approach, and book value, financial condition and goodwill are the asset approach.
What each approach actually measures
| Approach | The question it answers | Primary inputs |
|---|---|---|
| Income | What is the present value of the future economic benefit this business will produce for its owner? | Normalised earnings or cash flow, a growth expectation, and a discount or capitalisation rate reflecting risk |
| Market | What have buyers actually paid for businesses sufficiently like this one? | Guideline public company multiples, or completed transactions in private companies, adjusted for size, growth and risk differences |
| Asset | What would it cost to assemble this collection of assets, net of liabilities, from scratch? | Assets and liabilities restated from book to a stated value premise, including intangibles where they can be identified |
They are not three routes to one answer. They are three different questions, and a business can be worth genuinely different amounts depending on which one the buyer is asking. Reconciliation — explaining which approach carried the conclusion and why the others did not — is the analytical heart of the report, not its summary.
When each one dominates
| Situation | Approach that usually leads | Why |
|---|---|---|
| Profitable operating company, stable earnings | Income | The buyer is buying a stream of cash. Assets are the means, not the point. |
| Asset-heavy business, thin or erratic earnings | Asset | If the earnings do not justify the assets, a rational buyer prices the assets. Common in equipment-intensive operations. |
| Holding company — real estate, investments | Asset | The entity is a wrapper around assets that have their own values. |
| Industry with genuine transaction data | Market | Where enough comparable private sales are verifiable, actual buyer behaviour is strong evidence. |
| Business being wound up | Asset, on a liquidation premise | Going-concern earnings are not going to be realised, so pricing them would be pricing something that will not happen. |
| Early-stage or loss-making with real assets | Asset, with income tested | Income methods on negative earnings produce artefacts, not values. |
The reconciliation is where judgement shows. Two approaches producing similar numbers is corroboration worth stating. Two approaches producing very different numbers is information — it usually means the business is worth more dead than alive, or vice versa, and that is a finding the reader needs rather than a problem to be averaged away.
Normalisation: the work that happens before any approach
Closely held company financial statements are prepared for tax and for the owner, not for a buyer. Before any approach can be applied the earnings have to be restated to show what the business actually produces for whoever owns it. This is normalisation, and it is where a large part of the defensible work sits.
| Adjustment | What it corrects | Direction |
|---|---|---|
| Owner compensation | Owners are frequently paid above or below what a hired manager would cost. The adjustment restates to market compensation. | Either way |
| Discretionary and personal expenses | Vehicles, travel, family on payroll, personal insurance run through the business | Usually increases earnings |
| Non-recurring items | A lawsuit settlement, a one-off gain, storm damage, a single extraordinary contract | Either way |
| Related-party rent or transactions | Premises rented from an entity the owner also controls, at a rate that is not arm's length | Either way |
| Non-operating assets | Investment property, excess cash, assets unrelated to the trade — removed from operations and valued separately | Separated out |
Every adjustment is a claim that has to be evidenced. An unsupported add-back is the fastest way to lose a report in front of a reviewer, because it is the easiest thing to test.
Normalisation is also where the level of value is quietly set. Adjusting owner compensation to market produces a controlling indication, because only a controlling owner can change their own pay. Leaving actual compensation in place produces something closer to a minority indication. Reports that normalise fully and then apply a full minority discount stack have often double-counted — see discounts.
Why a single-approach report is a red flag
Not a disqualification. A red flag — something that should prompt the question “why?” and should already be answered in the report.
USPAP Standard 9 governs the development of a business or intangible asset appraisal and requires the appraiser to be aware of, understand and correctly employ the recognised methods and procedures necessary to produce a credible result. Standard 10 governs reporting, and requires that the analyses, opinions and conclusions be communicated in a manner that is not misleading.
Together those produce a practical rule: an approach that is not used should be addressed and dismissed with a reason, not passed over. “The market approach was considered and not developed, because no verifiable transactions in sufficiently comparable private companies could be obtained” is a complete answer. Silence is not, because the reader cannot tell the difference between an approach that was rejected on analysis and one that was never attempted.
| What you see | What to ask |
|---|---|
| Only an income approach, no reconciliation | Were the assets tested? An asset-heavy business can be worth more than its earnings support. |
| Only a market approach, using rules of thumb | Rev. Rul. 59-60 expressly rejects rules of thumb. What were the actual transactions, and how were they verified? |
| Only an asset approach on a profitable operating company | Why were the earnings not priced? This tends to understate a going concern. |
| Three approaches, then a simple average | Averaging is not reconciliation. Which one is most reliable here, and why? |
What the report itself has to contain
USPAP Standard 10 governs the reporting of a business or intangible asset appraisal. Beyond the analysis, a credible report has to let a reader who was not part of the engagement understand what was done and test it.
| Element | Why a reader needs it |
|---|---|
| Client and intended users | Determines who may rely on the report. A lender relying on a report written for a shareholder is relying on something not written for them. |
| Intended use | A report developed for a buy-out is not automatically usable for a gift tax filing, even on the same interest and date. |
| Standard and premise of value, defined and sourced | Without them the number has no meaning. This is the most common material omission. |
| The interest valued, and its rights | Percentage alone is not the interest. Voting, veto and transfer rights are part of what is being measured. |
| Effective date | Frequently retrospective. Evidence must be contemporaneous with it, not with the report date. |
| Scope of work, including what was not done | A reader has to know whether records were audited, reviewed, or accepted as presented. |
| Extraordinary assumptions and hypothetical conditions | Load-bearing assumptions must be visible, because the conclusion moves if they fail. |
What the report has to identify
Before any method is selected, four things have to be fixed, and getting them wrong invalidates everything downstream:
| Element | Why it governs |
|---|---|
| Standard of value | Fair market value, fair value, investment value and intrinsic value are different standards producing different numbers. The engagement, statute or agreement decides which applies — not the appraiser. |
| Premise of value | Going concern or liquidation. Whether the business continues is an assumption, and it has to be stated rather than implied. |
| The interest being valued | A 100% controlling interest, a 40% minority block and a 2% passive interest are three different assets in the same company. |
| Effective date | Value is as of a date. In dissolution and estate matters that date is frequently in the past and is set by law or by the court. |
Where the engagement is silent on any of these, the appraiser raises it in writing before work begins rather than choosing quietly and disclosing later. A conclusion built on an unstated standard of value is not wrong so much as unusable.
Where this sits
This is the framework underneath every business valuation engagement. The adjustments that come after it are covered in discounts for lack of control and marketability; where an agreement governs, see buy-sell agreements and the standard of value. Counsel instructing on a contested matter may prefer what we do for attorneys.
Jeremy C. Johnson, Arizona Certified Residential Real Estate Appraiser #21358 · AQB Certified USPAP Instructor.
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What the work actually looks like
Real assignments, client details removed — what each engagement actually turned on, rather than how it felt.
A house, a workshop of machine tools, a forty-year firearms collection and a stake in the family company — four disciplines that three appraisers had only partly covered. One engagement, one effective date, one set of assumptions.
A donation the regulations would have aggregated past the appraisal threshold, which the donor had assessed item by item. One qualified appraisal covering the group, itemized, signed inside the window the regulations allow.
An opposing report whose number was not obviously wrong — which is what made it dangerous. It failed on its own certification, and was answered section by section with an independent valuation to the correct definition of value.