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Using the market approach, business valuation professionals base the value of a company on how similar companies, both private and public, were priced in the market in the past. The market approach is the most direct approach for establishing the market value of a business. This approach is based on the principal of substitution that a prudent investor will not pay for an investment more than it would cost to purchase a comparable substitute investment.
When applying the market approach business appraisers aim to locate comparable businesses that are traded on a public market, or entire public or privately held companies that have been sold. Based on the identified transactions appropriate pricing multiples are calculated, such as price to revenue or price to earnings ratios, and applied to the revenue or earnings of a closely-held business being valued.
Transactional market data may consist of either minority or controlling interests in publicly traded or closely held companies. There are basic considerations that provide useful guidelines in the selection of comparative publicly traded companies or acquisitions. Some of the more important considerations include the availability of adequate financial and price information; the company’s line of business, location, quality, and depth of management; the size of the comparative company; trading activity in the stock; and the specific block of stock or equity ownership interest that is the subject of the valuation assignment.
For the market approach to be used there must be a sufficient number of comparable companies to make meaningful comparisons to. Typically, this valuation approach is particularly useful when valuing public companies or privately held companies large enough to consider going public because data on comparable public businesses is readily available. This approach is difficult to use for relatively small, privately held businesses because there may be not enough comparable companies with similar valuation fundamentals and in the same sector, and reliable information is difficult to obtain. Any public companies are often found to be too diversified and too large to provide meaningful market statistics in relation to a privately held company being valued.
The market approach is much more likely to reflect the current mood of the market, that is the collective mood of investors regarding a particular market or asset. Since market conditions can change dramatically quickly, a market approach business valuation may become irrelevant when investor sentiments change.
The four main methods, within the market approach, typically used in professional business valuations are the Guideline Public Company Method, the Merger and Acquisition method, the Prior Sales of Interest in Subject Company Method, and the Dividend Paying Capacity method.
1. The Guideline Public Company Method within the market approach encompasses determining market multiples from market prices of stocks of guideline companies, which are publicly traded companies engaged in the same or similar lines of business as the company being valued.
This method usually relies on transactions consisting of minority interests of publicly traded companies. A minority interest represents an ownership interest of less than 50% of the voting interest in a business, and characterized by having no power to direct the management and policies of a business. Search for publicly traded controlling interests representing an ownership interest over 51% of the voting interest in a business often yields no transactions for comparable companies engaged in the subject’s business.
The typical steps in applying the Guideline Public Company Method include identifying guideline companies based on the relevant industry, size, financial performance and transaction date; performing a peer group analysis comparing the company being valued to its peers; calculating and analyzing pricing multiples for the guideline companies; adjusting guideline companies pricing multiples to account for the difference in size and specific operating characteristics of the company being valued, and applying the most relevant adjusted multiples to the revenue or earnings of the company being valued.
Statistical analysis such as the regression analysis may be used to verify how reliable and accurate the calculated pricing multiples are. The regression analysis is an advanced statistical technique that allows to estimate the value of a business by measuring a mathematical relationship between the pricing multiples and revenue or earnings of identified guideline companies. Business valuation experts tend to rely on pricing multiples that were selected based on guideline company sales data reflecting high correlation between the pricing multiples and revenue or earnings of identified guideline companies, and low variances of sales multiples from their calculated mean or average.
When utilizing the Guideline Public Company Method to value a privately held company business valuation experts keep in mind that, in general, financial data for public companies is readily available and prepared in conformity with generally accepted accounting principles and SEC filing requirements while there is limited access to data for privately held companies where financial data is often prepared for tax purposes; public companies are substantially larger than privately held companies; and there are other fundamental differences that cause distortions between publicly traded and closely held businesses. Specifically, closely held companies have one or more of the following risk attributes that are not inherent in their public company counterparts: lack of management depth or key person dependence, dependence upon a single product or service line, dependence upon a few customers, limited geographic market, relatively small market share, limited buying power or supplier dependence, unstable margins and/or highly volatile earnings, investment motivation is to acquire a job and the investment is less liquid, high financial leverage and sources of debt financing is limited.
These and other material differences between publicly traded and privately-owned companies make this method a challenge to use for relatively small, privately held businesses.
2. The Merger and Acquisition Method, although similar to the Guideline Company Method in its use of price multiples, focuses on the transactions involving the sales of entire companies, rather than sales of minority interests of publicly traded stock. Entire companies represent controlling interest, which is an ownership interest of at least 50% of the voting interest in a business and characterized by having the power to direct the management and policies of a business. This method generally can be applied by using both public company and privately held company data. Multiples derived from public company data result in control, marketable values, while multiples determined from private company data result in control, non-marketable values.
Similar to the typical steps applied under the Guideline Public Company Method, the typical step under the Merger and Acquisition Method include identifying past sales of entire companies based on the relevant industry, size, financial performance and transaction date; performing a peer group analysis; calculating and analyzing pricing multiples; adjusting pricing multiples to account for the difference in size and specific operating characteristics of the company being valued, and applying the most relevant adjusted multiples to the revenue or earnings of the company being valued.
One of the advantages of using the Merger and Acquisition Method to value a privately held company is the fact that the market for closely held companies has the following characteristics: (1) limited access to data where financial data is often prepared for tax purposes; (2) closely held companies are typically similar in size; and (3) there are more fundamental similarities between closely held companies because of their common interests and because they do not benefit from the relatively easy liquidity of the public market.
One of the disadvantages of using the Merger and Acquisition Method is the fact that the available information on companies’ sales is often incomplete given the private nature of most comparable transactions. However, the appropriate application of this valuation method is an important part of valuation analysis.
3. The Prior Sales of Interest in Subject Company Method focuses on the transactions involving the past sales of interest in the subject company and is similar to the Guideline Company Method in its use of price multiples.
Arm’s-length transactions in the subject company’s stock can provide a good indication of value and must be considered when valuing a company. Generally, when applying this valuation method it is of key importance how comparable the economic factors that drove the subject company at the time of prior transactions are to those of the subject company as of the current valuation date. It is important to note that a company during its periods of significantly greater revenue and earnings will sell for higher multiples than during the periods of significantly smaller revenue and earnings. This is because larger companies tend to have greater management depth, stronger market positions, more diversified customers and products, easier access to capital and, due to the greater financial resources, are generally viewed as less risky than smaller companies.
Since the past transactions can include sales of entire company or partial ownership interest, a derived value for the subject company using this method can result in a control or non-control value.
4. The Dividend Paying Capacity Method is an income-focused valuation method but it is considered a market approach because it is based on market data. The difference between this method and the Capitalization of Earnings income-based method described below is the type of earnings used in the calculations and the source of the capitalization rate.
The Dividend Paying Capacity Method is based on the future expected dividends to be paid out or the dividend-paying capacity. Within this method a business valuation expert capitalizes such dividends with a five-year weighted average of dividend yields of five comparable businesses.
Primary consideration under this method is given to the capacity of the business to pay out dividends rather than to the dividends actually paid in the past. When valuing a controlling interest in a business, the dividend paying capacity is not a significant factor since the payment of such dividends is discretionary with the controlling stockholders. The controlling stockholders can substitute salaries and bonuses for dividends reducing net income and understating the dividend-paying capacity of the business. As such, the dividends are less reliable criteria of fair market value than other applicable factors.
In addition, if a privately held company being valued has not paid dividends in past years and does not intend to pay dividends in future years, this method of valuation is not considered applicable.
To read about the Three Main Approaches to Value a Business click here.
Bibliography
AICPA, ASA, CICBV, NACVA and IBA (2017). International Glossary of Business Valuation Terms. Retrieved from: ttps://s3.amazonaws.com/web.nacva.com/TL-Website/PDF/Glossary.pdf
Internal Revenue Service (1959). IRS Revenue Ruling 59-60. Valuation of Non-Traded Assets. See a Link to Full Text (PDF)
Aswath Damodaran (2018). The Dark Side of Valuation. Pearson Education