Pros and Cons of the Market Approach for Business Valuation
The valuation of businesses presents a unique challenge for valuation advisors, appraisers, and entrepreneurs who need to find an answer to the question “What isÂ theÂ business worth?”
No two businesses are the same, even those in the same industry. Each differs in business model, type, size, specialization, geographical expanse, competition, culture, values, and more.
As no two companies are the same, calculating their value cannot be the same. There is no universal formula to calculate the business value and no one-size-fits-all approach for business valuation. Business valuation experts use different valuation approaches and methods to meet the needs of different types of companies.
You need expert advice, not just for the complex business valuation process but also for choosing the valuation approach most suitable for your unique business.
Basic Valuation Methods
Experts choose a valuation method depending on a particular company’s need, the purpose for valuation, and the information (variables). Business valuation experts usually rely on three basic approaches:
- Cost approach
- Income approach
- Market approach.
Using the cost approach, valuation experts calculate the value of a business from the fair market value of its net assets (total assets minus total liabilities). The idea is to identify the cost to replace or rebuild the object under review (company, product, system, etc.)
The cost approach helps to value asset-intensive companies, holding companies, and distressed businesses which are not worth more than their net asset value.
This approach includes the book value method and the adjusted net asset method for business valuation. As the name suggests, the book value method uses data from the company books. The adjusted net asset method accounts for unrecorded liabilities and intangible assets and converts book values to fair market values.
The income approach values a business based on its ability to generate future earnings. It converts estimated future earnings or cash flows to their present value. This approach best suits the business valuation of profitable and established companies.
It includes the capitalization of earnings method and discounted cash flow method for business valuation.
With the capitalization of earnings method, valuation experts apply the capitalization rate to estimated future earnings. They adjust for discretionary expenses like non-recurring expenses, unusual tax issues, differences in capital structure, anomalies in the ownerâ€™s compensation, etc. This method is suitable for businesses having stable cash flows.
The discounted cash flow method considers the factors used in the capitalization of earnings method and additional factors, including projected cash flows over three or five years and a terminal value at the end of the period. The experts use a discount rate to convert all future cash flows, including the terminal value, to present value.
Experts use the market approach to determine the value of the business based on the value that market forces assign in comparable situations. These situations include:
- Prior transactions involving the same business,
- Stock prices of a comparable public company, or
- Ownership transfer transaction involving comparable companies.
The market approach of business valuation values an asset relative to other comparable transactions. It involves finding a price multiple of the benchmark, multiplying it with the financial metric of the business, and estimating value. The benchmark could be enterprise value (EV) to EBITDA, price-to-earnings ratio, price-to-book value, etc.
The market approach of business valuation includes the primary transactions method, guideline public company method, and guideline transaction method.
Prior Transactions Method
Using the prior transactions method of the market approach, valuation experts research historical transactions in securities of the business under review.
The method helps in the valuation of both minority and majority stakes in the business. A minority stake could be a historical stock quote from a listed stock exchange; an M&A transaction could comprise a majority stake.
They also take additional factors into account while selecting prior transactions as a benchmark. These factors include the economic situation and other circumstances during the transaction, the transaction timeline, etc.
Guideline Public Company Method
As the name suggests, the guideline public company method identifies a comparable public company and obtains the price of its listed securities. However, the stock prices usually represent a minority stake.
The benefits of using this method are the number of sources of information for public companies and the availability of a large set of recent data. However, establishing a comparison for the business under the valuation may be challenging.
Most public companies have large revenue sizes, diversified revenue streams, complex capital structures, skilled management, global operations, ready access to capital markets, etc., which many private companies lack. Valuation experts must adjust the benchmarks used for capital structure, revenue size, etc., challenging.
Guideline Transaction Method
When using the guideline transaction method, valuation experts identify prior transactions of comparable private or public companies, such as divestitures, mergers, acquisitions, etc. The information is sourced from relevant valuation databases that collect and analyze transactions.
Such transactions may either represent a minority or majority perspective. If a direct transaction (from a similar company in the same industry) is unavailable, experts use other data after considering factors like market niche, product, etc. They further adjust transaction data for transaction-specific factors like employment contracts, complete agreements, etc.
While selecting the valuation method, experts consider the definition of value, the company size, and the magnitude of the valuation stake (majority or minority). In the valuation assignment of a majority stake, they either select the prior transaction method or guideline transactions representing the majority stake in comparable companies. Similarly, for a minority stake valuation, they use the guideline public company method.
Like every other valuation approach, even the market approach has its pros and cons.
Market Approach Pros
The market approach eliminates subjective estimates and forecasts and focuses on objective, comparable data from the market. The data for comparable public companies is readily available and verifiable. The use of up-to-date market pricing reflects prevailing market conditions, performance expectations, present investor sentiment, and industry outlook.
The market approach analyzes actual transaction prices from companies in the same industry as the company under review. It is easier to find comparable companies in terms of size.
Market Approach Cons
The market approach offers low flexibility as compared to other approaches for business valuation. Public companies often lack direct comparability to private companies in several aspects like capital access, size, geographical expanse, diversity in products, services, and earnings streams. Even in the case of direct comparison transactions, some transactions may have occurred in entirely different market situations and may not represent the current M&A environment.
Is the Market Approach Best for Your Business?
The market approach of business valuation requires considering many factors and making substantial adjustments to use them successfully. As all approaches for business valuation have their pros and cons, a comprehensive valuation should ideally combine two approaches to bolster conclusions and give more confidence in the concluded values. This requires expertise.