Business Valuation Part 4: Market Approach
This post is part of a series covering business valuation and providing guideline information on the process of valuing a business. To start at the beginning and learn what business valuation is and why a business valuation is needed, read What is a Business Valuation?
Part 4: The Market Approach
In the market approach, the value of the organization can be compared to recent market activity whereby sales of similar interests in the same or similar industry. Valuation multiples, which are determined by dividing the sale price by a relevant financial metric (such as revenues), can be applied to the target company to determine an estimate of fair market value.
When valuing minority interests, the value of an interest may be compared to recent market activity in equity transactions, reported through public exchanges (e.g. NASDAQ or New York Stock Exchange), of organizations in the same or similar industries, subject to similar risks. Pertinent price ratios are applied to the target interest to determine an estimate of fair market value. This method of the market approach is referred to as the publicly traded company method, guideline publicly traded company method or the GPC method.
The notion behind the guideline publicly traded company method is that prices of publicly traded stocks in the same or a similar industry, provide objective evidence as to values at which investors are willing to buy and sell interests in companies in that industry. This method involves computing a value multiple using financial data for each guideline company. The derived value multiple is then applied to the financial data of the Company to arrive at an estimate of value for the appropriate interest.
Typically, publicly traded companies are significantly larger, more diversified and have better access to capital markets than the company that is the subject of the valuation. In addition, there may be differences between the subject company growth rate and the growth rates of publicly traded companies which can have a significant impact on value. Given these differences, the multiples used in the publicly traded method of the market approach are usually adjusted before being applied to the subject company’s relevant financial metric.
When valuing controlling interests, multiples may be derived from comparable merger and acquisition transactions. A limitation of the market approach is the availability and reliability of relevant market information. This method of the market approach is commonly referred to as the merger and acquisition (M&A) method.
Merger and acquisition transaction prices may be representative of fair market value, investment or strategic value, or something in between. On one end of the spectrum, a pure financial buyer (acquiring the business as a “stand alone operation”) will pay fair market value. Unique synergies (market share or competitive elements of a transaction which positively impact other related operations of the purchaser) can create additional value for specific strategic buyers, resulting in an incremental increase over fair market value to investment value.
Since mergers and acquisitions usually represent control transactions, they are most relevant to the valuation of other controlling interests. As such, if we are valuing a minority interest, an indicated enterprise value based on M&A data must be adjusted to reflect the lack of control and marketability inherent in the subject interest.
This post concludes the overview of the different valuation methodologies. Links to the other blog posts in this series are below: