GlobalBX

There are 3 approaches to valuing a business – market, income and asset. This article covers the market approach.

Preferred Approach
A market-based valuation is preferred by most appraisers and users because it relates directly to the actual sale of a similar property. There is no better evidence of value than an actual transaction, but it must be comparable. That is a major weakness for applying the market approach to a small company. It is difficult, if not impossible, to find comparable transactions.

Public Companies
Every day millions of shares of stock in large companies are freely traded on major exchanges like the New York Stock Exchange (NYSE). It should be the ideal source of market data for the sale of a company, but is buying shares of a public company comparable to buying a small business? The answer is no for a number of reasons. For professionals that believe comparable public companies exist, there is the guideline public company method. A single company or group of companies is identified as comparable and adjusted to increase comparability. The most appropriate pricing multiples are selected and applied to the company being valued.

Private Companies
Due to the differences between public and private companies, data from the actual sales of private companies would seem like a better alternative. The primary problem is that these sales are private transactions that are not reported publicly. There are several commercial databases that collect this information from various sources. The available data is from a small portion of the total transactions and a limited amount of information for each transaction is available. Under these conditions finding one reasonably comparable transaction is virtually impossible. Typically transactions within an industry group are used to provide an average multiple that is applied to the company being valued.

The most commonly used multiples from these databases are a percentage of annual revenue, and a multiple of sellers’ discretionary earnings (SDE). SDE is the earnings of a business excluding the following items: income taxes, non-recurring items, non-operating items, depreciation, amortization, interest income, interest expense, and the total compensation (including benefits) for one owner.

The two primary databases of private transactions are BIZCOMPS and Pratt’s Stats. These databases are available by subscription or for single searches at bvmarketdata.com. BIZCOMPS contains over 11,000 transactions involving companies with average annual sales of $393,000. Pratt’s Stats contains over 13,000 transactions involving companies with average annual sales of $1.06 million. The cost to search these databases one time is $129 and $199, respectively. The information about these databases is accurate as of May 2009. Your CPA may subscribe to one or both of these databases and may be willing to do a search for you for a minimal fee.

Because the data is limited and of questionable comparability, methods based on it are often used only to support or justify the conclusions reached using other valuation methods.

Industry Rules of Thumb
Some industries have formulas that are widely used to determine business value, often called rules of thumb. Rules of thumb are typically expressed as a range of multiples that are applied to sales or earnings. One of the most extensive listings of these formulas is published in an annual Business Reference Guide from Business Brokerage Press. You may also be able to find rules for your industry from a trade group or association.

Although these rules are purportedly based on actual transactions, there is no way to substantiate the rules or verify the data. So they are best suited for quick and dirty estimates.

Summary
In a perfect world the market-based approach would be the most widely used valuation method. Because of the incompatibility of public company data and the lack of quality, comparable private company information, the market-based approach is often relegated to playing just a supporting role.