Misunderstood Aspect of Business Value: The Market Approach
Carl L. Sheeler
more similar and numerous the number of historical sales
of comparable items within a given market, the narrower
the range of values assigned, using the market approach
to valuation. On occasion, “outlier” transactions
might reflect a particularly motivated buyer or seller.
The central tendency, however, is a steep bell curve, where
most sales prices aggregate around fair market value.
publicly traded companies, the starting point for establishing
market value is the “bid-ask” spread found in
the stock market. The seller (asker) seeks better investment
opportunities than the stock currently held. The buyer (bidder)
believes the stock offers potential and wants to buy. In
most cases, there is considerable investor activity with
posted pricing based on many historical trades. This is
a relatively narrow spread where the buyer and seller will
agree. The value of a single share is determined by the
market. Valuing closely held businesses, on the other hand,
is a more challenging task.
Influencing Investment Decisions
external factors, such as shifts in supply and demand or
lower interest rates, are considered, swings in the value
of businesses may result. Over time, however, investors
expect the value of their purchases to increase. The operative
issue is growth or appreciation.
benefit of this increase in equity does not become realized
until accessed through a sale or used as collateral for
a loan. This is one of the prerogatives of direct ownership.
A business may also produce income that is realized by its
owners. A favorable record of income generation (profits,
cash flow, or economic benefit) can also contribute to value
beyond property appreciation because it lowers the perceived
risk of ownership. Ownership of marketable securities of
publicly traded companies tends to be focused upon either
growth or income, or both. The risk of ownership of marketable
securities is generally perceived as lower than closely
the income approach to valuation, an analyst develops a
capitalization or discount rate, which is conceptually similar
to a multiple of earnings. (A capitalization rate of 33.3%
is the same as a multiple of three times earnings.) In order
to develop the rate (risk), an analyst customarily examines
the less risky publicly traded market and then adds an unsystemic
(company-specific) risk to develop a rate of return. A thorough
awareness of the subject company and its market is necessary
in order to simulate the price a pool of reasonable and
informed investors would be willing to pay for ownership.
market approach, in some ways, can be more objective, as
it intends to capture what actual investors pay for businesses
in many industries. Subjectivity exists in determining what
is comparable and what adjustments should be made. Both
approaches require a degree of skill and experience to justify
selections, exclusions, and adjustments among available
Fallacy of Incomparability
analyst’s dismissal of the market approach out-of-hand
should be worrisome. The explanation is often: “Insufficient
comparable data were identified; therefore this approach
was not applied.” What is insufficient, and why? Another
perspective would pose the question: “If transactional
data were insufficient, how was there adequate information
to opine the risk rate in the income approach?”
the subject company is a going concern and the market approach
is not developed, or at least considered, then the only
approach available would be the income approach. In effect,
there becomes no evidence to substantiate the analyst’s
opinion modeling actual investor activity in the given industry.
abuse is characterized by the statement: “A multiple
of three times earnings for the specific business was selected.”
Without further information, this statement lacks an objective
basis. Analysts frequently claim to base such statements
on their experience or professional opinion, with no concrete
proof of actual transactions.
poor practice is the sole reliance upon “rules of
to the logic of applying this method is the determination
that the business being valued operates within the norm
reflected in the rules of thumb. This ignores the potentially
wide variations in revenues and profitability that comprise
the norm. Subjects of differing size or profitability cannot
be valued by the same rule of thumb.
valuing a closely held business, an analyst must recognize
the strengths and deficiencies of the transactional data.
There is general consensus that a minimum of five transactions
is required to render an opinion using the market approach.
An analyst should explain the universe of potential comparable
transactions, why some were selected or rejected, and what
adjustments were made to improve comparability. The greater
the comparability, the more likely the transaction will
be considered and the market approach used.
some industries, such as food services, businesses are frequently
bought, creating a large universe of comparable transactions.
Conversely, niche businesses, such as a massage table manufacturer,
may require a broader selection base. In such a case, an
analyst might begin by using the company’s four-digit
Standard Industrial Classification (SIC) to locate all furniture
manufacturers, then focusing on those producing wooden furniture.
Operating characteristics similar to the company in question,
such as annual revenues, profit margins, costs of sales,
or asset composition, may be specified. In drastic situations,
a two-digit SIC may have to suffice.
the transactions occurred, where they transpired, and between
whom, may be relevant factors in an analysis but may have
limited probative value. A determination must be made as
to whether the whole business is being valued free of, or
with, debt. The assignment may also indicate a minority
interest that is being valued.
Internet has made information concerning publicly traded
company transactions easily available. Industry norms can
also be identified. Historic and present price multiples
can be derived. While useful when valuing large closely
held businesses (with annual revenues in excess of $100
million), public companies’ revenues, market size,
and capitalization may make them less appropriate when valuing
a smaller business. Such differences certainly require downward
adjustments. However, there may also be useful identifiable
similarities. Adjustments follow the rationale applied in
the income approach when adding company-specific risk in
developing a risk rate. These adjustments should be explained
and the data source given weight relative to other methods
and approaches depending upon degree of comparability.
many cases, the business or business interest (shares held)
being valued is owned by one person. This implies the prerogatives
and benefits derived from managerial control. Many analysts
argue that shares bought and sold in the publicly traded
market do not have such “enterprise” control
and that a premium should be added to adjust the value of
shares in a closely held company. A controlling interest
might warrant a premium of 30% or more. Some argue that
the combination of all minority interests in a publicly
traded company represents its enterprise value, because
the shareholders can sell their interests in underperforming
companies, which can decrease company value and influence
management. In addition, shares of most public companies
have a significantly higher degree of liquidity, able to
be sold and converted into cash in about three days. The
closely held business does not have such liquidity; therefore,
a discount for lack of marketability is likely required.
Such discounts and premiums should not be made arbitrarily.
Their quantification requires empirical support from company
performance and industry indicators relative to other alternative
investments. An example of how the market approach may be
applied is shown in the Sidebar.
Mergers and Acquisitions
midmarket category (annual revenues generally between $10
million and $100 million) typically includes purchases of
an entire company by another, larger company. Payment is
usually in terms of stock of the acquiring company, cash,
debt, or a combination. Some analysts argue these purchases
are “synergistic” because their investment value
is higher to a specific buyer than to the general pool of
potential buyers. Therefore, some argue, a downward adjustment
is needed to reflect fair market value. The wide variety
of sizes of comparable business may necessitate adjustments.
are several data sources for these transactions. Merger
& Acquisitions and Mergerstat report both private and
publicly traded acquisitions. Midmarket Comps and DoneDeals
report almost exclusively private transactions. These data
sources do not report nearly as many transactions as found
in public markets. Verification of reported financial data
is often difficult. Financial data are often sufficient
to obtain price multiples based on annual revenues, earnings,
and book value. The strength of these sources lies in the
fact they are almost always acquisitions of an entire entity,
and the acquirer often has fiscal similarities to the closely
held company being acquired and valued. Discounts for lack
of control and marketability would be smaller, depending
upon the circumstances of the company being valued and the
transactions that are relied upon.
Held (Private) Transactions
90% of U.S. businesses have annual sales below $10 million.
Two data sources on small transactions are provided by IBA
and Bizcomps. IBA data include more transactions, but contain
a limited amount of detail on each. A large number of IBA
transactions can be grouped into segments. The pricing multiples
of the segment that most closely mirrors the subject company’s
performance can be applied. Bizcomps
data are similar to IBA data, but offer more information
about the transaction, including the asking and sales price,
days listed, terms of sale, amount down, and values of inventory,
fixtures, and equipment. Another company, Pratt’s
Stats, provides greater detail. It offers more price multiples,
and indicates whether the sale was asset or stock. It has
somewhat fewer transactions than Bizcomps, and more transactions
are in the midmarket range.
IBA and Bizcomps contain the earnings’ benefit referred
to as sellers’ discretionary cash flow (SDCF). SDCF
includes the owner’s compensation and all discretionary
earnings and distributable profits. These figures are assumed
to be on a pretax basis, are asset sales inclusive of fixtures
and equipment, and offer sufficient information to identify
price-to-revenues and SDCF multiples. Bizcomps sales prices
exclude inventory, which would be added to any subsequent
valuation. See the Sidebar for an example of how closely
held transaction data can be used in a valuation.
All Available Resources
valuation analyst must have the resources and experience
to effectively use the market approach. A balanced business
valuation will commonly demonstrate similarities in both
the income and market approaches, both of which will require
a degree of analyst assumptions. A report without development
of the market approach suggests a questionable work product.
Understanding the process allows the user to review and
question the analyst’s conclusions, which are frequently
represented as reflecting the investment behavior of the
buyer and seller.
L. Sheeler, PhD, CBA, AVA, is the managing partner
of the nationwide business valuation and economic damages
firm Allison Appraisals & Assessments, Inc. and an adjunct
professor at Bryant University. He is also an instructor for
the National Association of Certified Valuation Analysts.
He can be reached at 800-286-6635 or firstname.lastname@example.org.