In the real world comparisons rule. We compare products, services, features and prices all the time. Price per square foot is the yard stick used by the real estate industry to compare properties. In a world of substitutes it seems there is always the next best thing out there.
But how about this: can you compare a one of a kind painting by a famed artist to somebody else’s work? Probably not. Reason is simple: a work of art is not the same as another. There are no substitutes for the real thing.
In business valuation, the situation may be quite complex as well. While many companies can be compared to their industry peers, some businesses are unique enough to defy comparison.
Imagine, for example, comparing Google to figure out its value in the early 2000’s before the company went public. There were no other businesses who offered the kind of search engine technology Google became famous for. If you tried to use market comparisons, you’d be matching the proverbial apples and oranges.
Indeed, professional appraisers know that market based comparisons may be misleading. After all, each business is unique. It is precisely its specific value set of drivers that determine its true value. Things like technology, business relations, skills of the company’s staff, and relationship with its customers tend to play a significant role in how it competes. No two businesses are ever the same.
Yet market comparison is based on the simple assumption that businesses operating in the same industry are interchangeable. If you know the selling price of several companies out there, you can estimate the value of your firm. Well, yes and no.
Market comps are good for initial business value estimates. It is easy to see how valuation multiples you get from sold businesses can be applied to your company’s revenue, asset base, EBITDA or net income to figure out what your company may be worth.
Market evidence is also useful if your business valuation comes under fire. Examples are legal disputes, or challenges by the tax authorities. If you can furnish proof of companies’ selling prices, your business value analysis gains support from the actual market place.
However, as the saying goes, there are lies, damn lies, and statistics. Market valuation is based on statistics collected either by yourself or someone else. The stats may be very misleading, depending on who and how collects and analyzes the market data.
Private business sales data is a case in point. Usually, such data is collected on a voluntary basis by business brokers. Only a fraction of the actual business sales ever get disclosed to the business sale data vendors.
Business people and brokers are not required to report private company sales to anyone. Most of such sales never get reported. Business owners may consider their acquisition strategy highly competitive. Brokers may view their knowledge of the market place as a key advantage and keep their deal statistics to themselves. What you see is just a sliver of the actual deal flow.
In addition, most business brokers are not financial reporting experts. Be wary of the financial numbers as they are not reviewed, let alone audited by a financial accounting professional. That is one reason private business financials require adjustment or normalization before you can value a company.
For these reasons, many business appraisal experts tend to approach the market valuation methods with caution. One way to get better quality data is to examine small cap public companies or private company acquisition deals done by public firms. Such transactions must be reported to the authorities, such as the US Securities and Exchange Commission, under law. In addition, the financial numbers must comply with the standard GAAP format and be audited by licensed accountants.
So your comparison is more likely to be “apples to apples”. But what about the difference between the public and private companies? Business appraisers use the discount for lack of marketability to adjust the valuation multiples from public company sources. Fortunately for your business valuation, the difference is visible in the market place – just check the prices of restricted company stock and freely marketable shares of the same firm. This measure of price reduction gives you an idea how much the investors discount the value of assets that have limited marketability.
Remember that market comparison is but one approach to business value. To uncover what your company is really worth, you need to apply the various methods under the income and asset approaches. In particular, the income valuation helps you delve into the value drivers that create business value. This type of analysis is as unique as the company itself.