The market approach to business valuation

What is the market approach to business valuation?

The market approach is a collection of methods which equate the value of a business with the apparent price of similar deals.

Publicly listed company comparisons

Some business valuation practitioners will compare their subject small business to one in the same industry, but listed on an exchange. The thinking is that the listed company's shares are traded between willing buyers and sellers every day. The willing-buyer / willing-seller fallacy forms the basis for their valuation.

Public companies shares on exchanges are usually very liquid. They can (and do) trade tiny fractions of a percent of their issued shares. Sometimes buyers and sellers will do this many times a minute. It may be worthwhile if the comparison is between peer companies on the same exchange. But even then, in almost every exchange board we see different price-earnings ratios. 

Private SMEs owners regard each transaction as a major, life changing event. And it is. There are months of preparation. Then more months of pitching. And then the due diligences which follow. That is what selling, say 30% of the stock, would involve.

Business valuers can "beta" themselves crazy trying to find a way of relating SMEs to public companies. Even so, they do.

The results are garbage.

Industry-wide guidelines

Industry-wide guidelines are akin to directives in a command economy directives. 

  • "You can sell your franchise for 5 X its nett profit."
  • "We will pay you 1.2 X your turnover."
  • Your business is worth 2.27272 X the owner benefit

Guidelines rely on the protagonists of the negotiation being willing to tow-the-line to a convention. And while using guideline multipliers appears to make for easy succession or retirement planning, the results often disappoint. The guidelines often leave the seller receiving too little for their value. Very seldom will the buyers pay too much.

Franchisors like this approach because it keeps a control of their brand's perception of value. It makes it easier for them to sell their new stores.

Fuel stations use this sort of approach a lot. At one time the “value” of the station was linked directly to the litres of fuel sold. Then the convenience stores arrived and made things a bit more complicated. But they still operate on very narrow guidelines.

Contemporary transaction comparisons

Of these, the listed company comparison will give the most accurate results. The price:earnings ratio works from the perspective of minority shareholders. That is great for businesses of comparable size and governance thresholds.But it is PRICE to earnings ratio, not VALUE to earnings ratio!Valuers of small, medium, and large companies claim that they have some sort of inside view of the market.

But there are two problems with the claims:

1. They would need to know the transaction details of a large sample of businesses

  • by industry, and
  • by size.

2. Prices. All the comparatives involved relate to the closing, agreed selling PRICES.

The first problem

Sample size and available data. A company similar in size, market, and governance policies to a public listed company might compare. We know the exchange data up to the last 15 minutes. But the lack of liquidity in private companies remains a problem.

So why not compare to smaller, private companies then?

1. Regardless of what the big business broker groups tell you, they do not know. How could they?2. Companies that business brokers represent are small. They are all private. Without exception.

3. Investment banks may have larger clients, and medium size, but generally private too.The biggest business broker in South Africa does one deal per broker, every eight months! That is across all industries. And most of them are very small deals.

A workable, valid, representative group of “anythings” does not exist.

The second problem

They want to base all their comparisons on price. Because all their qualifiers use phrases like “comparable businesses sold for”.  Consider for a moment what goes into a price negotiation:

  • lies
  • fears
  • offers
  • stories
  • reasoning
  • desperation
  • opportunities
  • uncertainty
  • argument
  • rumour
  • fallacy
  • greed
  • bluff
  • risk
  • bid

the unsuitability of the negotiated price as a comparison for value is clear.We know that price is what you pay. Value is what you get. the judicious buyer pays a lower price than the value they receive.But as a seller of a business, value is what you give up. Price is what you get. The fact is that the seller receives less than the value they give up.

  • Value to the seller is higher than the selling price.
  • Buyer and seller agree a price.
  • Value to the buyer is higher than the purchase price.
The market approach to business valuation is flawed for private companies.

Business owners owe it to themselves to invest in professional business valuations.

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