The Market Approach determines the value of a business by comparing the subject company to businesses that have recently sold in the marketplace. This approach to business valuation is based on simple economics. If a company were underpriced, it would have attracted more buyers until there were no buyers willing to pay more for the company. If a company were overpriced, the seller of a business would not be able to attract any buyers. Thus, the price that most businesses transact at is likely the fair market value of the business. A reasonable pricing comparison can be made if there are enough transactions of companies that are similar to the subject company.
Just as a real estate appraiser compares a house to similar houses in the area to determine an estimated market price, so do business appraisers examine the sale prices of businesses similar to the subject company to establish a reasonable estimate. However, unlike a house, a company may carry significant goodwill (reputation, customer loyalty), extensive client lists, or other special attributes that distinguish it from many peer companies. Effective business appraisers account for these company-specific attributes when using the Market Approach in order to determine a reasonable estimate of value.
Sources of Data:
There are a number of different data sources available to business appraisers attempting to apply the Market Approach to a company. Selection of an appropriate source of data depends on the characteristics of the subject company. One of the most important characteristics that appraisers consider is the size of the subject company. If the company is large, the appraiser may determine that the most appropriate source of data would be transactions of publicly traded companies. If the company is small, the appraiser may consult one of the databases that collect information on completed transactions of privately held companies. The actual methodology that is used to determine value would vary depending on the source of transaction data.
Quality of Data:
Once the appropriate data source has been selected and transactional information has been gathered, our appraisers must then review the quality of the data. Does the data make practical sense? Is the number of comparable transactions statistically significant? Does the data provide meaningful information about the subject company? Are there any factors that might distinguish the subject company from the data set? If so, are there any adjustments that need to be made?
If there are an insufficient number of comparable transactions, it may be necessary to broaden the search to a general industry or to adjust other search criteria such as upper and lower limits for annual sales. Although comparable transactions drawn from a general industry (rather than the specific SIC code) may not be an exact match, they would still allow for a reasonable pricing comparison.
Typical search criteria include:
Asset vs. Stock sale data
Size (by sales or employees)
Fixed asset ratios
Geography (regional, U.S. only, etc. )
Industry
Excluded outliers
Types of Multiples:
If the data is determined to be adequate for a reasonable pricing comparison, the next step is to select what type of multiple should be applied.
One of the first multiples that might be looked at is the Sale Price to Sales multiple. If companies in the industry have very little variation in gross margins and operating margins, a Sale Price to Sales multiple may be an appropriate multiple.
However, most companies do have different gross margins and operating margins. To determine a multiple that captures the efficiencies (or inefficiencies) that distinguish the subject company from the sample set, the appraiser should consider a bottom line multiple (Net Income, EBIT, EBITDA) rather than a top line multiple (Sales). For investors, value is driven by the company’s earnings.
Another consideration is the strength of the relationship (correlation) between the selling price of a company and the metric underlying a multiple. For example, if the correlation between the selling price of companies and the net income that those companies generate is particularly strong, this may indicate that the Sale Price to Net Income multiple should be a reliable indicator of value.
The appraiser may use several different types of multiples such as Sale Price to Sales, Sale Price to EBITDA and Sale Price to Owner’s Cash Flow. By using several different types of multiples the appraiser would be able to describe a range of values rather than a single point estimate. Depending on the strength of a multiples’ correlation to selling price, the appraiser may choose to give more weight to one multiple over another in determining value.
Application:
In applying multiples, it is important to remember that they typically produce a selling price rather than an equity value. The selling price of a business would not include personal assets, cash, accounts receivables or any liabilities. These non-transferring assets and liabilities must be accounted for before it is possible to determine what a business’s equity value or its worth to its current owners.
Selecting appropriate pricing multiples would allow the appraiser to determine a range of values for the subject company. Our appraisers would then consider this range, along with values derived from the Income and/or Asset Approach, to determine a final estimate of value.
