Market Approach—The market approach derives an indication of value by comparing the company to other similar companies that have been sold in the past. The “guideline publicly traded company method” uses the prices of similar and relevant public companies as guidelines for determining the value of a closely held or family controlled business. The “direct market data method” relies on transaction data of similar closely held and family controlled businesses to determine an indication of value.
The premise of this approach is based on the economic principle of substitution stating that one will not pay more for an asset than the amount at which they can acquire an equally desirable substitute. The market price of stocks in corporations having their shares actively traded in a free and open market can be an indication of value when the transactions in such freely traded companies are sufficiently similar to the company being valued to permit a meaningful comparison.
Guideline company transactions in the open market may involve either minority or controlling interests in the guideline companies. To be sufficiently similar to the company being valued, however, the guideline company must exhibit similar factors such as:
- Investment characteristics,
- Business size,
- Markets served,
- Depth of management,
- Probable future earnings expectations.
Relevant factors to be considered focus on the characteristics of the willing buyer and include:
- Risk tolerance,
- Degree of owner involvement in management of the company,
- Expected holding period.
The guideline publicly traded company method is appropriate when similar and relevant proxy companies may be identified and employed in estimating the value of a closely held and family controlled company.
The direct market data method develops an estimate of value for the subject company through use of transactional information on actual sales of a large sample of closely held companies. Sources of transactional data may include databases such as The Institute of Business Appraisers (IBA) Transaction Database, Pratt’s Stats, DoneDeals, Bizcomps, etc. Though similar to the guideline publicly traded company method, there are several major differences that distinguish the two methods.
Under the guideline publicly traded company method, a small number of companies are selected as being similar to the company being valued. They and their stock prices are compared to the company being valued to arrive at a valuation estimate. The direct market data method, however, assumes that the sample of transactions for which market data is obtained represents the statistical population of the market for similar businesses as the one being valued. The company is then compared to the market based on its relative strengths and weaknesses with respect to financial condition, performance, etc. The market value of the company is then estimated based on the prices at which other companies have sold.
The direct market data method is usually employed when there is a large enough sample of transactional data of similar and relevant companies to develop a reliable indication of value.