The market approach in business valuation is similar in many respects to the real estate appraisal method of finding comparable properties to the one in question that have recently sold, making any necessary adjustments for differences between the properties, and determining a value based on those observed sales prices. Just as real estate appraisers can use databases to find recent sales of real estate properties, business appraisers also have data available which allows them to draw comparisons between transactions of other companies to determine an implied value for the company they are trying to value.
There are two common sources of data business appraisers can use. First, they may observe the market data for similar companies traded on a public stock exchange. This method is known as the publicly traded guideline company method. Second, they have databases available to them that report details of transactions involving all or parts of the stock or asset transactions of privately held companies involved in mergers or acquisitions. This method is known as the guideline transaction method. Although we will not discuss it in additional detail here, it is worth noting that when appraisers observe and use past transactions in the subject company's stock as a basis for determining value, this is generally recognized as a market approach method.
Adequately Comparable Companies
In both methods, the key is finding companies that are adequately comparable to the company being valued. While such factors as square footage, neighborhood, and number of bathrooms might easily translate to an adjustable amount in a real estate appraisal, the factors which distinguish one business from another are generally more intangible in nature and make the task more difficult. For example, how much difference does the management depth of a publicly traded company make when compared to the subject company? It may be easy to say it makes a difference, but quantifying that difference is difficult.
When trying to determine whether a company is similar enough to use to determine the value of the company, among factors the appraiser will likely consider include such things as whether the companies offer the same products or services, whether they operate within the same industry, whether either of the companies operate in more than one industry, where the companies are located, whether they compete for the same business, whether the companies are similar in size, and whether the companies are similar in profitability.
The Guideline Transaction Method
When considering using the guideline transaction method, the appraiser must also consider whether the reported transaction is similar in nature to the one contemplated by the appraisal she is performing, and when the transaction occurred in relation to the valuation date of the appraisal. It should also be noted that while plenty of data exists for publicly traded companies, the data regarding guideline transactions can be sketchy, which then requires the appraiser's judgment regarding whether it is appropriate to include such a transaction in determining value.
Once a comparable company has been found, the appraiser usually calculates one or more multiples observable in the guideline public company or the guideline transaction, and applies these multiples to the company she is valuing. Multiples are usually ratios, such as price to sales, price to net income, price to cash flow or price to assets.
For example, if a comparable company sold for $1 million, and had net income in the year prior to the sale of $200,000, the price to net income multiple for that transaction would be 5 ($1,000,000 / $200,000). The appraiser would then apply the multiple of 5 to the subject company's net income of say $60,000 to determine a value for the company under the market approach of $300,000 ($60,000 x 5).
The selection of the appropriate multiple can also be subjective. Generally, when the appraiser uses the market approach, she attempts to identify as many comparable companies as possible, and then uses an average, or median multiple to calculate the value of the business.
What to Look for When Evaluating a Market Approach
When evaluating an appraiser's market approach, make sure you agree with whether the companies she uses as comparables really are comparable to your company. If you know of the company that is publicly traded or has recently sold that is comparable to your company, but which the appraiser has not identified, speak up. Not every transaction is reported and not every search for comparable companies is perfect. The appraiser will appreciate the help.