April 16, 2019
The market approach, whereby appraisers use comparable “guideline companies” to help them estimate the value of a private business, has become a long-standing valuation touchstone.
Two primary valuation methods are categorized under the market approach:
- Guideline public company method. Here, appraisers identify companies with stock (or partnership interests) that are actively traded in the public markets, such as the AMEX or NYSE. Then they calculate key financial variables, using the stock price and a variety of pricing multiples such as price-to-revenue, price-to-net income and price-to-book.
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 appraiser’s professional judgment.
The subject company’s fair market value equals the pricing multiple times the subject company’s financial variable (for example, revenues, net income or book value). Because the guideline public company method is based on individual stock prices, under certain circumstances it generates a minority, marketable basis of value.
- Merger and acquisition (M&A) method. For guideline transactions under this method, appraisers analyze sales of entire public or private businesses. So this technique typically generates a controlling, marketable basis of value.
Because private businesses aren’t required to disclose sales to the SEC, finding out their details can be difficult. Fortunately, appraisers have access to several proprietary databases (such as DealStats, Done Deals and BIZCOMPS) that they can use to identify and analyze private deals.
Once appraisers have identified a relevant sample of potential guideline transactions, they calculate pricing multiples relative to key financial variables. Fair market value is a function of the pricing multiple and the subject company’s financial metric (say, last year’s revenues or book value).
Deciding Which Way to Go
The availability of transaction data is a key determinant of whether an appraiser uses the market approach. 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. And some industries lack a meaningful sample of M&A transactions, particularly those involving small niche participants.
In general, the guideline public company method makes more sense if the subject company is large enough to consider going public and when valuing a minority interest in a going concern business. Using this method to value a controlling interest may require subjective adjustments for control.
Conversely, the M&A method is generally more appropriate when valuing controlling interests. But, with proper adjustments and analyses, it can be used to value minority interests.
Other disadvantages of the M&A method are:
- Transaction databases provide limited information about guideline companies.
- Details provided are unverified.
- The sales price may include buyer-specific synergies and undisclosed terms (such as installment sales, employment contracts and noncompete agreements).
One common valuation mistake that may occur under the market approach is failing to adjust the financial statements of the subject company or the guideline companies to ensure accurate comparisons.
For example, nonrecurring items and discontinued operations may need to be eliminated. Or, for comparative purposes, appraisers may need to rectify accounting inconsistencies, say, for depreciation or inventory methods. Ideally, appraisers make these adjustments before selecting guideline companies and computing pricing multiples.
Inconsistent terminology may also lead to problems. Slight differences in the ways databases or appraisers define terms such as “cash flow” or “earnings” can trigger significant valuation differences. It’s imperative to understand how each database defines variables as well as what’s included (or excluded) in the selling price.
An Accurate and Defensible Valuation
The market approach has intuitive appeal: The value of an investment should be comparable to similar investments in the marketplace. But finding a reliable sample of comparable transactions isn’t as easy as it appears, especially for small niche players. An experienced valuation pro knows the tricks to applying the market approach to derive accurate and defensible valuations.