What Is The Market Approach Valuation?
The Market Approach valuation is one of the three approaches to value a business along with the cost approach and income approach. In simple words, the Market Approach determines the value of a business based on the price of transfer or the value of comparable businesses or even the same business.
This valuation approach leverages the principle that the price of an asset should be the one at which similar assets are traded or valued.
For example, if one apple costs $1 what price should the other apple have if it has the same characteristics and on the same day in the same supermarket? = $1. You could not use the price of an orange to compare to the apple to try determine the price of the apple, they are not similar in characteristics.
It works the same way for businesses but has an added complexity since you need to consider points such as the date at which the comparable businesses were sold or valued, the comparability of the businesses to the one being valued, and expectations of the industry and economic conditions in which the business operates, among others.
Some comparability points between businesses are:
- Revenue levels
- Earnings / Profit levels and margins
- Geographic area of operation
- Economic and industry conditions at the date of transaction
- Total assets value.
- Management’s capabilities.
- Customer concentration / diversification.
Is very unlikely that two businesses are exactly identical at all possible measurements / metrics, , however if there’s enough similar characteristics to the subject business, found in enough transactions (often needing several transactions, not just one for example), the Market Approach can be the best approach to value a business. This is because the transaction has happened, unlike the income approach that is saying a hypothetical (doesn’t exist yet) transaction.
Once enough similar businesses are found, one calculates the pricing multiples at which the comparable businesses have been traded and adjust where necessary to use a pricing multiple for the business being valued.
Pricing multiples are ratios to different metrics of the business, a couple of the most used are:
- Price-to-sales ratio: In which the price/value of a business is divided by its sales.
- Price-to-earnings ratio: calculated by dividing the price/value of a business by its earnings.
Once you have the ratios of the different companies or transactions and determine which multiple is reasonable for your company, you multiply it by your business earnings measure, and this will be your subject company’s value. Let’s check the different valuation methods and an example as well next.
Market Approach Methods of Valuation
When applying the Market Approach, experts identify recent, arm’s length transaction that involve similar public or private business or the same business (if it was sold previously & recently) and develop pricing multiples to use for the subject business.
Some of the methods are:
- Guideline public company method: Under this method, you consider the pricing multiples of comparable businesses publicly traded in the stock market to determine your company’s multiple.
- Merger and acquisition (M&A) method: In this method, you use merger and acquisition data of comparable private companies to determine the pricing multiple applicable to your subject company.
- Prior Transactions Method: As the name suggests, the prior transactions method, uses the subject company’s transaction history to determine its current price.
Market Valuation Example
Let’s say that we are valuing Company A and found 5 comparable companies with the following information:
The above is the information you get from the market i.e., different earnings multiples where the high can be almost 3 times the smallest or double the average. To determine an appropriate multiple, you then analyze the operational information of the companies against company A to the determine where company A stands against its comparables based on profitability, growth, revenue levels, etc.
Finally, you apply the multiple you believe to be the most applicable to Company A based on the various points. For example, if we take the average earnings multiple of 3.82 and multiply it by company A’s earnings:
Company A’s Value = $1 million x 3.82 = $3.82 million
Benefits of the Market Approach for valuing businesses
The Market Approach is the most powerful approach to valuing a business as you are using prices that the market (different investors) agrees with.
Below are some of the advantages of the Market Approach:
- The calculations to apply the method are relatively simple. As you can see in the example above, once you have determined which multiple to use a simple multiplication can suffice.
- The Market Approach allows the owner to utilize public data which is most often audited which makes it more reliable
- Another great advantage of Market Approach valuations is that it does not depend on a single subjective forecast but provides the expectations and analyses of several market participants.
Some limitations of the Market Approach are:
- For private companies the availability of information can be difficult.
- Reliability of the information available.
- Finding truly comparable businesses.
- Knowing the exact motivation of the buyer / seller in private company transactions as one can pay premiums for certain reasons, like buying your competitor at a premium to have control.
Business valuation is a very important aspect of running any public or private company. This is the reason why there are various methods of business valuation available to gain the most accurate valuation and be able to make the most informed decision.
The Market Approach is used to determine the price of an asset by reviewing the selling price of similar assets. This approach allows you to find a price that has been accepted historically in the market and does not depend on a single forecast which may or may not be accurate.
However, for the Market Approach to be as powerful as it can be, it’s necessary to have reliable and sufficient information in order to derive a reasonable conclusion of value.