Market approach is a method of estimation the value of a company. Investor estimates the value based on fair market value, reviewing actual transactions of that and comparable companies. It also uses prices of publicly traded stocks. Unfortunately less than 1% of the companies is publicly traded. Finding fair price can be then difficult.
The most common methods in market approach are:
- Guideline Transaction Method - prices of similar companies recently sold
- Guideline Public Company Method - prices of similar companies publicly traded
Attention should be paid to sales and revenues. Two similar companies can have products in different phases of the cycle. In such event comparison can be not relevant . Valuation: The Market Approach A market approach is a method of determining the appraisal value of an asset, based on the selling price of similar items. The market approach is a business valuation method that can be used to calculate the value of property or as part of the valuation process for a closely held business. Additionally, the market approach can be used to determine the value of a business ownership interest, security, or intangible asset. Regardless of which asset is being valued, the market approach studies recent sales of similar assets, making adjustments for differences in size, quantity or quality.
Market approach methods
There are a number of valuation methods that may be used by a valuation analyst under the market approach. The methods are named according to the source of known values that are used as guidelines. The two main valuation methods that are used under the market approach are:
Public company comparables
The Public Company Comparables Method entails using valuation metrics from companies that have been traded publicly, which are considered to be rightly similar to the subject entity. In most situations, direct comparability is hard to attain since a majority of public companies are not only larger but also more dissimilar to the subject.
Nonetheless, the direct comparability threshold should be a little flexible so that public companies that have comparable business features are not excluded from giving guidance on the subject company's valuation.
Direct comparability can be readily achieved in comparatively few industries. Most of them are faced with challenges of scalar differences existing between most private enterprises and public operators. The process of selecting, adjusting, and applying public company valuation data is usually complex and needs significant experience and appraiser skill.
Guideline companies are usually companies that have been traded publicly in a similar or equivalent industry as the subject company. They should also have a practical basis for comparison to the subject of evaluation because of resemblances in demand and supply factors, operational processes and financial composition.
The Precedent Transactions Method involves deriving value using pricing multiples that are based on observed transactions of companies in the industry of the subject company. It is based on the perception that comprehensive company financial data is not easily available, but there is an availability of transaction value.
Precedent transactions can be analyzed through conventional industry classification methods, like SIC codes. Furthermore, there are also valuation databases that can be examined for evidence of historical actuals and valuation. Such transactions may represent a majority or a minority perspective. A good guideline transaction should be from a very comparable company in the same industry. In cases where there is no direct comparability, other data can be used but not before considering such things as their market or products.
The use of the Transaction Method can be valuable in cases where a purchase or sale is under consideration or as an exit strategy for the management of the company. One weakness though is that some transactions may have happened in significantly diverse markets or industry conditions and therefore may not represent the prevailing acquisition and merger environment. Moreover, a major challenge in finding out if a transaction is suitable enough to be used as comparable data is the lack of information in the public spectrum or in research databases.
In both market valuation methods discussed above, the key is searching for companies that are sufficiently comparable to the subject company under valuation. When trying to find out whether a company is comparable enough to be used in determining the value of the other company, the appraiser should consider a number of factors such as:
- Whether the companies are operating in the same industry
- Whether they are similar in size
- Whether they offer identical services or products
- Whether any of the companies are operating in multiple industries
- The location of the companies
- Whether they are in competition for the same business
- Whether they have similar profits.
Advantages and disadvantages of the market approach
All methods under the Market Approach come with their own advantages and disadvantages. However, as a whole, the Market Approach offers the following benefits and weaknesses:
- It is straightforward and involves simple calculations.
- It uses data that is real and public.
- It is not dependent on subjective forecasts.
- It is difficult to identify transactions or companies that are comparable. There is usually a lack of a sufficient number of comparable companies or transactions.
- It is less flexible compared to other methods.
- The method raises questions on how much data is available and how good the data is.
The market approach: areas of potential concern
Areas that investors and analysts should pay close attention to when taking the market approach include sales or revenues figures. Two companies may both be in the healthcare industry; however, if one is a large pharma firm and the other a small-cap biotechnology company, comparing transactions involving them could not be fully relevant. It is also crucial to apply correct pricing multiples during the valuation process. For example, a TTM (trailing twelve months) enterprise value multiple should not be applied when considering a NTM (next twelve months) projection of a company being valued.
- Vazquez, C., Rivier, M., & Pérez-Arriaga, I. J. (2002). A market approach to long-term security of supply. IEEE Transactions on power systems, 17(2), 349-357.
- Shannon P. P. (2006).The Market Approach to Valuing Businesses 25-42
- Bernstrom S. (2014). Valuation: The Market Approach Wiley,chapter 2
- Schindler R.M. (2011) Pricing Strategies: A Marketing ApproachSage,251-273
Author: Iwona Maślak