FAQs About Using the Market Approach To Value a Business

The market approach is based on a straightforward premise: A company’s value can be derived from the prices others pay for similar businesses. But, in practice, this technique isn’t nearly so straightforward. Here are answers to some frequently asked questions about this approach.

How Does It Work?

The market approach estimates the value of a business by comparing it to other companies or business interests that have been sold or are actively traded. These reference points — commonly called guideline transactions or “comparables” — provide pricing data that can be applied, with appropriate adjustments, to the subject company. Of course, the goal isn’t to find an exact match. Instead, valuation professionals look for companies that are reasonably comparable in terms of industry, size, risk and other operating characteristics.

When Is It Appropriate?

The market approach isn’t used in every business valuation. The availability of relevant transactional data is a key determinant of whether a valuator uses it.

Pure players (companies that focus on a single target market or offer a limited menu of products) may be hard to come by in the public markets, especially in industries dominated by conglomerates. Of course, private company transactions aren’t publicly disclosed. However, proprietary databases are available to identify relevant deals.

The expanding availability of transaction databases and the growth of small-cap public companies have made the market approach increasingly useful for valuing closely held businesses. But some industries lack a meaningful sample of transactions, particularly those involving small niche participants.

What Methods Fall Under This Approach?

When relevant market data is available, the next step is choosing the appropriate methodology to apply. There are two primary methods under the market approach:

1. The Guideline Transaction (Merger and Acquisition) Method This method relies on sales of controlling interests in private or public businesses.

2. The Guideline Public Company Method Under this method, value is derived from comparable stocks (or partnership interests) that are actively traded on the New York Stock Exchange or other public markets. Public stock prices are used to compute pricing multiples — such as price-to-revenue, price-to-net income and price-to-book value — to apply to the subject company’s results.

Financial variables may be calculated for a variety of time periods, such as next year’s forecasted performance, the preceding 12 months or an average of the last five years. The appropriate pricing multiple depends on case specifics and is a matter of the valuator’s professional judgment.

How Do Valuators Decide Between Methods?

In general, the guideline transaction method tends to be more appropriate when valuing controlling interests. However, with proper adjustments, it may also be applied to noncontrolling interests.

Conversely, the guideline public company method makes more sense when the subject company is large enough to consider going public and when valuing a noncontrolling interest in a going concern business. Using this method to value a controlling interest may require subjective adjustments for control.

What Makes a Company or Transaction Comparable?

When selecting comparables, industry classification is only the starting point. Valuation professionals also consider factors such as:

• • • Financial performance (for example, profitability, asset management and cash flow),
    • Capital structure,
    • Management quality,
    • Products and services,
    • Brand strength,
    • Markets served and competitive position,
    • Stage of business maturity,
    • Transaction timing, and
    • Size of the ownership interest being valued.

Additional criteria may apply depending on the industry. For example, when valuing a hospital, the number of licensed beds may be a key value driver.

Selecting appropriate comparables and applying market data requires careful judgment. No two companies are identical, and valuation reports must clearly explain why certain comparables were selected and how differences were addressed.

Is It Appropriate for Your Situation?

Valuation professionals always consider the market approach when appraising closely held businesses. But they might not necessarily rely on either M&A data or public stock prices to reach their final conclusions. Sometimes there are too few true comparables within a reasonable time frame. Other times, there’s too much variation in the transaction data to provide a meaningful pricing multiple.

Contact us to discuss whether the market approach is right for your situation. We can help you understand the pros and cons and answer any additional valuation-related questions.