Estimation of business value by comparison to similar companies in your industry sector is at the heart of the market approach. 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 are the tools you have to do such comparisons. The multiples are ratios that relate business value to some measure of the company’s financial performance. Typical valuation multiples used in business appraisals are:
- Enterprise value (EV) to gross revenue or net sales.
- EV to gross profit.
- EV to net income.
- EV to EBIT or EBITDA.
- EV 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, there are two central methods under the market approach you can use:
- Comparative private company transactions method.
- Guideline publicly traded company method.
While comparison to private business sales seems compelling, gathering reliable, consistent transaction data is a challenge. There are a couple of reasons for this.
Private businesses are not required to comply with major financial reporting standards such as GAAP or IFRS. Private company owners typically manage their firms to minimize taxes. This tends to obscure the firm’s actual earning power. Without knowing more about each private company selected for comparison, there is no way of knowing if, say, net income or EBITDA can be calculated 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, is required to 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 there are 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
This is important to 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.