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What makes the market approach method different from the income approach method?

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If you are involved in business valuation and mergers and acquisitions, you may have encountered different methods to estimate the value of a company or an asset. Two common methods are the market approach and the income approach. In this article, you will learn what makes them different and how to apply them in different situations.

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Utilize market comparisons:

The market approach relies on comparing similar assets or businesses to determine value. This method works best when ample market data is available, enabling you to reflect current industry trends in your valuations.### *Assess future income:The income approach estimates present value based on future cash flows or earnings. Use this method when market data is scarce, allowing you to focus on unique growth prospects and specific financial projections.

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Tomi Akinwale ACCA, ACA, ACTI, B.TECH, FMVA, AAT.

Tax | Deloitte | Financial Reporting &…
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1 Market approach

The market approach is a method that uses the prices of comparable or similar companies or assets in the same industry or market to estimate the value of the target company or asset. The market approach assumes that the value of the target is influenced by the supply and demand forces in the market and reflects the expectations of the buyers and sellers. The market approach can use different sources of data, such as publicly traded companies, mergers and acquisitions transactions, or industry multiples. The market approach is often used when there is enough reliable and relevant data available and when the target is comparable to the peers.

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Tomi Akinwale ACCA, ACA, ACTI, B.TECH, FMVA, AAT.

Tax | Deloitte | Financial Reporting & Modelling |
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Market approach looks at current rates prevailing, so as to reduce errors in estimation and maintain effectiveness of pricing that's suitable for both demand and supply.

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In my experience, the key distinction between the market approach method and the income approach method lies in their fundamental evaluation strategies. The market approach method primarily relies on comparing similar assets or businesses in the market to determine value, taking into account factors such as recent sales, transactions, or industry benchmarks. On the other hand, the income approach method focuses on assessing the present value of future income streams generated by the asset or business, considering factors like projected cash flows, risk factors, and discount rates. Each approach offers unique insights into valuation, catering to different scenarios and objectives.

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Muhammad Zaurez Afshar

FCMA, CGMA
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The market approach, a valuation method, determines an asset's value by analyzing recent sales of comparable assets. It assumes market rationality, where prices reflect fair value. This objective approach excels when abundant data on similar transactions exists. However, it may not capture unique features or account for market fluctuations, making it less suitable for assets with limited comparables or those with unique characteristics.

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Anant Jain

CA|BDO|M&A- Deal Advisory| Corporate Finance| Valuation| Financial Modelling| FDD| Python Enthusiast
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Income approach calculates the 'value' of the business whereas market approach computes the 'Price' of the business (thanks to Aswath Damodaran sir for this insight). This is primarily because, the market approach (CCM, CTM, etc.) uses the price at which comparable companies were transacted which is a result of negotiations between the parties and their perceived value of the strengths and weaknesses of the business. Whereas, the Income approach uses DCF method which help break down the business model using the value drivers, its future capex plans and free cash flows. When you breakdown the business financials in such a way, all the inherent strengths and weaknesses are automatically incorporated in the free cash flows and the value.

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2 Income approach

The income approach is a method that uses the future cash flows or earnings of the company or asset to estimate its present value. The income approach assumes that the value of the target is based on its ability to generate income in the future and discounts the future cash flows or earnings to the present using an appropriate discount rate. The income approach can use different techniques, such as the discounted cash flow (DCF) method, the capitalized cash flow method, or the residual income method. The income approach is often used when there is not enough market data available or when the target has unique characteristics or growth prospects.

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3 Advantages and disadvantages

Both the market approach and the income approach have advantages and disadvantages that depend on the context and purpose of the valuation. The market approach is more objective and observable than the income approach, as it uses market data rather than assumptions and projections. However, it may not capture the specific value drivers or risks of the target. Additionally, it may be affected by market fluctuations or anomalies that distort the prices of comparables. On the other hand, the income approach is more flexible and customized than the market approach, as it allows for incorporating the target's specific cash flow or earnings projections, growth rate, discount rate, and terminal value. Nevertheless, it is more subjective and uncertain than the market approach, as it depends on accurate and reliable assumptions and projections. Furthermore, its complexity and variability of valuation techniques and inputs can be challenging.

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4 Choosing a method

When determining the best method for a given valuation situation, there is no definitive answer. The choice of method is based on multiple factors, such as the availability of market data and financial information, the comparability of the target and peers, the purpose of the valuation, and industry standards. To ensure accuracy, it is recommended to use more than one method to cross-check and validate results. Additionally, the valuer should explain their rationale and assumptions behind each method, as well as disclose any limitations or uncertainties that may impact the valuation.

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Muhammad Zaurez Afshar

FCMA, CGMA
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Selecting the appropriate asset valuation method hinges on several key factors. The purpose of the valuation, type of asset, and availability of data all play crucial roles. The market approach leverages comparable transactions for readily tradable assets, while the income approach estimates future cash flow value for assets with limited market data or unique characteristics. In some cases, a combined approach utilizing both methods can offer a more comprehensive and reliable valuation, particularly for complex assets or situations with limited data availability.

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5 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?

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What makes the market approach method different from the income approach method?

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1 Market approach

2 Income approach

3 Advantages and disadvantages

4 Choosing a method

5 Here’s what else to consider

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