The market approach is based on a straightforward premise: The value of a business can be derived from the prices others are paying for similar businesses. But, in practice, this valuation technique isn’t nearly so simple. There are a number of pitfalls experienced experts have learned to avoid.
Failure to recognize public vs. private company differences
Under the market approach, comparables (or guideline companies) can be publicly traded or privately held. Although the data for public transactions is usually readily available, the size of public companies and the motivations of their buyers and sellers can make these transactions less relevant when the subject is a small or midsize private company.
In addition, pure players (companies that focus on a single target market or offer a limited menu of products) can be hard to come by in the public markets — especially in industries dominated by conglomerates.
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. Moreover, using public stock prices to value a controlling interest may require subjective adjustments for control.
Insufficient selection criteria
There are various proprietary databases that valuation experts can search for comparable transactions involving private businesses. But, just because two companies operate in the same industry, that alone doesn’t guarantee they’re similar. Other factors experts may consider when using the market approach include:
Size. Large entities tend to have professional management, more sophisticated financial reporting and controls, and more cash reserves to help them weather downturns. It’s also important to consider the relevant size of the company’s market.
Geographic location. A business’s location may affect competitive forces, such as regulatory requirements and the number of competitors and suppliers.
Financial performance. Examples of possible financial performance criteria include debt ratios, profit margins and working capital.
In addition, the transaction date is increasingly relevant in today’s volatile marketplace. Old transactions may not be relevant if market conditions have changed. For instance, is a low point in the industry’s cycle driving values down (or vice versa)?
Failure to look beyond selling price
After an expert has identified relevant transaction data, he or she must delve into the details to understand the transactions’ terms and the elements driving their value. In some cases, the selling price listed in a transaction database may not tell the full story.
For example, part of the purchase price might be buried in employment contracts or be contingent on future operations. The use of these alternative terms can make a deal more (or less) valuable than it appears on the surface, necessitating adjustments to arrive at a cash-equivalent value.
Failure to understand comparable data
Another common mistake that may occur under the market approach is failing to adjust the financial statements of the subject company or the comparables companies to ensure accurate comparisons. For example, nonrecurring items and discontinued operations may need to be eliminated.
Or, for comparative purposes, a valuation professional may need to rectify differences in accounting methods — say, for reporting depreciation or inventory. Ideally, an expert makes these adjustments before selecting guideline companies and computing pricing multiples.
Inconsistent terminology may also lead to problems. Slight differences in the ways databases or experts 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.
It’s also important to consider timing. For instance, is a low point in the industry’s cycle driving values down (or vice versa)?
Use with caution
Many judges and attorneys prefer the market approach over the income approach for its perceived objectivity. But applying the market approach isn’t as easy as it appears on the surface. It’s important to hire an experienced business valuation expert to avoid potential pitfalls and arrive at a value that can withstand scrutiny.
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