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There are three conceptually distinct methodologies that can be applied when performing business valuations or asset appraisals: (a) the income approach, (b) the market approach, and (c) the cost approach.
The income approach quantifies the present value of anticipated future income generated by a business or an asset. Forecasts of future income require analyses of variables that influence income, such as revenues, expenses and taxes. The income approach is unique in its ability to account for the specific contribution to the overall value of various factors of production.
The market approach considers the implied pricing in third-party transactions of comparable businesses or assets. Transactions are analyzed in order to identify pricing patterns or trends that can be used to infer value on the subject business or asset. Adjustments are made to the transaction data to account for relative differences between the subject and the comparable transactions. The market approach is most applicable to highly homogeneous assets or businesses for which a ready market exists.
The cost approach considers replacement cost as the primary indicator of value. The cost approach is based on the reasoning that a prudent investor would not pay more for the subject business or an asset than the cost to the investor to replace or re-create it. Like the market approach, the cost approach makes fewer assumptions than the income approach, but the primary limitation inherent in the cost approach is its inability to capture the value of many categories of intangible assets.
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