The market approach is an intuitive way to value a private business interest. It bases the subject company’s value on sales of other similar businesses or business interests, which are commonly referred to as “guideline transactions” or “comparables.” Each business is unique, so identifying an exact match is impossible.

2 methods

The following two primary valuation methods fall under the market approach umbrella:

1. 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.

2. Guideline transaction method. Under this method, sales of controlling interests in businesses are used to develop pricing multiples. Because private businesses aren’t required to disclose sales to the Securities and Exchange Commission, finding out the details can be difficult. Fortunately, valuation professionals have access to various proprietary databases that can identify and analyze private deals.

Public vs. private comparables

The availability of transactional data is a key determinant of whether a valuator 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 transactions, particularly those involving small niche participants.

In general, the guideline public company method makes more sense when 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 guideline transaction method may be more appropriate when valuing controlling interests. But, with proper adjustments, it can be used to value minority interests.

Selection criteria

When selecting public and private comparables, the subject company’s industry is just a starting point. Other relevant selection criteria might include:

• Financial performance (for example, profitability, liquidity and asset management),
• Capital structure,
• Management quality,
• Products and services offered,
• Brand recognition,
• Markets served as well as market share and nature of competition,
• Business maturity,
• Transaction date, and
• Size of the block.

This list isn’t all-inclusive. In fact, some selection criteria may be industry specific. For example, when valuing a hospital, the number of beds might be a relevant value driver.

Valuation professionals tailor their selection criteria to fit the characteristics of the subject company. Selecting a meaningful sample of guideline stocks or transactions is a matter of professional judgment. It’s imperative that the valuation report explain the logic underlying selection criteria to persuade readers that valuator’s application of the market approach makes sense.

Increasingly applicable

The market approach doesn’t always apply. But the growing sophistication of today’s transaction databases and prevalence of small cap stocks make it increasingly applicable to private business interests.

(This is Blog Post #1304)