Value Blog

The conceptual background behind the market approach is to use the behavior of buyers and sellers to arrive at a multiple which reflects the market.  Market methods can be divided into two basic groups: guideline public companies and private company transactions.

There are some major distinctions between the underlying data used for each method.  The public guideline company method uses information from publicly traded companies that are most similar to the company being valued.  The appraiser’s analysis of comparability may include factors such as type of business, size, geographic operations, growth prospects, past historical operating performance and any other factors which may be appropriate.  The appraiser identifies the most comparable companies and then derives valuation multiples based on the trading prices of the guideline companies’ stock as of the valuation date.  This data is based on marketable, minority interests in the guideline companies.

Private company transaction methodology is generally based on the theory that a sufficient number of private transactions will emulate the market for that type of company.  There are a number of databases which track private transactions of companies.  The information is collected from business brokers and intermediaries involved in the transactions, who report the information to the database services.  Each database contains different amounts of information regarding the companies.  The information about these companies represents a non-marketable, control interest in the transaction companies.

So what is the difference?  The public company transactions are evidence of the market value based on a large number of transactions which have been completed between buyers and sellers.  That is the reason that a large number of public companies is not required in order to use the methodology to arrive at valuation multiples.  Each company alone is evidence of the market.

Private company transactions may or may not take place at market value. Buyers and sellers have their own motivations for entering into transactions.   There is only one transaction for each company, unlike with public companies where you could have anywhere from under one million to over 250 million trades in a single day.  The concept behind private company transaction methodology is that with a sufficient number of transactions, the average or mid-point will represent what the market looks like.  That is why more transactions are necessary under the private company transaction methodology.  A few transactions may not be sufficient to represent the market.

What is important to understand is that each valuation is different. Applying any methodology is based on the facts and circumstances particular to the company being valued and the valuation date.

©2009 Florida Business Valuation Group

One of the approaches to valuing a business is the market approach.  This approach looks to either private transactions or publicly traded stock to develop an indicator of value, usually in the form of a multiple.   Is a single transaction representative of the value in the market?

With public companies, the marketplace allows for buyers and sellers to negotiate each transaction by using bidding system.  A buyer will indicate what he wants to pay for a stock and a seller will indicate what he wants to sell the stock for.  When buyers and sellers are matched, there is a sale.  The public stock exchanges provide an efficient system for trades.

When a public guideline company method is used to value a business, comparable companies are identified and the information from the market is used to develop a market value.  Because the data captures the prices paid in the market, it is considered to be a good proxy of fair market value.  Since there are many transactions for each company, it is not necessary that an appraiser use a large number of comparable publicly traded companies in applying this methodology.  (The IRS heavily favors using publicly traded companies as a basis for value in developing opinions of value.)

When comparable publicly traded companies are not available, we look to private markets.  Private markets are no where near as efficient as publicly traded markets.  Often, limited information is available about the sale and the company operations.  Private companies are not require to report information and most information available is from database services that collect the information from brokers and intermediaries.

Since private markets are not efficient, the sales prices usually reflect an investment value rather than fair market value.

With all these challenges, how do we use these private transactions to develop indicators of fair market value?  Using private transactions is based on the concept that when transactions for similar companies are looked at together, these values represent the market as a whole.  The values for companies sold at distressed prices offset the values for companies sold at premiums, resulting in a market value.

Since the private transaction methodology relies upon a group of transactions to extrapolate multiples representative of the entire market, it is necessary to have a sufficient number of transactions to achieve this.  The problem is there is no absolute number.  We know that you need more than five transactions to get a statistically valid multiple.  Most agree that you need more than ten transactions.  The obvious answer is the more the better. With more transactions, an appraiser is better able to analyze the data into groups and arrive at a multiple based on factors that are similar to the company being valued.

While a single transaction price may be representative of fair market value, it is not sufficient to prove fair market value.  Remember price does not necessary equal value.  Price is the negotiated amount at which a transaction takes place and can be influenced by non-market factors.

For more information on the market approach, click here.

©2009 Florida Business Valuation Group

There are terms that are frequently used in valuation that have specific meanings.  A group of the appraisal organizations got together and created a glossary defining various terms, the International Glossary of Business Valuation Terms.  Definitions below are taken from the Glossary.

An appraisal is the same as a valuation, which is defined as “the act or process of determining the value of a business, business ownership interest, security or intangible asset.”

The three approaches to valuation are the asset approach, the income approach and the market approach.  Within each approach are various methodologies used in the process of business valuation.

The asset approach is “a general way of determining a value indication of a business, business ownership interest or security using one or more methods based on the value of the assets net of liabilities.”

The income approach is “a general way of determining a value indication of a business, business ownership interest, security or intangible asset using one or more methods that covert anticipated economic benefits into a present single amount.”

The market approach is “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.”

Discounted cash flow method is “a method within the income approach whereby the present value of expected economic benefits is calculated using a discount rate.”

Discount rate is “a rate of return used to covert a future monetary sum into a present value.” The discount rate converts future net income, earnings or cash flow to a present value.  The rate is used in a formula which takes into consideration the point in time in the future when the benefit is expected to be received.

Capitalization rate or cap rate is “any divisor (usually expressed as a percentage) used to convert anticipated economic benefits of a single period into value.”  In simple terms is a rate that is divided in an estimate of net income, earnings or cash flow for a single period to arrive at a value of a business or business interest under the income approach.  The higher the rate, the lower the value.

A multiple is “the inverse of a capitalization rate.”

These definitions are a start to understanding the terminology used by appraisers.  In future postings I will discuss the application of different approaches and methodology.

© 2009 Florida Business Valuation Group