Valuation techniques Market approach

Valuation techniques Market approach – when valuing a company as a going concern there are three main valuation methods used by industry practitioners: the cost approach, the market approach and the income approach.  These are the most common methods of valuation used in investment banking, equity research, private equity, corporate development, mergers & acquisitions (M&A), leveraged buyouts (LBO) and most areas of finance.

Valuing a Business, Group of assets (and liabilities) or a Cash generating unit

Cost approach

Market approach

Income approach

Cost to build

Precedent transactions

Forecast of business results

Replacement costs – the amount that would be required currently to replace the service capacity of an asset.

Comparable company transaction data

– Public company transactions

– Private company transactions

– Prior transactions of the subject company

Present value techniques discounting future cash flows using a risk adjusted discount rate

Multi-period excess earnings method

and others

Appraised value by a specialised industry expert – Validation of replacement calculation to objectify the value estimate.

Special purpose report by a specialised business valuator – Validation of data used to objectify the value estimate.

Special purpose report by a specialised business valuator – Comparison of valuation models and inputs used to objectify the value estimate.

Something else -   Verifiability

The market approach uses prices and other relevant information generated by market transactions involving identical or comparable (i.e. similar) assets, liabilities or a group of assets and liabilities, such as a business. For example, valuation techniques consistent with the market approach often use market multiples derived from a set of comparables.

Multiples might be in ranges with a different multiple for each comparable. The selection of the appropriate multiple within the range requires judgment, considering qualitative and quantitative factors specific to the measurement. Valuation techniques Market approach

Valuation techniques consistent with the market approach include matrix pricing. Matrix pricing is a mathematical technique used principally to value some types of financial instruments, such as debt securities, without relying exclusively on quoted prices for the specific securities, but rather relying on the securities’ relationship to other benchmark quoted securities.

For a business valuation expert, a good set of comparable companies (‘comps’) may be as many as two or three – and sometimes no comparable company data can be found. (The objective of analyzing these components is to determine if the comparable company has a similar risk profile.) There are three sources of comparable company transaction data:

  • Public company transactions ValEstimating market rate of return when volume or activity is slightuation techniques Market approach
  • Private company transactions Valuation techniques Market approach
  • Prior transactions of the subject company Valuation techniques Market approach

As with any valuation approach, there are significant advantages and disadvantages. Valuation techniques Market approach

Advantages

  1. It is “user friendly.” Companies with similar product, geographic, and/or business risk and/or financial characteristics should have similar pricing characteristics. People outside of business valuation can understand this logic. Users of valuation reports (transaction participants, juries, judges, etc.) tend to find market-based methods to be familiar and easy to understand in comparison to other approaches.
  2. It uses actual data. The estimates of value are based on actual transaction prices, not estimates based on number of complex assumptions or judgments. The data can be independently obtained, verified, and tested. Valuation techniques Market approach
  3. It is relatively simple to apply. The market approach derives estimates of value from relatively simple financial ratios, drawn from a group of similar companies. The most complicated mathematics involved is multiplication. However, this is an advantage more in perception than in reality. Valuation techniques Market approach
  4. It does not rely on explicit forecasts. The income approach requires a set of assumptions used in developing the forecasted cash flows. The market approach does not require as many assumptions. Valuation techniques Market approach

Disadvantages

  1. Sometimes, no recent comparable company data can be found. This may be the biggest reason the approach is not used in valuation; the analyst may not be able to find guideline companies that are sufficiently like the subject. Some companies are so unusual, small, diversified, etc. that there are no other similar companies. Valuation techniques Market approach
  2. The standard of value may be unclear. Most transaction databases provide financial and pricing data but do not explicitly indicate whether the reported transaction was arms-length, strategic, synergistic, fire sale, asset vs. stock, etc. Some argue that the occurrence of actual fair market value transactions reported in transaction databases is probably less than 50%. If the guideline transaction was synergistic, the resulting values multiple will likely produce a synergistic value – not fair market value. Valuation techniques Market approach
  3. Most of the important assumptions are hidden. Among the most important assumptions in a guideline price multiple is the company’s expected growth in sales or earnings. In the income approach the growth rates are disclosed. When applying multiples from guideline companies the implicit subject company growth will be a function of the growth rates built into the prices of the guideline companies on which the value of the subject is based. Valuation techniques Market approach
  4. It is a costly approach. Done correctly, the valuation analyst must perform significant financial analysis on the subject company and equally on each of the comparable companies. The analysis must be done to verify comparability as well as to identify underlying assumptions built into the pricing multiple. This is after and in addition to the significant time and effort to first identify possible comps. Valuation techniques Market approach
  5. It is not as flexible or adaptable as other approaches. Unlike the income approach, the market approach is sometimes difficult to include unique operating characteristics of the firm in the value it produces. Valuation techniques Market approach
  6. Reliability of the transaction data is questionable. Great strides have been made in improving the accuracy, completeness, and depth of the data reported by various subscription services (discussed below). However, particularly with private company transactions, the analyst would do well to use such data with caution.
Something else -   Concise information

Valuation techniques Market approach

Valuation techniques Market approach

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Something else -   Adjusted net asset method

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