It is likely that when in the market for a new home, the appraiser will look at a handful comparable homes (“comps”) in the area to help determine the value of a particular home. The appraiser will typically review other home sales in the same geographic area that have similar characteristics to the home being purchased, including square footage, number of bedrooms/bathrooms, lot size, etc. Based on the sales of these comparable homes, the appraiser has some insight into how much a specific home is worth.
As commonplace as this type of analysis is in the residential real estate industry, a similar analysis often takes place when businesses or are on the market for sale. This type of appraisal is known as the Market Approach.
The Market Approach begins with the concept that a business’ value is correlated to the value of other businesses with similar characteristics. As in the case of residential homes analyzing square footage, number of bedrooms/bathrooms, and lot size, appraisers using the Market Approach to value businesses generally examine attributes such as revenue, earnings, cash flow, or number of employees. The Market Approach will typically involve some sort of multiple of one of these attributes in order to determine the value of the subject company.
There are a number of databases that valuators utilize to analyze transactions involving companies that could be classified as comparable to the subject company. The Market Approach relies heavily on the transactions in these databases. How strongly the companies included in the completed transactions relate to the subject company dictates the reliability of the ultimate value of the subject company using the Market Approach. The following is a simple example of how the Market Approach can be used to determine the value of a company, and the approach mirrors how “comps” are used to determine the value of residential homes.
Upstate NY Solar, LLC is a company headquartered in Rochester, NY that manufactures solar panels. The transaction database used by the valuator included the following three transactions involving prior sales occurring in the previous four years of solar panel manufacturers in the Northeastern US:
|Business||Sales Price||Annual Revenue||Sales Price/Revenue|
|Solar A, LLC||$33,100,000||$15,500,000||2.14|
|Solar B, LLC||$22,000,000||$10,025,000||2.19|
|Solar C, LLC||$24,750,000||$14,200,000||1.74|
Upstate NY Solar, LLC Annual Revenues = $12 million
Average Sales Price/Revenue Multiple = 2.0x
Estimated Value of Upstate NY Solar, LLC = $12 million x 2.0 = $24 million
As shown above, the average of the sales price divided by revenue for the three transactions involving similar companies yields a revenue multiple of 2.0x. This allows us to compute an estimate of the value of our subject company at $24 million based on sales of $12 million.
The potential shortcomings of the Market Approach generally involve the validity of the dataset used. This list highlights a few potential issues in the data that would prevent a reliable value to be determined using the Market Approach:
- Transactions in the database are not recent enough to be relevant (i.e. a valuation date of 12/31/2017, while all transactions in the database occurring prior to 12/31/2011).
- Transactions in the database are from geographic regions that are different from the subject company (i.e. the subject company is located in New York City, while all transactions in the database involve companies in the southeastern US, which has a much different economic environment).
- Transactions in the database include companies that are significantly smaller than the subject company (i.e. the subject company has annual sales of $12 million, while all transactions in the database involve companies with less than $1 million in annual sales).
If the above are true, it may be the case that the Market Approach cannot be relied upon for the determination of value for the subject company. There are essentially no “comps” for the business, in the same way a home may not have any “comps” if it is a mansion on the North Pole.
The Market Approach is just one tool at the valuators’ disposal and should be examined within the context of the specific facts and circumstances of the subject company. The Market Approach provides a fairly intuitive calculation for determining the value of a subject company and is often easier to understand due to its close proximity to the comparable sales method used by most residential real estate appraisers.