The Market Approach Made Simple
Prior to the 1920s, business valuation was really left up to the negotiation skills of both the seller and the buyer. However, when prohibition began on January 17, 1920, and the passing of the 18th Amendment this all changed. Up to this point, there were no official guidelines for valuing a business. Business prices were selected based on negotiation skills and the lifestyle of the business owner. Prohibition led to the first valuation guidelines established by the IRS. These guidelines were the Appeals and Review Memorandums (ARMs). These guidelines have led to the development of several approaches to value a business. This article will specifically discuss one of those methods – the market approach.
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Common Business Valuation Approaches
Today those looking to buy or sell a business get a business valuation from a professional. Business valuation analysts use three main approaches to value a business. They include the following:
- The Income Approach
- The Asset or Cost Approach
- The Market Approach
Business valuation specialists like Peak Business Valuation, business appraiser California, use a combination of these approaches to appraise a business. In this article, we examine how to use the Market Approach to arrive at a fair business price. Two methods used under The Market Approach are The Guideline Public Company Method and The Guideline Company Transaction Method. We will look at both of these methods and their pros and cons.
What is the market approach?
The Market Approach is akin to how a real estate appraiser values a house, by comparable houses. This approach compares a company to similar peers. ‘Similar company’ could mean operating in the same geographic area, industry, or size. It also includes any company you can justify as similar. If that sounds vague it’s because it is. Picking comparable or ‘guideline’ companies requires expertise and skill.
Common Multiples to Compare Companies:
A valuation expert considers several different metrics. They can then use these metrics to determine multiples. Multiples allow the valuation expert to compare similar companies. Common metrics a valuation expert uses include the following:
- Sales Price
- Sales Price / Revenue
- EBITDA % (A measure of profitability)
- Sales Price / EBITDA
- Sales Price / Sellers Discretionary Earnings (SDE)
- SDE % (Another measure of profitability)
The similarity in these metrics is a good sign as it shows the two companies are similar. Because each business is different it is necessary to use different approaches.
Using The Market Approach
Within the market approach, there are two common valuation approaches. So, let us take a closer look at The Guideline Public Company Method and The Guideline Company Transaction Method.
The Guideline Public Company Method
The Guideline Public Company Method compares a closely-held business to a similar public company. This method is based on stock prices being an objective measure of value. There are three basic steps to using this method:
Step 1: Find Guideline Companies
Search databases, industries, and company websites to make a list of similar companies.
Step 2: Examine Similarities
Operating in the same industry does not justify a company as similar. Other factors to consider are the size, the structure of the balance sheet, and the growth of the company. Cut from your list any obvious outliers in the companies you have selected so far.
Step 3: Compare Multiples
Compare the financial multiples of each company to the company you are valuing. This narrows down your list even more. You should have a good list of comparable companies at this point. Apply the average multiples of your list to the company you are valuing. Below is an example of how you would do this with a company value to EBITDA multiple.
Company Value = Company’s EBITDA * Average multiple of company value to EBITDA
For more information on multiples see “What is a Valuation Multiple?.”
Benefits of the Guideline Public Company Method
- Stock prices are objective
- Public companies financial data is available to the public
- A large number of companies to choose from
Disadvantages of the Guideline Public Company Method
- Public companies are often much larger than closely held small businesses
- Capital structure is often very different from closely held companies
- Some argue that public companies do not compare to closely-held companies
The Guideline Company Transaction Method
The Guideline Company Transaction Method is like The Guideline Public Company Method. But, instead of comparing the subject company to a public company, you compare it to a private business transaction. In other words, the price someone bought a similar business for in the past. This helps determine a fair valuation of what a business is potentially worth. This approach is much more applicable to small businesses. Peak Business Valuation, business appraiser California, often uses this method.
Step 1: Search for Guideline Transactions
Search for comparable private transactions. For example, at Peak Business Valuation, business appraiser California, we use databases of private business transactions like PeerComps, Deal Stats, BVDataWorld, and IBA Database. Databases like these have increased accuracy when valuing a small business.
Step 2: Filter out Outliers
Filter out transactions that do not compare to the business you are valuing. It is common to look at only recent transactions in the industry your company is in. Other factors to consider include revenue, size, and business type.
Step 3: Compare Multiples
Compare the company you are valuing to the average multiples of your list. By applying your company’s financial data to the average multiples in your list, you arrive at a company’s range of values. The formula below shows how you would arrive at the Company Value by comparing the company value to the EBITDA multiple.
Company Value = Company’s EBITDA * Average Multiple of company value to EBITDA
For more information on multiples see “What is a Valuation Multiple?.”
Benefits of the Guideline Company Transaction Method
- Closely held companies are more likely to be similar in size
- Comparing small businesses to each other is more of apples to apples comparison
Disadvantages of the Guideline Company Transaction Method
- Audited statements usually are not available
- Fewer tools to analyze potential guideline companies
- Incomplete/Missing data
Summary
The Market Approach is one of the three commonly used approaches to valuing a business. Peak Business Valuation, business appraiser California, uses a combination of several methods when providing a valuation. Each of these methods requires expertise to fairly represent the business. Don’t leave the value of your business up to negotiation skills. We are happy to answer any questions you may have! Please reach out by scheduling your free consultation below.
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