Market Approaches in business valuation compare market sales to the company being valued. This is done by estimating a ratio of sales price to cash flow called a multiple or multiplier (i.e. $300 sales price / $100 of cash flow = a multiplier of 3.) Then the selected multiple is applied to the same estimated cash flow of the subject company to determine a value.
Thereafter the multiplier is multiplied against the subject company cash flow to obtain an estimate of value. See below.
Business brokers often have “rules of thumb” that use the market method formula. For instance deli’s sell for 35% of revenues. This is not based on research and detailed thought, just a form of common knowledge. Technically, that does not reach the level of a valuation as it is unlikely to be supportable.
Two primary Market Methods are most frequently used by valuators are:
The Public Company Guideline Comparable Method which uses stock prices from similar public companies. This methodology is really not suitable for most small and very small business valuations as large companies tend to be quite different from small ones. Namely, is Home Depot like your corner hardware store?
The second method is the Private Company Guideline Comparable Method.
The Private Company Guideline Comparable Method uses transaction data from private company sale databases. DealStats, Bizcomps, and Valusource Market Comps are all good sources for small and very small business comparables.
Typically, the valuator will start the process to find comparables by searching for the industry by NAICS (North American Industry Classification System) or SIC (Standard Industrial Classification) system codes. Depending on the number of results (at least 8-10), the valuator may add related codes or narrow the search by company size based on revenues and perhaps profitability based on profits or a defined cash flow. Comparable data is then reviewed using key word sorts, detailed data, charting and graphing results based on cash flow profitability and other indicators to see how similar it is to the subject company. These reviews are very detailed and complex.
Finally, a multiplier is selected by reviewing the comparable data and the subject company for both financial information and soft data. (These resources can include both internal such as concentrations, management strength, systems, etc. and external such as the economy and industry).
This process requires both skill at analyzing the data and professional judgment. But, for small and very small businesses (also known as micro-businesses), the market method is the only method of business valuation that can really be tied into market data.
Typical cash flows used for valuation may include:
- gross profit
- EBITDA (earnings before interest, taxes, depreciation, and amortization)
- SDE (seller’s discretionary earnings which is EBITDA plus all the ways one owner makes money from the business)
Each has advantages and disadvantages. The choice should be based on the fact pattern of the business and, of course, the available, selected comparable data. In general, in less experienced valuators hands, EBITDA or SDE tend to result in more useful values than the other possible cash flow choices. This is because people buy businesses based on the amount of money they think they will make in the future owning the business.
In many cases, a final adjustment needs to be made for assets or liabilities on the balance sheet beyond those typically conveyed for the price specified in the market data database.
An example of this is that in many retail businesses inventory purchased by the buyer is added to the value found based on cash flow.
The Market Method for providing an opinion of value of a business is often complex and relies heavily on experienced professional judgment. With a skilled valuator, the Market Method is the best method for valuing most small businesses with revenues below $5,000,000 and should be reviewed carefully for valuing companies with revenues up to $10,000,000 or more.
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Download the e-book “7 Things to Know About Business Valuation“ – and then connect with Greg if you have any questions about a business valuation for you or your clients
Greg is a Partner at Harvest Business Advisors where he has valued and brokered hundreds of small and mid-sized businesses. As Editor-In-Chief of “Around the Valuation World,” a monthly webinar for the National Association of Certified Valuators and Analysts (NACVA), he is in the forefront of current business valuation practices.