Market-based business valuation methods are routinely used by business owners, buyers and their professional advisors to determine the business worth. This is especially so when a business sale transaction is planned. After all, if you plan to buy or sell your business, it is a good idea to check what the market thinks about the selling price of similar businesses.
The market approach offers the view of business market value that is both easy to grasp and straightforward to apply. The idea is to compare your business to similar businesses that have actually sold.
If the comparison is relevant, you can gain valuable insights about the kind of price your business would fetch in the marketplace. You can use the market-based business valuation methods to get a quick sanity check pricing estimate or as a compelling market evidence of the likely business selling price.
Pricing multiples for business selling price estimation
All business valuation methods under the market approach fall within one or more of the following categories:
- Empirical, using comparative business sale data.
- Empirical, which rely upon guideline public company data.
- Heuristic, which use expert opinions of professional practitioners.
Business value measures and pricing multiples
Each of these business valuation methods uses a number of so-called value measures which relate the business selling price estimate to some value of business financial performance. Generally, these value measures are ratios, known as pricing multiples, of the estimated selling price to a known financial performance characteristic. The typical ones are:
- Selling price divided by the business revenue.
- Selling price divided by some measure of business earnings.
- Business sale price to the market value of all business assets, or fixed assets.
- Selling price divided by a measure of owners’ equity such as the business book value.
For example, to estimate the business selling price you can take the business revenue and multiply it by the selling price to business revenue pricing multiple.
One way to arrive at an estimate of the business selling price is to use a single pricing multiple value, such as the average or the median. Another way is to calculate a pricing range by using a pair of values, for example the minimum and the maximum. The likely selling price will fall somewhere in between.
Market business valuation methods – pros and cons
A key difference between the various market-based business valuation methods is how these pricing multiples are determined. Each method has a number of pros and cons.
Comparative private company sale data method
Under this business valuation method, you gather data on sales of private companies that closely resemble the business being valued. The method is formally known as the Comparative Transaction Method.
- Comparison data includes sales of small businesses that are quite similar to the small business being valued.
- Availability of good sources of private business sales data.
- Insufficient market evidence in some industries.
- Requires careful data selection, analysis and consistent data reporting standards.
Guideline public company method
In this method, you review the data involving sales of ownership interest in publicly traded companies that resemble the small business being valued. Professionals call this the Guideline Publicly Traded Company Method.
- Plenty of transaction data available from the public capital markets.
- Business sale data reporting is generally consistent and reliable.
- Business financial reporting data are readily available.
Heuristic pricing rules method
In this method, you use business pricing formulas that are developed based on the expert opinion of professionals involved in business sales. The best known professional group that does this is the business intermediaries that broker business sale transactions in specific industries. Their knowledge of the market place and direct exposure to transactions puts these experts in an excellent position to estimate the likely business selling price.
- Pricing multiples based on the expert opinion of active market participants, from the trenches.
- Pricing formulas are often relied upon both by practitioners and their client business owners and buyers when pricing a deal.
- Pricing multiples may not be backed by rigorous statistical data analysis.
- Non-brokered business sale transaction data may not be included.
Business selling price estimates – which one is best?
Given these choices of market-based business valuation methods, what is the “best practice” approach you can use? Since all methods have their strengths and weaknesses, it seems that a combination of empirical and heuristic approaches may be your best choice. Here is one suggestion:
- Gather and study the relevant business sale data.
- Select the appropriate business pricing multiples.
- Use the pricing multiples to calculate the business selling price estimate.
- Check this estimate against the heuristic expert pricing rules.
- If the two estimates agree, you have the increased confidence in your business pricing estimate.
- If the estimates are wide apart, review your empirical data selection and pricing multiples.
- Assign a weight to each pricing estimate to calculate an average business value.