A Misunderstood Aspect of Business Value: The Market Approach

By Carl L. Sheeler

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For 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.

Factors Influencing Investment Decisions

When 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.

The 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 held businesses.

The Income Approach

In 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.

The 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 data.

The Fallacy of Incomparability

An 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?”

If 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.

Another 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.

Another poor practice is the sole reliance upon “rules of thumb.” Inherent 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.

Evaluating Transactional Data

When 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.

In 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.

When 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.

Publicly Traded Companies

The 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.

In 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.

Midmarket: Mergers and Acquisitions

The 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.

There 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.

Closely Held (Private) Transactions

Over 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.

Both 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.

Using All Available Resources

A business 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.