Market Approach

What is the Market Approach?

The market approach is a valuation method that determines the value of a business or other asset by looking at what other companies or assets are selling for. Adjustments are made for differences between them.

It is often the most reliable valuation method, as long as enough data is available and the data is reliable.

The market approach method is often used in business appraisals, sometimes in combination with, the asset approach or the income approach.

In this article, we will focus on the market approach as used in business valuation.

When is the Market Approach Used?

The market approach is a useful method for valuing small or medium-sized businesses, particularly when there is sufficient comparable transaction data, such as in an active local market.

It is commonly used in mergers and acquisitions, business sales, and valuations for investment, tax, or legal purposes.

This method can be used for both profitable and unprofitable businesses but is generally not suitable for startups due to the lack of comparable sales data.

How the Market Approach Should be Applied

In brief, here is how the market approach is applied:

1. Determine whether there is sufficient comparable sales data.
2. Scrutinize the data to ensure its reliability.
3. Remove any statistical outliers.
4. Evaluate sales prices of similar businesses from recent transactions.
5. Where appropriate, combine this method with the asset approach and/or income approach for a more comprehensive valuation.

1. Is there enough data?

First, we must ensure that there is sufficient data from comparable sales transactions. Without sufficient data, the estimates will be unreliable. If this is the case, you may need to consider alternative valuation methods.

2. Validate the data

The next step is to verify the accuracy of the data. Data sets typically include information on EBITDA, profit margins, net income, and transaction terms.

Because business brokers typically compile this information, the quality can vary widely. Therefore, you need to check it carefully before using it.

Check whether the EBITDA has been adjusted and whether the financials have been audited. Check what time period the data is for, and so on.

Without reliable data, comparisons are unreliable.

3. Remove Outliers

The next step is to identify and remove statistical outliers from the data set, as these can skew the results and lead to an inaccurate valuation.

4. Compare With Sale Prices of Similar Businesses

After removing outliers, you can compare the business to similar businesses that have recently been sold.

By applying relevant valuation multiples, such as P/E or EBITDA multiples, you can estimate a reasonable value of the business.

5. Combine With Other Methods as Needed

You may need to combine the market approach with other valuation methods, especially if sales data is limited.

In theory, the market approach is a powerful method. However, it is important to apply it carefully in practice. Be critical of your data sources if you want accurate results.

Example of the Market Approach in Practice

Here is a simple example of how the market approach can be applied in practice in a business valuation. Please note that this is an oversimplification for illustrative purposes only.

Example:

You want to buy a small coffee shop in Austin, Texas. The owner is asking $250,000. The location is good in downtown Austin, but the coffee shops needs repairs. It has no website or other online presence, but it has a steady local customer base.

Despite the attractive location, you feel the seller is asking too much. You do your research and find the sale price of several similar coffee shops in the area. The prices you collected are all from the past year.

Comparable sales data:

Based on the information gathered, you can calculate the price-to-EBITA multiple for each transaction. Using this data, you can decide whether or not $250,000 is a reasonable price.

Here are the multiples:

As you can see, coffee shops in the area sell for an average price-to-EBITDA multiple of about 9x. The coffee shop you are considering buying has an EBITDA of $24,000, which gives it a fair market value of:

$24,000 (EBITDA) x 9 = $216,000

By this measure, the coffee shop is slightly overpriced at $250,000.

You point out to the seller the weaknesses compared to similar businesses and decide to make an offer of $210,000. After some negotiation, the seller accepts your offer.