Market Approach to Business Valuation
Market approach to business valuation involves attributing a value to a business based on the value assigned by the market forces in comparable situations. The comparable situation could be either a prior transaction involving the same business, a market quote of listed securities of a comparable public company and/or an ownership transfer transaction involving a comparable (public or private) company.
Market approach is a relative valuation approach as it values a business or an intangible asset relative to other actual valuation transactions. The mechanics of market approach involve finding a price multiple of the benchmark, i.e. price to earnings ratio, EV to EBITDA, price to book value, etc. The price multiple is then multiplied with the relevant financial metric of the business being valued to arrive at a valuation estimate. Depending on the source of comparable valuation used, the market approach is further classified into (a) prior transactions method, (b) guideline public company method and (c) guideline transactions method.
Prior transactions method
The prior transaction method involves looking up historical transactions in securities of the business undervaluation. The valuation might be for minority stake such a historical stock quote from a listed stock exchange or it might be for a majority stake such a merger and acquisition transaction involving the business. Additional considerations in selecting prior transactions as a benchmark include the time line of the transaction, the economic situation at the time of the transaction, etc.
Guideline public company method
The guideline public company method involves identifying a comparable company and obtaining the stock price for the company’s listed securities. In most cases, the stock prices as obtained from a public market represent a minority stake. The advantage of this method lies in the availability of a large set of recent data. However, it might not be very appropriate in valuing early-stage and/or small businesses. In using public company data to value private companies, proper adjustments must be made to the benchmarks being used on account of size, growth potential, capital structure, business life cycle (i.e. early stage or maturity), etc.
Guideline transaction method
The guideline transaction method involves finding out prior transactions (i.e. mergers and acquisitions, divesture, etc.) of comparable companies. Such a transaction might represent either a minority perspective or a majority perspective. Transactions data can be obtained by finding out the exact industry of the business under consideration using the established industry classification methods such as SIC and NAICS and searching valuation databases for historical valuation evidence. An ideal guideline transaction would be the one from a very similar company in the same industry. If no direct comparison is available, other data might be used after considering their market, products, etc. Transactions data required adjustment for the transaction-specific factors such as non-compete agreement, employment contracts, etc.
In selecting which method to employ in a valuation assignment, the definition of value, the size of the company being valued and the magnitude of the valuation stake (majority vs minority) are important. A majority stake in a large well-established should be valued relative to either (a) a prior transaction of the same company involving a majority stake or (b) guideline transactions representing a majority stake involving a comparable company. A minority stake should be valued using the guideline public company method after applying proper discounts and adjustments.
You are a valuation advisor at OJM Capital. You are advising a large technology company on the potential acquisition of ZK, Inc., a relatively small enterprise which engages in health-tracking hardware and software. The company was founded in 2011. The co-founders sold a 20% stake in 2014 for $2,500,000 when the company’s sales were $3 million. The company’s revenue for the last twelve months (LTM) stands at $20 million, its EBITDA is $8 million and net income for the same period is $5 million. The company’s debt is valued at $10 million.
There are five comparable companies whose shares are publicly-traded. Their P/E ratios at 25, 22, 18, 12 and 20. They all represent less than 25% of the total share capital of each company.
You have identified three transactions which closely resemble the one under consideration:
- A: LTM sales of $50 million, EV/net income of 12 and EV/EBITDA of 17, the transaction represents 70% stake
- B: LTM sales of $10 million, EV/net income of 20 and EV/EBITDA of 15, 20% stake
- C: LTM sales of $25 million, EV/net income of 18 and EV/EBITDA of 16, 51% stake
In this example, we have one prior transaction from the same company when 20% ownership interest in the company was valued at $2.5 million. This translates to total equity value of at least $12.5 million. A 100% stake is more valuable than five times 20% stake due to the acquirer’s ability to control the company (which is possible at more than 51% holding only). But for the sake of simplicity, we are ignoring the control premium. Even though this information is dated, we can arrive at a forecasted value using the price to sales ratio from 2014 and applying it to 2017. Doing this gives us a value indication of $83 million. Again, we are assuming there is no change in the growth outlook of the company between the two dates.
Since ZK, Inc. is not publicly-traded, and the ownership interest being valued is a majority stake, the guideline public company method is not very appropriate due to the mismatch because of size, maturity, marketability, control, etc. However, we can use the valuation under this method after proper adjustments as additional evidence. Under the guideline public company method, the value is indicated as $97.5 million (average P/E of 19.5 for the 5 companies multiplied by earnings of ZK, Inc. for the last twelve months).
The guideline public transaction method can be used in two ways, we can either use the average/median values or we can use the data for the company most similar. If we use the most similar transaction, we are indirectly adjusting our valuation to automatically account for any size, control, etc. difference between the universe of transactions and the company being valued. If we go with average values for benchmarks, we need to adjust for marketability, control, etc. EV/EBITDA is a decent price multiple to use in this situation. Applying the average EV/EBITDA, which is 16, to the LTM EBITDA of ZK ($8 million) gives an EV indication of $96 million. This is the enterprise value, i.e. the market value of invested capital (inclusive of debt). Removing debt from $96 million gives an equity value of $86 million.
We can conclude that the justified business value falls in the range is $83 million - $87 million.
Some important sources for obtaining valuation data relevant to either of the market approach-based valuation methods include Thomson Reuters, CBInsights, etc.