There are three approaches that business valuations use and this video covers the market approach which means the business is valued based on references to other comparable guideline companies.
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There are three approaches that are used when valuing a business. This video focuses on the market approach. So, what exactly is the market approach? The market approach is valuing a business based on references to other comparable guideline companies. Those could be either public or private, but you’re looking for companies that are comparable. In this video we’ll walk through what the advantages are for the market approach.
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Hi, I’m Sheila Darby, a managing director here at BizWorth. Thank you for joining me for today’s video on how to value a business. We’ve previously covered two other approaches. We’ve covered the asset approach and the income approach. Today, we’re going to focus on the market approach. So, what exactly is the market approach? The market approach is valuing a business based on references to other comparable guideline companies. Those could be either public or private, but you’re looking for companies that are comparable. So, let’s walk through what the advantages are for the market approach.
- The market approach is considered by many to be user friendly. It’s easy to explain.
- The market approach also uses actual data from real transactions.
- It’s relatively simple to apply.
- It does not rely on explicit forecasts for a company. If a company such as your own doesn’t have reliable forecasts or projections for the future, then the market approach may be helpful to use. This is also somewhat similar to the ‘rules of thumb’ approach. Many people will hear from the market that they need to use a six times revenue tool to value their company or two times revenue or two times EBITDA. Those are all rules of thumb. Now those are rules of thumb based on information that have hopefully been compiled overtime. Industries may have rule of thumbs, but the market approach is different from that. You’re using actual transactions from private or public firms and you’re using that information to place a value on your subject company, on your business.
There are disadvantages to the market approach.
- Sometimes for a particular business in a particular regional area or particular industry, there are no good comparable companies either in the public sector or the private sector.
- The standard of value may also be unclear (another video series will cover the standards of value. There are three standards of value. You have fair value, fair market value and investment value).
- The most important assumptions may be hidden. They may not be covered during the during the review.
- It’s also a costly approach and the reason why it’s costly is because publicly traded company information is somewhat readily available. However, the private transactions, those are captured by companies that sell the information based on subscriptions and that is very costly. Now, here at BizWorth, we have subscriptions to pretty much every possible database there is on private transactions, but this is a very costly approach.
- It’s not as flexible or adaptable as the other approaches
- Sometimes the reliability of the information can be questionable because the information is submitted oftentimes by either brokers or bankers to these companies that have these subscription-based databases.
Now that you’ve decided to use the market approach, how do we use it? Well, there is a basic formula: Value = (Price/Parameter)comp X ParameterSubject
Now, this isn’t going to make a whole lot of sense at this point, but let’s break down each one of these and explain them more clearly. The first is considered the pricing multiple. The pricing model multiple consists of the price of the comparable transaction. It could also consist of the median value of a set of data, or it could be the average of a set of data. I won’t discuss the pros and cons of using one transaction, multiple transactions or whether you use the median or the average, but just know that the price in the numerator is of the comparable transaction, the price in which it was sold.
I thought it’d be helpful to talk about a bakery that we did in North Texas several years ago. The sale price of this particular company was $270,000. The sale price of the comparable bakery was $270,000 and the annual revenue of the comparable bakery was $600,000 a year on average. The private company transactions there are lots of different databases you can have subscriptions to, but here are some of the most common ones:
- The Institute of Business Appraisers (IBA)
- DealStats (formerly Pratt’s States)
- ValuSource (formerly Done Deals)
Some of these databases are purchased by other companies so their names can be ever changing but these were the names of the businesses on the date of this video. We walk through what these different sources are good for: some are good for very small companies, others are good for more medium to small businesses, and others have a good mixture of publicly traded companies in addition to privately owned companies. You have to know what the different databases are good for and what information they have.
The denominator is the parameter – what exactly does that mean? Well, the parameter is in the denominator of the pricing multiple and it’s the financial statement parameter for the comparable companies. What can the different parameters be? It could be revenues, gross profit, EBITDA (earnings before interest, taxes, depreciation and amortization), EBIT, debt-free net income, and the list goes on. So back to our example – the comparable bakery sale that we found, the sale price was $270,000. The annual revenue was $600,000 for this company. Here the revenue is the parameter.
So, the particular bakery that we valued in North Texas, your bakery, the annual revenue was $850,000 so you want to know what the perimeter is for your company, for the subject company. Let’s apply the information that we have. We know that the price of our comparable bakery was sold at $270,000. The annual revenue was $600,000. When you take that and multiply it by our company, $850,000 revenue, you come up with the value of the business: $382,500. This is a value for this particular example, based on one comparable company. We could have a whole other video series discussing how many comparables is good. One or many? Should it be private or public? Should you use average or median? There is lots of information out there, lots of good approaches, and sometimes the circumstances of your particular case will dictate what’s the best approach.
I hope this video on the market approach is helpful and we’ve now covered all three approaches. We covered the asset approach, the income approach and the market approach. We have covered methods under each approach under this video series. Please reach out if you have any questions. If you go to our web site, www.BizWorth.com, you can schedule an appointment to meet with me or one of our advisors to talk about your business valuation. Even if you’re not sure it’s the right time for a business valuation, hop on a free consultation and let’s talk through that. We’re always happy to help business owners so feel free to reach out. If you like our content and would like to see more, visit our blog or follow us on Facebook, LinkedIn, and YouTube. Thanks so much.