Valuation Basics: Understanding the Market Approach

At some point in the business lifecycle, business owners feel the need to know the worth of their companies. The business valuation process is highly complex, and the valuation method you select depends on the purpose of valuation and the unique characteristics of your business.

The market approach is one the most popular business valuation methods, along with the asset approach and the income approach.

The asset approach focuses on the value of the company’s assets or the fair market value of its total assets after deducting liabilities. The income approach focuses on the business or asset’s future income-generating capacity.

The Market Approach Defined

The market approach is a valuation method–also referred to as the market comparison approach or the market-based approach–considers the market prices of comparable assets or similar companies to determine the appraisal value of assets, businesses, or business ownership interest. These may be recently sold assets or businesses or those currently available in the marketplace.

When businesses are similar concerning the industry, revenue, growth potential, market influence, etc., the market approach becomes the ideal method for valuation. It works well when ample data is available to make comparisons, such as publicly-traded companies and residential real estate.

On the other hand, you should not opt for the market approach of the business valuation if finding information about similar businesses is difficult, like privately held sole proprietorships or when there are too few companies to compare.

When using the market approach, valuators try to determine the fair market value of a particular asset by surveying recent transactions involving similar assets and adjusting them as necessary because similar assets are unlikely to be identical to the asset in question.

The market approach consists of two primary valuation methods: public company comparables and precedent transactions. A valuation analyst may use many valuation methods under the market approach. The names of the methods are based on the source of known values, which they use as guidelines.

Public Company Comparable

As its name suggests, the public company comparable method uses the valuation metrics of publicly traded companies similar to the subject company. However, direct comparison is difficult to obtain, as most public companies are dissimilar and more significant than the subject company. Therefore, your comparability threshold should be flexible to avoid excluding from the valuation process those public companies having comparable business features.

While you may achieve direct comparability in some industries, differences of scale exist between private and public firms in most industries. To use the public company comparable method of valuation requires you to select, adjust, and apply public company valuation data, a complex process that involves appraiser skills and experience.

Select publicly traded companies to serve as guidelines from an industry similar or equivalent to the subject company. Those companies should resemble the company’s financial composition, operational processes, and demand and supply factors. A relative form of valuation, public company comparable, helps you look at the ratios of similar publicly traded companies and use them to derive the subject company’s value.

To use the public company comparable method of valuation, you need to:

• Identify and list the right comparable companies from the same industry with similar characteristics in size, geography, growth rate, profitability, margins, etc.
• Gather relevant financial information about these companies.
• Set up the comparison tables for the companies you will analyze.
• Calculate the various comparable ratios using historical financials and analyst estimates from the comparison tables.
• Determine the value of the subject company by using the multiples from the comparable companies.

Precedent Transactions

The precedent transactions method of valuation is based on the perception that comprehensive financial data of companies is difficult to find, whereas transaction value is readily available. The process derives the value of the subject company by using pricing multiples based on observed transactions of comparable companies.

You can use conventional industry classification methods (e.g., SIC or NAICS codes) to analyze precedent transactions and examine valuation databases for evidence of historical actuals and valuations. Consider transactions from comparable companies in the same industry; if there is no comparability, use other data after considering factors such as same industry, similar company size, identical products or services, location, competition, profitability, etc.

The precedent transactions method may be valuable when a company considers a purchase or sale or an exit strategy for the company’s management. However, this method has a weakness: transactions in significantly diverse industry conditions do not represent the prevailing M&A environment. Therefore, you must select guideline companies carefully. The lack of publicly available information also poses challenges in finding transactions suitable for comparable data.

Market Approach Advantages & Disadvantages

The market approach of business valuation benefits owners by using accurate and public data. It has no place for subjective forecasts. This straightforward approach involves simple calculations to determine company value.

On the flip side, it has some weaknesses, such as difficulty identifying comparable companies or transactions and a lack of flexibility regarding business valuation. The lack of a sufficient number of similar companies or transactions may raise questions about the quality and quantity of available data.

Key Uses of Market Approach

Using the market approach to determine business value best works when:

• There is a dispute, such as a partner disagreement or buyout, and you need to justify the value of your business.
• You want to set the asking price for a business purchase.
• There is a legal or tax dispute, and you want to defend the valuation of your company.

Summing Up

The market approach method of business valuation determines the value of a company by comparing it with similar companies. It is most suitable in situations and industries where relevant data from comparable companies is readily available.