In real estate appraisal, the prevalent method of valuation is the market approach. Real estate appraisers have access to a vast database of recent sales, which enables them to identify recent sales that are comparable to the property being appraised. While there are some databases of business sales, the quantity of comparable sales data is not as vast, and businesses are much harder to compare than real estate. Still, one of the methods that business appraisers might consider is the market approach.
Principle of Substitution
The market approach to business valuation is rooted in the economic principle of substitution: that buyers would not pay more for an item than the price at which they can obtain anequally desirable substitute. It is similar in many respects to the “comparable sales” method that is commonly used in real estate appraisal. The market price of the stocks of publicly traded companies engaged in the same or a similar line of business, whose shares are actively traded in a free and open market, can be a valid indicator of value when the transactions in which stocks are traded are sufficiently similar to permit meaningful comparison. The difficulty lies in identifying public companies that are sufficiently comparable to the subject company for this purpose.
Guideline Public Company method
The Guideline Public Company method entails a comparison of the subject company to publicly-traded companies. The comparison is generally based on published data regarding the public companies’ stock price and earnings, sales, or revenues, which is expressed as a fraction known as a “multiple.” If the guideline public companies are sufficiently similar to each other and the subject company to permit a meaningful comparison, then their multiples should be nearly equal. The public companies identified for comparison purposes should be similar to the subject company in terms of industry, product lines, market, growth, and risk.
In another variation of this method, the valuator may determine market multiples by reviewing published data regarding actual transactions involving either minority or controlling interests in either publicly traded or closely held companies. In judging whether a reasonable basis for comparison exists, the valuator must consider: (1) the similarity of qualitative and quantitative investment and investor characteristics; (2) the extent to which reliable data is known about the transactions in which interests in the guideline companies were bought and sold; and (3) whether or not the price paid for the guideline companies was in an arms-length transaction, or a forced or distressed sale.