A Closer Look at the Market Approach

There are three approaches to valuing a business: the cost, market and income approaches.

In this article, we focus on the market approach, which the International Glossary of Business Valuation Terms defines as:

A general way of determining a value indication of a business, business ownership interest, security, or intangible asset by using one or more methods that compare the subject to similar businesses, business ownership interests, securities, or intangible assets that have been sold.

Common Market Approach Methods

Two methods generally fall under the market approach umbrella:

1. Guideline Public Company Method. This method derives pricing multiples from publicly traded stock prices of companies that are engaged in the same or similar lines of business. It is often used to value larger private firms that might consider going public.

One advantage of using public stock prices is the abundance of relevant financial data. More than 16,000 companies file reports with the Securities and Exchange Commission (SEC). In addition, many of these entities have market capitalizations of less than $10 million, making them comparable in size to most private firms.

Adjustments should be made to pricing multiples if the subject company differs significantly from the guideline comparable companies in terms of size, growth, risk and financial performance. Company financial information also may require adjustment for unusual or nonrecurring items, as well as for differences in accounting practices between the subject company and its comparables.

Industry classification codes often come to mind first when choosing comparables. But sometimes the most comparable firms will sell different products but experience similar supply and demand forces or face similar risk factors.

For example, when valuing a marine contractor, it may be necessary to include construction and engineering contractors to obtain a representative sample of guideline public comparables, because so few marine contractors are publicly traded.

2. Guideline Merger and Acquisition Method. This method derives pricing multiples from sales of entire companies engaged in the same or similar lines of business. Some guideline transactions involve controlling interests in public companies, but most involve private firms, which are not required to publish their transactions to the SEC. Instead, the sales are recorded in private transaction databases.

When using these databases, appraisers should understand exactly what's sold (assets, equity or invested capital) and the terms of the deal (such as installment payments, earnouts, non-competes or employment agreements).

Appraisers also need to know exactly how each database defines financial terms. For example, earnings could mean net income; pretax operating income; sellers' discretionary cash flow (SDCF); or earnings before interest, tax, depreciation, and amortization expenses (EBITDA).

Mixing comparables from multiple transaction databases can result in duplicate transactions. Or it might result in apples-to-oranges comparisons, if the appraiser doesn't understand how the database defines financial terms or what's included in (or excluded from) the selling price.

Picking Comparables

Regardless of whether they're publicly traded or privately held, guideline comparables should be both similar and relevant.

"Similar" means that comparables share attributes with the subject company such as:

Industry,

Size and growth,

Products and markets served,

Geographic location,

Management depth and

Financial performance (profitability, liquidity, leverage, asset management)

A transaction is "relevant" if the desires and expectations of investors are similar, including:

Risk tolerance,
Liquidity of investment,
Management involvement and
Probable holding period.

When selecting comparable, courts often look beyond Standard Industrial Classification (SIC) or North American Industry Classification (NAICS) codes. In an uncertain market, transaction date may also be a relevant selection criterion.

Pricing Multiples

Regardless of whether an appraiser uses the guideline public company or guideline merger and acquisition method, the market approach derives pricing multiples from guideline comparable transactions. These pricing multiples are adjusted and applied to the subject company's future earnings.

In other words, the market approach establishes a relationship between the selling price and some financial metric. The most familiar multiple for a layperson to imagine is price-to-earnings. But a closer look reveals that "price" and "earnings" can refer to very different numbers in a transaction. Selling price could include only assets, equity or invested capital (both debt and equity financing). In turn, the price could be related to a variety of financial metrics, such as:

Net income
Pretax income
Earnings before interest and taxes (EBT)
Invested capital (or equity) net free cash flow, or
Book value.

A picture is worth 1,000 words. So valuators often use graphs to illustrate the relationship between price and the guideline companies' financial metrics. Statistics can help demonstrate which pricing multiples are the most reliable, based on their standard deviations, coefficients of variance and other statistical measures. The appropriate pricing multiple varies depending on the unique attributes of the subject company, industry value drivers -- and your appraiser's professional judgment.

Easy in Theory, Complex in Practice

Courts often prefer the market approach for its perceived simplicity and objectivity. But a closer look at how the market approach works reveals that it requires many subjective judgment calls. Your appraiser must decide which method works better: the guideline public company or guideline merger and acquisition method. In addition, subjectivity factors into the market approach when making adjustments to financial statements and pricing multiples -- and when

picking selection criteria and pricing multiples.

Such complexity makes do-it-yourself appraisals perilous. Instead, hire a credentialed appraiser who will carefully research and analyze public and private market data to arrive at an acceptable estimate of value.

About Romanchuk & Co.

Romanchuk & Co. is a boutique investment banking and advisory firm, dedicated to providing candid, independent, and sound financial insight and consulting services to lower middle market companies and their owners. With a focused expertise in energy, power, infrastructure and oilfield services, construction and niche manufacturing, we specialize in sell-side M&A advisory services, advising owners on the preparation and sale of their company, assisting them in identifying strategic opportunities and then helping them to execute upon those strategies. Through our CPA advisory practice, we provide independent business valuations, financial due diligence services, forensic accounting investigations, litigation support and restructuring advisory services.