Magazine article The CPA Journal

A Misunderstood Aspect of Business Value: The Market Approach

Magazine article The CPA Journal

A Misunderstood Aspect of Business Value: The Market Approach

Article excerpt

The more similar and numerous the number of historical sales of comparable items within a given market, the narrower the range of values assigned, using the market approach to valuation. On occasion, "outlier" transactions might reflect a particularly motivated buyer or seller. The central tendency, however, is a steep bell curve, where most sales prices aggregate around fair market value.

For publicly traded companies, the slatting point for establishing market value is the "bid-ask" spread found in the stock market. The seller (asker) seeks better investment opportunities than the stock currently held. The buyer (bidder) believes the stock offers potential and wants to buy. In most cases, there is considerable investor activity with posted pricing based on many historical trades. This is a relatively narrow spread where the buyer and seller will agree. The value of a single share is determined by the market. Valuing closely held businesses, on the other hand, is a more challenging task.

Factors Influencing Investment Decisions

When external factors, such as shifts in supply and demand or lower interest rates, are considered, swings in the value of businesses may result. Over time, however, investors expect the value of their purchases to increase. The operative issue is growth or appreciation.

The benefit of this increase in equity does not become realized until accessed through a sale or used as collateral for a loan. This is one of the prerogatives of direct ownership. A business may also produce income that is realized by its owners. A favorable record of income generation (profits, cash flow, or economic benefit) can also contribute to value beyond property appreciation because it lowers the perceived risk of ownership. Ownership of marketable securities of publicly traded companies tends to be focused upon either growth or income, or both. The risk of ownership of marketable securities is generally perceived as lower than closely held businesses.

The Income Approach

In the income approach to valuation, an analyst develops a capitalization or discount rate, which is conceptually similar to a multiple of earnings. (A capitalization rate of 33.3% is the same as a multiple of three times earnings.) In order to develop the rate (risk), an analyst customarily examines the less risky publicly traded market and then adds an unsystemic (company-specific) risk to develop a rate of return. A thorough awareness of the subject company and its market is necessary in order to simulate the price a pool of reasonable and informed investors would be willing to pay for ownership.

The market approach, in some ways, can be more objective, as it intends to capture what actual investors pay for businesses in many industries. Subjectivity exists in determining what is comparable and what adjustments should be made. Both approaches require a degree of skill and experience to justify selections, exclusions, and adjustments among available data.

The Fallacy of Incomparability

An analyst's dismissal of the market approach out-of-hand should be worrisome. The explanation is often: "Insufficient comparable data were identified; therefore this approach was not applied." What is insufficient, and why? Another perspective would pose the question: "If transactional data were insufficient, how was there adequate information to opine the risk rate in the income approach?"

If the subject company is a going concern and the market approach is not developed, or at least considered, then the only approach available would be the income approach. In effect, there becomes no evidence to substantiate the analyst's opinion modeling actual investor activity in the given industry.

Another abuse is characterized by the statement: "A multiple of three times earnings for the specific business was selected." Without further information, this statement lacks an objective basis. Analysts frequently claim to base such statements on their experience or professional opinion, with no concrete proof of actual transactions. …

Search by... Author
Show... All Results Primary Sources Peer-reviewed

Oops!

An unknown error has occurred. Please click the button below to reload the page. If the problem persists, please try again in a little while.