Business Valuation: The Market Value Approach
Here you will learn all about the market value approach and its process.
Business valuation is one of the most important processes that you will have to face at least once in your business lifecycle. This situation can come up mostly when you are about to raise funding for your business. That is when you need a person to help you get the value of your business so investors can get the right amount of shares of your business in exchange for the funds they provide.
And you might be thinking that getting the value of a business is pretty simple; all you need are some accounting figures from your company’s financial statements. But this is not true. There are a lot of things that come into consideration when you want to value a business. One such thing is selecting the right valuation method. Out of the many approaches to value a business out there, the market value approach business valuation method is most suitable when comparing to other companies in the industry.
Market Value Approach Business Valuation
The market value approach business valuation is a process where a value is assigned to a business based on market forces in comparable situations. The comparable situation here can be either a prior transaction involving the same business, an ownership transfer transaction involving a comparable (public or private) company, and/or a market quote of listed securities of a comparable public company.
The price multiple is then multiplied with the relevant financial metric of the business being valued to arrive at a valuation estimate. Based on the source of comparable valuations used, the market value approach is further classified into two methods which have been explained below in detail.
How the Market Approach Works?
Just as the name says, the market approach to business valuation method looks to answer one question, which is: “What is the fair market value of this asset?” To get the answer to this question, the valuation has to survey recent transactions that involve similar assets. Additionally, since these assets are unlikely to be identical to the one that is being valued, a lot of adjustments would have to be made.
The main advantage of the market value approach is that it is based on publicly available data on comparable transactions. Due to this, it would need a fewer number of assumptions as compared to the other approaches. Figuring out the value of your business using the market value approach for business valuation is most suitable in the following situations:
- When you want to justify the value of your business when there is a dispute such as a buyout or partner disagreements.
- When there is a need for you to defend the valuation of your business before the tax authorities or in a legal dispute.
- When you want to set the offer price or asking price for a business purchase.
Example of the Market Approach
Let us take a real estate example to understand this approach better. Assuming that you are in the market to buy a new apartment. You see a listing for an apartment in your preferred neighborhood being offered for $200,000. This apartment that you are looking at is a 1,000 square-foot apartment with one bedroom and one bathroom.
Additionally, this place is in good condition and only needs some minor renovations. Even though it is in a desirable neighborhood, its view is obscured and it does not have a built-in washing or drying machine. And although you like the apartment, you feel that the price of the place is too high. With the apartment listed for over a month, you feel the price is not at market value, and the seller may accept some negotiations.
Now that you have all the details for the house with you, you set out to get the fair market value in order to negotiate the price with the owner. For this, you will have to look at similar apartments in the same neighborhood.
The details of various deals are in a table as below:
|Price Per Square Feet (Rounded)||$275||$220||$135||$175||$140|
|Built-in Washer & Dryer?||Yes||No||Yes||No||No|
As mentioned earlier, the market value approach relies on the data from comparable transactions. And with the results gathered in the table above, you can begin to draw some conclusions. To begin with, you will be able to see the apartments’ price per SF ranges between $135 and $275. The higher price belongs to those with more bathrooms and bedrooms, built-in appliances, better views, and no need for renovations.
Compared to these, the apartment that you are about to buy is priced at $200 per square feet and has fewer of these features than even the cheapest priced apartment. This seems to justify your intuition that the apartment should have a lower price. And with all this research, you decide to make an offer of $150,000, which is then accepted by the owner.
Market Value Approach Methods
Now that you are clear with what the market value approach business valuation method is about, let us talk about the different types. There are many kinds under this as well based on the source of the known values that are used as guidelines. But we are going to talk about the two main types that are used most. These include:
1. Public company comparables method
The first method is called the public company comparables method. In this method, the valuation metrics are used from publicly traded companies. Try to make these companies are rightly similar to the subject entity. For most circumstances, direct comparability is hard to attain as most of the public companies are not only big but also more dissimilar to the subject company.
However, the direct comparability threshold should be a little flexible so that the public companies that have comparable business features aren’t excluded from consideration on the valuation of the subject company. Direct comparability can be achieved in comparatively few industries. A lot of them are faced with differences existing between most private enterprises and public operators.
Basically, the process of choosing, modifying, and implementing public company valuation data is normally complex and requires notable experience and appraiser skill. The guideline companies are normally publicly traded companies in a similar or equivalent industry as the subject company. They should also have a practical basis for comparison to the subject of business valuation due to the resemblances in financial composition, operational processes, and demand and supply factors.
2. Precedent Transactions method
The second kind of method is the precedent transaction method that involves deriving the value using pricing multiples that are based on observed transactions of the companies in the industry of the subject company. This method is based on the perception that the comprehensive company’s financial data is not easily available but there is the availability of the transaction value.
Precedent transactions can be analyzed via the conventional industry classification methods, such as SIC codes. In addition to this, there are many valuation databases that can be tested for evidence of historical actuals and valuation. These kinds of transactions might represent a large or small perspective. A good guideline transaction needs to be from a very comparable company in the same industry. If there isn’t any direct comparability, other data available can be used. But it cannot be used before considering such things as their products and market.
The use of the transaction method can be valuable in cases where a purchase or sale is under consideration or as an exit strategy for the management of the company. One of the main weaknesses is that some transactions might have taken place in notably diverse markets or industry conditions. And hence, it might not represent the prevailing acquisition and merger environment. Additionally, a huge challenge in determining if a transaction is suitable to be used as comparable data is the lack of public information or in research databases.
Here is an example of how comparing different companies within the same industry:
|Comparable Integrated Telecom Service |
($ in millions, except share data)
|Company||Stock Price as of 10/14/2013||EV||Revenue||EBITDA||Revenue||EBITDA||Revenue||EBITDA|
|Century Link, Inc.||$32.68||$40,001||$18,192||$7,560||2.2x||5.3x||2.2x||5.4x|
|Windstream Holdings, Inc.||$8.52||$13,998||$6,090||$2,259||2.3x||6.2x||2.3x||6.0x|
|Frontier Communications Corporation||$4.38||$11,989||$4,881||$2,266||2.5x||5.3x||2.5x||5.4x|
|Telephone & Data Systems Inc.||$29.15||$4.065||$5,253||$960||0.8x||4.2x||0.8x||4.5x|
|Cincinnati Bell Inc.||$2.75||$2,886||$1,381||$412||2.1x||7.0x||2.3x||7.4x|
|Consolidated Communications Holdings, Inc.||$17.87||$1,945||$633||$251||3.1x||7.7x||3.2x||6.9x|
|General Communication Inc.||$9.34||$1,360||$738||$227||1.8x||6.0x||1.7x||5.2x|
|Fairpoint Communications, Inc.||$9.69||$1,150||$952||$181||1.2x||6.3x||1.2x||4.9x|
|Shenandoah Telecommunications Co.||$26.50||$795||$301||$119||2.6x||6.7x||2.5x||7.1x|
|Alaska Communications Systems Group Inc.||$2.51||$634||$381||$128||1.7x||5.0x||1.8x||5.9x|
|Hickory Tech Corp.||$11.40||$298||$188||$46||1.6x||6.4x||1.6x||NA|
|New ULM Telecom Inc.||$6.44||$76||$35||$13||2.2x||6.0x||NA||NA|
For Both Methods
In both the market valuation methods shared above, the key is to look for the businesses that are sufficiently comparable to the subject company for the business valuation. When trying to determine if the company is comparable enough to be used in getting the value of the other company, the appraiser should consider a number of factors including:
- Whether they have similar profits
- Whether they are in competition for the same business
- The location of the companies
- Whether any of the companies are operating in multiple industries
- Whether they offer identical services or products
- Whether they are similar in size
- Whether the companies are operating in the same industry
Steps for the Comparable company analysis
With all this clear about the market value approach, you should also know what a comparable company analysis is and how it is done. The comparable company analysis is a valuation methodology that looks at ratios of similar companies and uses them to derive the value of another business.
To help you understand how it is done, below are the steps to perform the comparable company analysis as required in most financial analyst jobs:
Step 1: Find the right comparable companies
The very first thing that an analyst will have to do is look for the company they are trying to value. This will allow them to get a detailed description and industry classification of the business.
After this, the person would have to search databases for companies that have similar characteristics and operate in the same industry. The closer the match, the better. The analyst will have to run a screen based on the following criteria:
- Margins and profitability
- Growth rate
- Size (revenue, assets, employees)
- Industry classification
Step 2: Gather financial information
The next thing that the analyst needs to do after finding a list of relevant companies is to gather their financial information. For public companies you can look at the Bloomberg Terminal or use Capital IQ. Using either of these platforms, you can easily import the financial information of the companies to an Excel sheet.
The information that you will need here would vary based on the company’s stage in the business lifecycle and industry. For companies that are highly mature, you will have to look at metrics like EPS and EBITDA. But for early-stage companies, you might have to look at the gross profit or revenue of the companies. In case you do not have the access to the expensive tools like Capital IQ or Bloomberg, you will have to gather the details manually from their reports, which may be time-consuming.
Step 3: Setup the comps table
Next you will have to prepare a table that would list all the information gathered about the companies that you are about to analyze. Here are the details that you need for analyzing the companies:
- Analyst estimates
- Enterprise value
- Net debt
- Market capitalization
- Share price
- Company name
You can organize the above details in an excel sheet and move on to the next step.
Step 4: Calculate the comparable ratios
With a list of all the historical financials and analyst estimates in the table, the analyst can now start calculating the various ratios that would be used to value the company in question. The ratio needed in the table includes:
- P/B – The Market to Book ratio (also called the Price to Book ratio) is used to compare a business’s net assets available in relation to the sales price of its stock. The market value is the current stock price of all outstanding shares (i.e. the price that the market believes the company is worth). The book value is the amount that would be left if the company liquidated all of its assets and repaid all of its liabilities. The book value equals the net assets of the company and comes from the balance sheet.
- P/E – The Price Earnings Ratio (P/E Ratio) is the relationship between a company’s stock price and earnings per share (EPS). It shows the expectations of the market and is the price you must pay per unit of current earnings (or future earnings, as the case may be).
- EV/EBITDA – EV/EBITDA is a ratio that compares a company’s Enterprise Value (EV) to its Earnings Before Interest, Taxes, Depreciation & Amortization (EBITDA).
- EV/Gross Profit – Enterprise to Gross Profit ratio is obtained by dividing its enterprise value (equity plus debt minus cash) by its annual gross profit.
- EV/Revenue – Enterprise to revenue ratio is obtained by dividing its enterprise value (equity plus debt minus cash) by its annual revenue.
Here is an example of how the comparable ratios look while looking at different companies:
|Comparable Companies||P/E Ratio||P/Sales||P/Operating Cash Flow||P/Book Value||EV/EBITDA||EV/EBIT||EV/Sales||EV/Free Cash Flow (FCF)|
|Johnson & Johnson||19.0||3.7||15.7||5.9||11.1||12.9||3.5||18.3|
Step 5: Use the multiples from the comparable companies to value the company in question
It is normal for the analyst to take an average or median of the multiples of the comparable companies. These are then applied to the net income, EBITDA, gross profit, revenue or whatever metrics have been included in the table. And to come up with a meaningful average, they usually exclude or remove outliers and continuously adjust the numbers until they seem realistic and relevant.
For instance, if the average P/E ratio of the group of companies in comparison is 12.5 times, then the analyst will multiply the earnings of the company they are about to value by 12.5 times to get to their equity value.
Interpreting the results
As soon as the numbers are complete and the comparison table has been finalized, it is time to interpret the results. The main way to use the information is to look for companies that are over or undervalued. The comparable values would help you uncover a lot of opportunities. But the results have to be interpreted properly as they do not include any qualitative factors whatsoever. To evaluate the numbers in the table, you have to understand why the numbers are what they are. That is when the knowledge and the art of the financial analyst would come into play.
With everything we have covered on what the market value approach business valuation is all about, you now know how this method can help you in getting the value of your company. Keep in mind that this valuation process can only be used if there are similar companies that can be used for comparison. This means that if your company is a small sole proprietorship, using this valuation method may not be right. In such a case, you will have to use the other available valuation methods, such as the income-based approach. Learn more about it here.
And before you get into the valuation of your company, remember that you need to have a proper cap table to help the analyst get the right business valuation done. If you want some help with this, Eqvista is a great app to use.