(Part 3 of 4)
In our last article on the valuation process, we discussed the income approach, one of three valuation methods available to a valuation analyst as they determine the value of a company (or partial ownership of the company). This article talks about another approach, the market approach, and the specific methodologies within it.
The International Glossary of Business Valuation Terms defines the market approach as a general way of determining the value indication of a business, business ownership interest, security or intangible asset by using one or more methods that compare the subject of the valuation to similar businesses, business ownership interests, securities or intangible assets that have been sold.
In general, this approach is based on the theory of substitution, meaning that a known value can serve as a benchmark indicator of the value for a particular subject. In order to apply the market approach, the valuation analyst must identify and establish a relationship between the known values of another business (or business ownership interest) and the valuation subject.
Within the market approach, two of the more popular methodologies are the Guideline Public Company method and the Guideline Private Company Transaction method. As indicated by the names, the source of the known values used as guidelines is either public company values or private company values.
There are numerous sources for information on public companies, leading one to think this methodology would be most commonly utilized. While there is an abundance of data available for use in this method, the key to utilizing the method is establishing a “substitute” or “comparable” for the particular subject business or ownership interest.
When it comes to publicly traded companies, many are gigantic in revenue size and have diversified revenue streams, global operations, skilled and highly knowledgeable management, ready access to capital markets, complex capital structures and a wealth of other characteristics that simply don’t exist for a privately held business, or exist only in a limited fashion. These differences, if not properly adjusted for, can make use of this method quite challenging.
The private company transaction method is a second source for guideline information. In most instances private companies do not publicly disseminate the details of a sale. However, in some cases these transactions involve brokers or other professionals who may retain that information. With proper permission, they can submit it to various databases that collect and analyze transactions.
Valuation analysts subscribe to databases such as Prats’ Stats, BizComps, DoneDeals and the Institute of Business Appraisers (IBA) Market Database to gather information for use with the guideline private company transaction method.
Like the public company method, analysis of the information related to the transaction is key to identifying whether a particular transaction or a group of several transactions are a good substitute/comparable for use in valuing the subject business or ownership stake.
A third methodology often utilized within the market approach is the Prior Transaction method. This methodology uses prior transactions of the subject company as an indicator of current value. In applying this method, it is important to assess the circumstances surrounding the prior transaction in order to verify it is an arm’s length transaction and is representative of current market expectations.
In the final article of our series, we’ll analyze the asset approach to valuation.
For more questions about how to determine the value of your business, please contact Amber Hoover at (317) 613-7844 or [email protected].