Regardless of the asset under valuation, the market approach looks at the
prices of comparable assets and makes proper adjustments for different
quantities, qualities, or sizes. For instance, when you want to determine the
value of a share of stock, you should look at the recent selling price of
shares of stock that are similar. Since ownership shares of a company are
usually identical, the recent selling price of the shares will provide a good
estimation of their fair value.
The above-mentioned business valuation method is also referred to as the
market comparison approach or the market-based approach. It is one of
the three valuation methods used to estimate the value of an entity. The
other two include the Income Approach (Intrinsic Value or DCF
Analysis) and the Cost Approach.
Market Approach Methods
There are a number of valuation methods that may be used by a valuation
analyst under the market approach. The methods are named according to
the source of known values that are used as guidelines. The two main
valuation methods that are used under the market approach are:
1. Public Company Comparables
The Public Company Comparables Method entails using valuation metrics
from companies that have been traded publicly, which are considered to be
rightly similar to the subject entity. In most situations, direct comparability
is hard to attain since a majority of public companies are not only larger but
also more dissimilar to the subject.
Nonetheless, the direct comparability threshold should be a little flexible so
that public companies that have comparable business features are not
excluded from giving guidance on the subject company’s valuation.
Direct comparability can be readily achieved in comparatively few
industries. Most of them are faced with challenges of scalar differences
existing between most private enterprises and public operators. The
process of selecting, adjusting, and applying public company valuation data
is usually complex and needs significant experience and appraiser skill.
Guideline companies are usually companies that have been traded publicly
in a similar or equivalent industry as the subject company. They should also
have a practical basis for comparison to the subject of evaluation because
of resemblances in demand and supply factors, operational processes, and
financial composition.
2. Precedent Transactions
The Precedent Transactions Method involves deriving value using pricing
multiples that are based on observed transactions of companies in the
industry of the subject company. It is based on the perception that
comprehensive company financial data is not easily available, but there is
an availability of transaction value.
Precedent transactions can be analyzed through conventional industry
classification methods, like SIC codes. Furthermore, there are also valuation
databases that can be examined for evidence of historical actuals and
valuation. Such transactions may represent a majority or a minority
perspective. A good guideline transaction should be from a very
comparable company in the same industry. In cases where there is no direct
comparability, other data can be used but not before considering such
things as their market or products.
The use of the Transaction Method can be valuable in cases where a
purchase or sale is under consideration or as an exit strategy for the
management of the company. One weakness though is that some
transactions may have happened in significantly diverse markets or industry
conditions and therefore may not represent the prevailing acquisition and
merger environment. Moreover, a major challenge in finding out if a
transaction is suitable enough to be used as comparable data is the lack of
information in the public spectrum or in research databases.
In both market valuation methods discussed above, the key is searching for
companies that are sufficiently comparable to the subject company under
valuation. When trying to find out whether a company is comparable
enough to be used in determining the value of the other company, the
appraiser should consider a number of factors such as:
Whether the companies are operating in the same industry
Whether they are similar in size
Whether they offer identical services or products
Whether any of the companies are operating in multiple industries
The location of the companies
Whether they are in competition for the same business
Whether they have similar profits
