Under the Market Approach to business valuation, one consults the market place for indications of business value. Most commonly, sales of similar businesses are studied to collect comparative evidence that can be used to estimate the value of the subject business. Much like real estate, this approach seeks to estimate the value of a business in comparison to similar, competitive, businesses whose value has been recently established by the market.
Two areas to watch closely, among others, are: 1) How much do we know about the comps in terms of size, market, profitability, industry, etc. relative to the subject company. 2) Are the multiples used comparing apples to apples. For example, are liabilities included to value equity as opposed to a total valuation of assets. One of the major drawbacks of this method is that relevant data is hard to come by for private companies especially smaller companies. When this method is used it should be accompanied by clear written explanations for chosen comps. In addition, all valuation reports should use a balanced approach with a weighted average of all approaches to determine value.
A couple of points on multiples: A business that has an annual positive cash flow of $100,000 is worth $300,000 if the Price to Cash multiple is 3, or $600,000 if the multiple is 6. Comparable multiples can be adjusted and there is significant subjectivity in determining the multiple used. If you are in an industry expected to grow , the multiple would likely be higher. A declining industry has a lower multiple.
Your specific business’s history is also important in determining the multiple. A business that relies on a “Key Man” will have a lower multiple than one that generates cash flows in a more automated, standardized fashion. Businesses with consistent growth will command a higher multiple. A valuation might also be higher if your company owns intellectual property such as patents, copyrights and trademarks.
Much like all areas of financial analysis and modeling key assumptions should be transparent to the reader/users of the report with specific discussion always undertaken w/ management/key stakeholders.