Laboutin’s management is considering the acquisition of a rival firm, privately-held Frontier Energy Co. Laboutin is attracted to Frontier because they believe it is a developing company entering into a high growth stage.
The valuation method for Frontier is that he should use a(n):
Income approach
asset-based approach
market approach
The answer: income approach. The best way to value private companies in a high growth stage is to use a free cash flow method, which in private business appraisal is known as an income approach.
But, if a company is entering a high growth stage, the free cash flow can be negative and fluctuant because of the large investment in capital. Why income approach is appropriate for growing company, not market approach?
i think the key over here is “acquisition”. from my experience, we tend to use income approach when it comes to merger and acquisition
This question confused me too. I chose asset approach bc “developing” “high growth” firm is not established, so may lack reliable cash flows.
And I understand market approach to be best for larger, mature firms – features that make firm more comparable to typical public firms.
Income approach, I thought, is the most common…kinda a catch all so long as cash flows are reliable.
You cannot use asset based approach because the company is still relatively new and will not have sufficient asset to warrant asset based valuation.
You cannot use Market based approach because the question specifically state that Frontier Energy Co. is privately held.
So, you are left with only Income approach which on any other day is the most efficient method of valuing such a firm.
Hope that helps.