The Market Approach – What is a Market Based Valuation?

The Market Approach in Brief

The market approach is used in business valuations to estimate the fair market value of a business by comparing it to what similar businesses are selling for. You will need to take any differences into account and make adjustments accordingly.

This is a reliable method of valuation when sufficient and reliable market data is available (which is rarely the case, unfortunately).

This approach is often used in conjunction with the income approach and/or the asset approach to provide a more complete picture of the value of the business.

Market approach appraisals can also be used to value assets, but here we will focus on valuing businesses.

Making a Market Approach Appraisal – Step by Step

Let us break these points down into more detail:

1. Is There Plenty of Sales Data?

Often, it is not possible to perform a market based valuation because there is not enough comparable transaction data from similar business sales.

When there is not enough data, the valuation becomes unreliable. For example, if only two similar businesses have recently been sold, there is simply not enough data to draw conclusions from. The seller may have rushed to sell for personal reasons, or a buyer may have overpaid for fear of missing out.

2. Is the Data Valid?

The second step in the market approach is to verify that the data set is accurate and reliable. Data sets typically contain information on transaction terms, profit margins, EBITDA, net income and similar data.

The information in such records is usually compiled by business brokers. As a result, the quality of the data varies widely. Some are more thorough than others.

For example, it is a good idea to check whether there were adjustments to EBITDA or not, and if the financials used were audited. It is important that the data is timestamped to be of any practical use.

3. Eliminate Statistical Outliers

If you have verified that you have enough data and that it is reliable, the next step is to eliminate any statistical outliers to make sure that the results are not skewed.

4. Look at What Similar Business Have Sold For

Now that the data is verified and clean, you are ready to compare the business to other, similar businesses and see what they sold for.

Apply valuation multiples to estimate the value. Examples of multiples include EBITDA and P/E.

5. Combine the Market Approach with other Approaches

It can often be advantageous to use the market approach with other approaches in business valuation. This is especially true when sales data is limited.

For example, you can use it with the income approach to get a valuation that takes into account sales and profits. If the business has significant assets, it is useful to also use the asset approach to ensure that the market value of the assets is considered.

Example: The Market Value Approach Calculation

We can use a simplified hypothetical example to illustrate how the market value approach works in practice.

Let’s say you want to sell a restaurant in Queens, New York. The location is good, although the restaurant and its kitchen are in need of repair and upgrades. It has regular customers, but almost no growth. The restaurant has a website, but you have not invested in digital marketing and it is not possible to make reservations online.

You have found a dataset containing sales data for restaurants in the New York area, and you have verified that the data is reliable. Using this data, you have identified historical sales data for five comparable restaurants in the area.

Here are the sales data:

Based on this information, you calculate the price-to-EBITDA multiple for every transaction.

Price-to-EBITDA Multiples

Price-to-EBITDA multiples are on average:

(5.0+4.7+4.75+4.74+4.75) / 5 = 4.78

Your restaurant has an EBITDA of $75,000, so the estimated fair market value is:

$75,000 times 4.78 = $358,500

Valuation Conclusion

The price-to-EBITDA multiples in the area are fairly consistent, regardless of the differences between restaurants. Your restaurant may be valued at average or slightly below average due to needed repairs, lack of digital marketing, and lack of an online table booking system. Based on this, you decide to list the restaurant for $350,000 to attract potential buyers.

Please note that this is an oversimplification for illustrative purposes only. In reality the market approach is more complex.