Ask a finance professor about the best business valuation method. The answer will be there are three approaches to choose from. When pressed for a simple answer though, even the professor would admit that nothing beats the market comps for valuing a business.
Benefits of market comps in business valuation
Just think of all the good things the market comparison brings. You get the business sale comps from the real market place. That’s where the prices of businesses are really determined. Figuring out what your business is worth uses the tried and true valuation multiples. Remember the price to earnings or PE ratios, the darling of public company investors? Even aunt Millie got it right. Simple and easy to use.
With this in mind, you might ask, are there any weak points to the market based business valuation? If market comps are so easy and compelling, why do business appraisers bother to use the income and asset based valuation methods?
Market comps limitations: every company is unique
The biggest reason is any comparison suffers from the apples and oranges problem. If you compare two different companies across a range of financial and operational performance indicators, you will discover quite a few unique differences that set them apart. On top of that, each business sale transaction is one of a kind with its set of circumstances, real buyers and sellers, and timing that makes or breaks a deal.
But wait, there is more. To run a market comparison in order to figure out what your company is worth, you need to gather a set of recent business sales data you can trust. In the public capital markets, companies must file regulatory reports that stick to consistent reporting rules such as GAAP. So when your stock broker speaks about EBITDA or market cap for a public company, it’s an apples to apples comparison to like numbers for any other publicly traded company.
Major caveat: private company data quality is questionable
For private companies, it’s a jungle out there. No private business is required to file GAAP compliant financial reports similar to the public companies’ 10-K annual report. No one needs to audit a private firm’s financials to put it up for sale.
Creative financial adjustments to pad the profitability and cash flow numbers are commonplace. Since private companies are valued mainly based on the amount of cash they throw off, you can guess why the rosy financials tend to pop up in the business brokers’ offering memos.
The point is, reliable, consistent business sale numbers are hard to come by. While laws govern what information public companies must publish for the benefit of outside investors, no such transparency is required in the private business buying and selling. Doing your due diligence to weed out the bad apples is essential.
So market comparisons sound good in theory, but present challenges in the real world. There are a couple of ways you can address the problem.
Market comps: public or private?
On the one hand, you can search for the most believable, if not reliable, evidence of private business sales. On the other, you can resort to the much more reliable and consistent data on public company values, then make adjustments to account for the differences between the private and public businesses.
This latter avenue of valuing private businesses has an official name, viz. guideline public company valuation method. The idea is that you start with a solid data set of public companies in your industry sector. The good news is their values are well established, as they sell their stock and debt in the public markets and you can ask your stock brokerage for a quote. You also don’t have to pay anyone to get to this data, because public companies are required to report their key financial and operational results by law.
Adjustments needed to make the public market comps useful in private business valuation
So far, so good. To make your public data useful for a private company valuation, you need to make a few adjustments. First, apply the discount for lack of marketability, or DLOM for short. The idea is that private companies are less marketable and, as a result, their ownership interests are less valuable. That’s because selling a private business is a major project, and there is plenty of uncertainly as to the price, costs, and timing of closing a sale.
In comparison, selling public company stock is a piece of cake. You can unload stock in a few moments online these days. Price per share quoted is pretty much what you get once you click the mouse button.
If your public company market comps include firms substantially larger than your target private business, you would need to make another adjustment known as the company size premium. Larger firms tend to be less risky than their smaller counterparts, so their values are relatively higher.
The takeaway is this: you always have a way to run a market comparison for a private business valuation. If direct private business sale data is unavailable, or you don’t trust it, use the guideline public company valuations to get the answer you need.