Savvy business owners seek guidance from valuation experts to determine their company’s current market value (CMV). One might need to know the CMV for various reasons: taxation, establishing partner ownership, divorce proceedings, estate planning, litigation, determining the asking price of the company, etc.
Business valuation professionals often rely on the three primary business valuation approaches to determine a company’s CMV. These include the asset approach, income approach, and market approach. The market approach works best when comparable data from similar companies is available.
Market Approach Explained
The market approach estimates a company’s CMV by comparing the subject company with its peers. It applies the logic that a company may sell through an earnings multiple similar to industry peers comparable in size, revenue, market influence, growth potential, and other significant factors.
The market approach is also called the market comparison approach or the market-based approach. It compares recently sold assets, ownership transactions, or similar-sized companies available in the marketplace. Because every company is unique, analysts must make necessary adjustments while surveying recent transactions involving similar assets.
The market approach is ideal for residential real estate and publicly traded companies for which relevant comparable data is available. Finding relevant information about similar businesses is difficult, or when there are too few comparable companies, other methods work better.
Why Use the Market Approach to Determine CMV
The market approach is a straightforward business valuation method and involves simple calculations. It does not depend on subjective forecasts of income/earnings but uses historical, public data that can be verified.
Calculate CMV using the market approach when disputes between business owners/partners arise, and enterprise value must be justified. Other issues requiring business value justification include legal disputes, tax discrepancies, divorce, buy/sell agreement, buyout, etc.
This method best suits business owners who want to determine the sale prices of their companies or when they want to purchase another company or enter into an M&A (mergers & acquisitions) transaction.
How to Calculate CMV Using the Market Approach
The market approach helps determine the fair market value of an asset by surveying recent transactions involving similar assets. It involves adjusting the available data, as similar assets may not be identical.
Valuation service providers make preceding transactions data available to analysts, and publicly traded companies disclose their financial performance. This information helps analysts select similar companies to compare with the subject company. Analysts’ experience and knowledge come into play when selecting an accurate list of comparable companies and making the necessary adjustments to the available data.
The market approach often calculates a higher multiple due to the difference between the size of publicly traded and private companies. This makes an analyst’s expertise crucial.
Methods used under the market approach of business valuation include the public company comparables and precedent transactions.
Public company comparable. Analysts use this method to calculate the CMV of publicly traded companies by comparing them with the valuation metrics of similar companies.
As most public companies are dissimilar, analysts keep their comparability thresholds flexible to include companies with similar business features. They list comparable companies from the same industry with similar characteristics, such as size, geography, growth rate, profitability, margins, etc., and gather relevant financial information. They set up the comparison tables, calculate different comparable ratios using historical financials, and determine the subject company’s value by using the multiples from the comparable companies.
Precedent transactions. This market approach method relies on the assumption that historical transactions of comparable companies are easier to find than comprehensive data. Therefore, analysts select similar companies having comparable factors, e.g., industry, company size, products and services, competition, etc. They take care to eliminate transactions in significantly diverse industry conditions, as those do not represent the current M&A environment.
They may use SIC (Standard Industrial Classification) or NAICS (North American Industry Classification System) codes or other conventional industry classification methods to analyze precedent transactions and study valuation databases for historical valuations and actuals.
The precedent transaction method best suits a subject company considering a sale, purchase, or exit strategy creation. This market approach uses different multiples to determine CMV.
Analysts commonly rely on the EBITDA (earnings before interest, tax, depreciation, and amortization) multiple. They use the seller’s discretionary earnings (SDE) or seller’s discretionary income (SDI) multiple to compare small businesses. Occasionally, they also use gross profit or revenue multiples.
Choosing the correct multiple for the unique situation and needs of a particular subject company and its owners, the analyst multiplies it with the corresponding financial metric to determine CMV—for example, Revenue x Revenue Multiple.
For deeper insight, consider this hypothetical scenario:
You want to purchase an apartment and find a listing in your preferred locality for $300,000. It is a 2-bedroom, 1,500-square-foot space with two bathrooms but no en suite laundry facilities. It requires some minor renovation and does not have a commanding view.
As it’s been up for sale for over three months, you suspect the apartment is overpriced and decide to determine a fair offering price. You look for similar apartments in the same neighborhood and make a table of comparable transactions. You use factors such as the asking price, square footage, price per square foot, numbers of bedrooms and bathrooms, quality of view, the extent of renovation required, and the availability of en suite laundry facilities.
Then you draw general conclusions from the comparable data collected and determine that the apartment you’re considering is overpriced. You make an offer at a lower but fair price based on your calculation, and the seller accepts it.
Use Real Data
The market approach method helps determine current market value by comparing the subject company with similar companies. It best suits situations and industries in which relevant data is available. The calculation accuracy under this method depends on the companies’ quality and the data analysts use for comparison. Professional value analysts possess the experience and insight to find that data and evaluate its validity. For the most accurate and justifiable calculations of current market value, seek guidance from experienced analysts.
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