Exploring the Fundamentals of Market-Based Valuation

Key Takeaways:
  • The market approach examines transactions of similar companies to estimate the value of your business.
  • The pricing multiples derived from these market transactions are applied to the subject company’s metrics to derive its relative value.  
  • The goal is to find the most accurate and relevant comparison to determine your company’s fair market value. 

 

Are you contemplating the future of your business? Wondering how to value your company for a potential transition or succession plan? Understanding the market approach to business valuation is important in this journey. It’s not just about numbers; it’s about recognizing the true worth of your business. 

When valuing a business, there are three general approaches an analyst looks at: 

  1. Income 
  2. Asset  
  3. Market 

In the world of business valuation, the market approach is often emphasized due to its reliance on market data to derive fair market value. This method examines transactions of similar companies to estimate the value of your business. The pricing multiples derived from these market transactions are applied to the subject company’s metrics to derive its relative value.  

The Potential Methods 

There are four commonly used methods within the market approach:  

  1. Guideline public company
  2. Guideline transaction (mergers and acquisitions) 
  3. Past transactions (sale of the company’s own stock) 
  4. Industry (rule of thumb)

Guideline Public Company Method 

This method assesses the value of your company based on the stock prices of similar public companies. It’s most effective when there are publicly traded companies that share characteristics with your business. 

These companies are ones that are traded on one of the publicly listed exchanges such as the NYSE, NASDAQ and American Stock Exchange. There are also other smaller exchanges including Chicago Board of Trade, Over the Counter, Bulletin Board and Pink Sheets.  

The advantage lies in the accessibility of data through public filings like 10Ks and 10Qs. However, the challenge is finding a truly comparable public company, especially for smaller or niche businesses. A main street electronics store is not going to compare well to an Apple or NVIDIA stock. 

Guideline Transaction Method 

The guideline transactions method relies on pricing multiples derived from transactions involving similar companies and applied to the subject’s metrics to determine the value of the subject interest. These transactions are found on databases such as BizComps, Institute of Business Appraisers, Done Deals, Factset Mergerstat, Capital IQ and DealStats (formerly Pratt’s Stats.) Each of these databases has information on tens of thousands of private company transactions.  

In this method, market multiples are derived from the transactions of the companies and applied to the subject company. The advantages to this method are information for similar sized companies and specific industries are available. However, the information is limited to what is reported, and comparable transactions may not exist. The transactions reported in these databases are generally lacking adjustment: stock transaction values are provided without interest bearing assets and liabilities and asset transaction values are provided without cash, receivables, prepaids, non-operating assets or liabilities. These items are added back to the calculation before the market value of implied capital amount is determined.  

Note: Depending on the number of transactions and the reliability of those transactions, the market approach could be used as a sanity check in comparison to the income approach. Sometimes, when the guideline companies are not very good, or the number is not sufficient, the market approach is excluded entirely. There are certain NAICS or SIC codes for which there is no data available. We see this commonly in the agriculture industry, since most of the transactions are closely-held, related party transactions of legacy farms. These transactions are hardly reported. 

Past Transactions Method 

When there are not applicable guideline transactions, either public or private, available for comparison, the past transactions method can be considered. However, this method is only applicable when the subject company has had previous arm’s length transactions. Transfers among family members or employees are generally not representative of fair market value. These transactions are provided by the internal management of the company, or prior valuations performed by a certified analyst. 

Industry Method 

The final method within the market approach is the industry method, or rule of thumb method. This method is a simplified form of the market approach. A “ballpark” multiple is applied to the earnings of the subject company to determine the value of the business. This method is applied commonly by business brokers and can be applicable to main street stores.  

Tailoring the Approach 

The choice among these methods depends heavily on the size, industry and specific characteristics of your company. The goal is to find the most accurate and relevant comparison to determine your company’s fair market value. 

Grasping the potential methods of the market approach is just the beginning of the business valuation journey. These methods form the foundation for a more detailed valuation process, where the chosen method is applied to determine your company’s market value accurately. Contact an Adams Brown valuation advisor if you would like to discuss your company’s value.