Estimation of business value by comparison to similar companies in your industry sector forms the foundation of the market approach. Importantly, many business appraisal experts and business people believe that business value can only be established by market participants – buyers and sellers of business ownership interests.
Valuation multiples represent the tools you can use to do such comparisons. The multiples are ratios that relate business value to some measure of the company’s financial performance. Take a look at the typical valuation multiples you can use in business appraisal:
- Enterprise value (EV) to gross revenue or net sales.
- EV to gross profit.
- Business enterprise value to net income.
- EV to EBIT or EBITDA.
- Enterprise value to hard assets or total business assets.
- EV to owners’ equity.
Sources of comparable business data for valuation multiples
If you are valuing a private company, you should consider these two central methods under the market approach:
- Comparative private company transactions method.
- Guideline publicly traded company method.
While comparison to private business sales seems compelling, gathering reliable, you may have trouble locating consistent transaction data. There are a couple of reasons for this.
Private businesses do not have to comply with major financial reporting standards such as GAAP or IFRS. Private company owners typically manage their firms to minimize taxes. And this tends to obscure the firm’s actual earning power. Without knowing more about each private company selected for comparison, you cannot figure out such quantities as net income or EBITDA with any degree of accuracy.
In addition, private company transactions are not required to be disclosed to the public. As a result, a very large number of such deals go unreported. For the purposes of calculating reliable valuation multiples for your comparison these important transactions do not exist.
Advantages of guideline public company method
In contrast, you have plenty of data on similar public companies in your industry sector. First, every publicly traded firm, regardless of its size, must make regular filings with the government. In the US, such filings are made with the Securities and Exchange Commission (SEC) and wind up in its EDGAR database.
Equally important, all financial disclosure documents on public companies must comply with accepted reporting standards, such as GAAP. So when you calculate your valuation multiples from such data, your calculations produce consistent, verifiable results.
Discount for lack of marketability (DLOM)
One key difference between the public and private companies is marketability of business ownership interests. Shares of public companies are freely traded, unlike those of privately owned firms. This lack of marketability is an extra risk that lowers the value of private company ownership interests.
To use the guideline public company data for private firm valuation, you need to apply what is known as discount for lack marketability.
For example, let’s assume that an EV to net sales valuation multiple you calculated by analyzing small capitalization public companies is 1.5. Applying a DLOM of 40% to this number gives you a private company valuation multiple of 0.9.
Calculating valuation multiples from guideline public companies: the procedure
To sum up, you can calculate a set of highly relevant valuation multiples for a private company valuation as follows:
Step 1. Identify the industry sector your firm operates in
Come up with the SIC and NAICS codes.
Step 2. Visit EDGAR database
Locate a number of small or mid-size guideline companies similar to yours. In just about every sector you can spot plenty of small cap public companies that you can include in your comparison data set.
Step 3. Calculate guideline valuation multiples
Decide upon the financial measures for your comparison, such as revenue, EBITDA or business assets. Then calculate the valuation multiples using the guideline public company data you have assembled.
Step 4. Adjust valuation multiples for DLOM
Most importantly, you must make your valuation multiples suitable for private company valuation. The typical sources of data for DLOM are the restricted stock and pre-IPO transaction prices compared to sales of fully marketable stock in the same companies.
Step 5. Calculate your company’s value estimates
You can now assess the business value using the valuation multiples developed. Take a look at a typical format for doing so.