Compared to the Income Approach that incorporates company specific estimates to arrive at the firm’s intrinsic value, the Market Approach relies on relative valuation to arrive at the value of a business, based upon how similar assets are priced in the market. 

The use of relative valuation and more specifically the Market Approach is widespread, especially in equity research reports and acquisition valuations. This is primarily because of its benefits, some of which are listed below:

  • It is easy to use, simple to comprehend and is hence, less time consuming and easily understood by users.
  • It incorporates information from other valuations in a simple way and provides consistency in the valuation process by ensuring that valuation is in line with other comparative valuations.
  • It relies upon market information and implicitly embodies current market consensus about assumptions such as the discount rate and growth rate. Hence, it reflects the current mood of the market.

The Market Approach provides a reasonable basis for valuation and is relatively a quick approach in its application, but it suffers from a number of limitations:

  • Relative valuation is as good as the valuation of the comparable companies and suffers from volatility of the market. For example, in case the market is overvaluing comparable companies, the relative valuation will also lead to overstatement of value.
  • Identifying comparable companies with similar growth rates, business composition, stage and riskiness of business is a difficult task and finding a perfect match is extremely challenging. Adjusting the multiples for company-specific information is subjective and, thus, debatable.
  • Differences in accounting policies related to revenue recognition, depreciation, etc., though adjustable to a certain extent, can result in a distorted valuation.
  • The Market Approach or relative valuation is more commonly applied to historical data and can result in the undervaluation of a company with a significant future potential or benefit that may arise due to beneficial circumstances such as market expansion.

The Market Approach can be applied through different methods, namely Market Price Method, Comparable Companies Multiple Method, Comparable Transaction Multiple Method and Prior Sale of Business Method, which are discussed in detail in the following paragraphs.

Market Price Method

In this method, a valuer shall consider the traded price observed over a reasonable period while valuing assets which are traded in the active market. A valuer shall also consider the market where the trading volume of asset is the highest when such asset is traded in more than one active market.

A valuer shall use average price of the asset over a reasonable period. The valuer should consider using weighted average or volume weighted average to reduce the impact of volatility or any one time event in the asset.

Comparable Companies Multiple Method

Market Comparable Method involves the identification of comparable companies followed by the derivation of market based multiples. While applying such multiples to the subject company’s financial metrics (e.g. revenue or earnings), careful adjustments to account for differences in fundamentals between the comparable companies and the subject must be undertaken.

Theoretically, a comparable company is the one with cash flows, growth potential and risk similar to the company being valued. Conventionally, looking at the companies within the sector provides a better-matched and similar-profiled set of comparable companies. Alternatively, in some cases, it is necessary to look across sectors to identify comparable companies. In practice, one seldom finds exactly similar companies.

The next step is to arrive at a standardised set of ratios for comparison, commonly known as multiples. Multiples are a ratio of the enterprise value/equity value over different financial parameters like Revenue, Earnings before Interest, Tax, Depreciation and Amortisation (“EBITDA”), Profit after Tax (“PAT”), Earnings per Share (“EPS”), book value etc., with some being preferred over the others. For example, EBITDA multiple is preferred over PAT multiple so as to eliminate the effect of differences in depreciation policies and the impact of leveraging.

As comparable companies are not exactly similar to the company being valued, the multiples derived from such companies cannot be applied sacrosanct, and thus merit various subjective adjustments to account for differences in risk profile, growth rate, etc. For example, a company with higher EBITDA margin should command a better multiple than an average performer or a positive adjustment is required for a company with better growth potential.

In some cases, multiples of non-financial parameters are also used. For example, it is a common practice to evaluate oil companies using multiples of value per barrel of oil or in case of banking shares using value based on the loan portfolio. Furthermore, while valuing hospitals, valuation practitioners rely on industry specific metrics such as enterprise value/operating hospital bed.

Comparable Companies Transaction Method

A variant of the Comparable Companies Multiple Method, the Comparable Companies Transaction Method uses transaction multiples in place of trading multiples. Transaction multiples, as the name suggests, are the multiples implied in the recent acquisitions/disposals of comparable companies.

This method is especially useful if there are limited comparable companies. Also, it incorporates the market sentiments in a better way, as the multiples, unlike trading multiples which are affected by the inefficiencies of the market, are based on an informed negotiation between buyers and sellers.

Various factors should be considered while using transaction multiples. These are nature of transaction – hostile deal, group restructuring, industry trends, negotiation or control premiums that may have been paid, time of transaction – whether at the high or low of industry cycle, consideration – share or cash, contingent to future performance, etc.

This method suffers from limitation of data availability, as the requisite information relating to transactions, specially about private companies, is seldom available.

Prior Sale of Business Method

Prior Sale of Business Method, like the Market Transaction Method, makes use of transaction multiples. However, transaction multiples used in this case are the ones implied in the prior transactions involving the subject company itself. For example, an earlier stake sale in business can be used to provide a benchmark valuation of a company, provided the same was between unrelated parties.

Transaction multiples should be adjusted for timings of the transactions and intermediate changes in the stage of business, earnings margin, growth rate, etc.

Author Bio

More Under Corporate Law

Leave a Comment

Your email address will not be published. Required fields are marked *

Search Posts by Date

February 2021