There are three general ways to value a business: the cost, income and market approaches. Here we compare and contrast two methods that fall under the market approach.
When business valuation experts use the market approach, they typically compute pricing multiples. These compare the prices paid in comparable, real-world transactions to some performance metric, such as revenue, cash flow or operating income. These pricing multiples are then applied to the same performance metric of the subject company to estimate its value.
To illustrate, a business valuation expert may generate a median price-to-net income multiple of five times based on comparable (or “guideline”) transaction data. If the subject company’s net income is $5 million, its preliminary equity value would be $25 million. From here, various adjustments and discounts may still be required to arrive at a value consistent with the appropriate basis and standard of value.
Under the merger and acquisition (M&A) method, business valuation experts evaluate sales of entire businesses. Private companies aren’t required to report the details of their sales, but valuation professionals subscribe to various transaction databases that track this information. In recent years, private transaction data has become more widely available and detailed as the business valuation discipline has matured and the M&A market has become increasingly active in some industries.
One downfall of this method is the perceived reliability of the data. Some M&A transactions may not represent fair market value, especially if the parties were related, a financially distressed seller was compelled to liquidate his or her interest, or a strategic buyer paid a synergistic premium to gain market share. These details may not be ascertainable from transaction data in the databases, which contain only limited information about the deals.
When applying the M&A method, business valuation experts analyze the details of comparables and understand the nuances of each transaction database used. For example, business valuation experts consider whether each comparable is an asset or stock deal and determine what was included in the sale, such as receivables, inventory, fixed assets and debt. Adjustments may be needed to make apples-to-apples comparisons.
The M&A method generally results in a controlling value. So, a discount sometimes is needed to value the interest on a minority basis.
Guideline public company method
Alternatively, under the guideline public company method, business valuation experts derive pricing multiples from prices paid for stocks in publicly traded companies that operate in the same or similar lines of business. This method can be difficult to apply to small businesses that operate as “pure players” in a single industry, because many public companies are conglomerates that participate in multiple industries and are generally much larger than private companies.
When comparable public stock data is available, it can generate a reliable valuation metric, especially if the guideline public stocks are traded actively, the subject company is large enough to trade on the public markets and the assignment calls for a minority basis of value. Because of its perceived objectivity, this method is often preferred by courts and the IRS — as well as when estimating fair value under U.S. Generally Accepted Accounting Principles.
To use or not to use
Business valuation experts consider the market approach in every appraisal engagement. But they don’t always rely on either M&A data or public stock prices to arrive at their final conclusions. Sometimes there are too few true comparables — or none at all — within a reasonable time frame. Other times, there’s too much variation in the transaction data to provide a meaningful pricing multiple.
Your business valuation expert will address these methods and explain why they’re included in (or excluded from) his or her analysis. Doing so will help you and others who rely on the report understand the expert’s mindset. It also prevents outsiders from assuming that methods were merely overlooked.
This publication is distributed with the understanding that the author, publisher and distributor are not rendering legal, accounting or other professional advice or opinions on specific facts or matters, and, accordingly, assume no liability whatsoever in connection with its use. In addition, any discounts are used for illustrative purposes and do not purport to be specific recommendations.