ValuAdder Business Valuation Blog

When it comes to business valuation, the market approach reigns supreme. Think about it – where else can you glean the values of businesses better than from the active, observable market place where companies change hands every day?

Unsurprisingly, the International Valuation Standards or IVS for short, accord a special place to the market-based valuation methods. By the way, these days a well defined bridge connects the venerable USPAP and the newer IVS valuation standards. As a result, you can comply with both. In fact, professional business valuations must demonstrate that they follow these standards.

Back to the market approach to business appraisal. The IVS standard puts a strong emphasis on the market based valuation whenever these conditions prevail:

  • The company being valued has recently sold in an arms-length transaction.
  • The company stock or ownership interests in very similar companies are actively and publicly traded.
  • There are frequent, recent, and observable sales of businesses similar to your business.

You will find market comparables less compelling in some situations. For example, they may be out of date, happen only once in a while, are not reported publicly, or the business sale comps involve companies that are quite different from yours.

How good is your business sale comps data?

In addition, you should be wary of business sale comps if the source of the data is questionable in quality. This would be the case if the deals are not done at arms length, the information on the business sales is scant or missing.

Even in the absence of reliable business sale comps data, the IVS standard encourages getting the information from the market place. This includes the risk-free rates of return and risk premia. You would need these for calculating the cost of capital in the form of discount and capitalization rates. Fortunately, as the Build-Up model shows, this market info is readily available from the public capital markets. Truly, where there is a will, there is a way.

Market approach valuation methods

For the actual calculations of your business value using the business sale comps, the IVS offers two main methods:

  • Comparable transactions method.
  • Guideline publicly traded comparable method.

As you might surmise, the comparable transactions method relies upon the sales of businesses similar to yours. The challenge of private business sale comps is data availability and its quality. Here is why:

No private company is required to file a disclosure of its M&A transactions. Moreover, private companies are not obligated to report their financial numbers in a consistent, standards compliant way.  For example,  the US Generally Accepted Accounting Principles, or GAAP.

In contrast, this is a virtual must for all publicly traded companies. So when you want to compare two public companies, you can rest assured that their income statements and balance sheets are consistent and recorded in accordance with GAAP. Say hello to apples to apples comparison!

What if you can’t trust the private business sale comps data? Then you can opt for the guideline publicly traded comparable method. Look at the comparable business sales of public companies. Their financials and business sale transactions are disclosed to the public by law and follow a well established reporting format such as GAAP or IFRS.

This method is especially useful for professionally managed private businesses that appear operationally quite similar to their smaller publicly traded competitors. What you need to do to make the comparison work is to adjust your valuation multiples for the relative lack of marketability. The tool used by professional business appraisers for this purpose is the discount for lack of marketability or DLOM for short.

Valuation multiples: tools of the business valuation trade

No matter the method you use, the tools are still the same. They are the various valuation multiples you develop from the comparable business sale statistics. They are ratios of business financial performance relative to its selling price, or market value. For example, a price to gross revenue valuation multiple lets you figure out your business value by multiplying the multiple by your company’s recent gross revenues.

Do you use high quality valuation multiples you got from studying guideline public companies? Then you would need to adjust them for DLOM in order to use the metrics in valuing a private business.

By the way, if you calculate the market capitalization of a public company using the currently quoted stock price, you may underestimate its enterprise value. Small blocks of company stock trade at a so-called minority discount. Public company acquisitions require that you pay a control premium to all those small investors in order to induce them to sell enough shares so you can put together a controlling ownership block.

Again, public capital markets tell all – look at the tender offer terms and notice the control premia in the offer. That is the price per share offered over and above the current market price quoted by your securities broker.