Market Approach Valuation
It is one of the three broad methods of valuing a business (the other two being the income approach (most commonly a DCF) and the asset-based approach).
What Is The Market Approach To Valuation?
The market valuation approach is one of the three broad methods of valuing a business (the other two being the income approach (most commonly a DCF) and the asset-based approach).
It is the approach that bankers, equity researchers, and private equity people use on a daily basis, as it is based on actual market prices rather than a long list of forecasts and assumptions. That is its strength, and it is also its weakness. If the market is incorrectly pricing an entire sector, then the market approach will take that error straight into your valuation.
Before you make an offer on a house, you'll look at what other houses on the street have sold for. The market approach to valuation is the same with companies. Rather than build a forecast from scratch, you look at what investors are paying for similar businesses at the moment, or what they paid for them in past transactions, and that's how you value the company you're looking at.
In practice, that means turning prices into multiples. You pick a group of comparable companies or transactions, you work out what each of them is worth on a multiple basis (so EV/EBITDA, or P/E for instance), and you apply those multiples to the target's own numbers.
- The market approach values the company by comparison with other companies in the same industry using a range of valuation multiples (EV/EBITDA, EV/Revenue, P/E, etc.).
- Market multiples are a reflection of current investor sentiment and so are a useful reality check on a DCF. The downside is that they can also bring the sector-wide overvaluation into your answer.
- A multiple only works when the top and bottom are in line. Enterprise value pairs with metrics pre-interest (e.g., EBITDA) and equity value pairs with metrics post-interest (e.g., net income).
- Its two principal methods are comparable company analysis (i.e., what similar publicly traded companies are trading at today) and precedent transactions (i.e., what acquirers have paid for similar companies in past transactions).
- Precedent transaction multiples tend to come out higher than trading multiples as the acquirers are paying a premium for control.
Methods Of Market Approach Valuation
The principle behind the market approach is simple, really: like assets should command like prices. Two companies will never be identical, so the approach is to compare them on a common basis by taking a price and dividing it by a financial multiple. That gives you a valuation multiple.
Implied value of the target = target's metric × multiple from the peer group
The market approach has two principal methods: comparable company analysis (often referred to as trading comps), which looks at the values of similar public companies, and precedent transaction analysis, which looks at what buyers have paid for similar companies in past transactions.
If the company you're valuing is itself a public company, then its own share price will provide you with a third data point (sometimes referred to as the market price method).
Now, let's explore each method used to value companies using the market approach in more depth.
Comparable Companies
The comparable company method estimates the firm's worth based on other firms in the same industry and other related criteria.
There are generally five steps to using the comparable companies method, which are listed below.
In the first step of the process, an analyst will try to understand the company they value.
Then, based on the findings, the list of companies within the same industry will be narrowed down based on similar criteria. The criteria are based on:
- Geography
- Size (revenues, profits, market share)
- Growth Rate
- Customers
- Margins and Profitability
Then, the relevant financial data for comparable companies is gathered by an analyst.
This is done by looking at the SEC.gov financial disclosures and other websites like Capital IQ or Bloomberg.
Because mature companies are well-established and profitable, we would look at metrics that display their profitability, such as EBITDA or Net Income.
For relatively young, small, and unprofitable firms, traditional profitability metrics like EBITDA or Net Income are often negative and therefore not useful, making metrics like revenue or gross profit more applicable.
The third step is to use the gathered financial data to calculate ratios that will be applied to the target company later.
Here are the most common ratios:
| Multiple | Formula | What it tells you | Commonly used for |
|---|---|---|---|
| EV/EBITDA | Enterprise value ÷ EBITDA | Value of the whole business relative to operating earnings, unaffected by how it's financed | Most mature, profitable industries |
| EV/Revenue | Enterprise value ÷ revenue | Value relative to sales | High-growth or unprofitable companies, such as early-stage software |
| P/E | Share price ÷ EPS (or market cap ÷ net income) | What investors pay for each dollar of profit to shareholders | Mature, profitable companies with stable capital structures |
| P/B | Share price ÷ book value per share | Value relative to net assets on the balance sheet | Banks and insurers |
After the calculations, find the mean and median of all the ratios across companies. Then, apply the ratio to the target company.
Comparable Companies Example
Let’s now look at one example of comparable companies for an imaginary company.
First, we list comparable companies under the “Company Comps” title.
Then, an analyst gathers financial data for each company. The example contains the data for price, shares, market capitalization, and enterprise value under the summary section.
Then, using the data, an analyst calculated the ratios for each company. The ratios are the P/E and EV/EBITDA ratios. For example, for the P/E ratio, the price will be taken and divided by the EPS.
Lastly, in the lower part of the model, the ratios are calculated for the average and median. These ratios are then applied to the target company.
Precedent Transactions
Precedent transactions are a valuation method that determines a company’s value by analyzing the transaction multiples of similar companies based on their acquisition prices.
Instead of looking at a company's current financial information, the method focuses on a company's market price based on how much it was purchased.
The steps for the valuation method are almost identical. However, instead of using steps for existing companies, the analyst must now search for financial information and compare transactions to apply multiple methods to the target company.
The steps mirror comparable company analysis:
- Screen for deals involving targets that are in a similar business, similar size and similar geography (generally over the past 3-5 years).
- Get the purchase price and the target's financials at announcement. For public companies, the best sources are the merger proxy and the tender offer documents filed with the SEC. For private companies, you'll need to rely on the press releases and databases (PitchBook, Capital IQ, Mergermarket, etc.) to get the information.
- Work out the transaction multiples (typically EV/LTM EBITDA and EV/LTM revenue) using the target's figures for the 12 months prior to the announcement of the deal.
- Apply the median and range to the company you're valuing.
Precedent Transactions Example
Looking at the example, we first identify the list of target firms acquired within the same industry under the “Acquirer” and “Target” columns.
Then, an analyst collects data for the enterprise value, the revenue for the last 12 months, and the EBITDA, adjusting for any non-recurring items or extraordinary events.
After using the gathered information, the ratios are calculated, averaged, and applied to the target company.
Advantages and Limitations of the Market Approach
These are the trade-offs, which is why the market approach works best in conjunction with a DCF rather than as a substitute for one.
Advantages
- It's based on actual prices. A valuation that is based on what people actually paid in the market is something that a client, a board, or a court can readily understand and is very difficult to dismiss as just theory.
- It's quick. Once you've got a peer group, updating the valuation takes minutes, which is why you'll see comps in virtually every pitch book.
- It needs fewer forecasts. LTM multiples are based on the reported numbers, so there's not much scope for optimistic forecasts to inflate the result.
- It's all reflective of where we are at the moment. The interest rates, the sector sentiment and the M&A cycle are all baked into the multiples today.
Limitations
- True comparables are scarce. Two software companies can be very different in terms of growth, margins, and customer mix and so warrant very different multiples. Peer selection is a judgment call, and two analysts could well come to different conclusions.
- It inherits the market's errors. If an entire sector is overvalued, then a comps-based valuation will be too. Valuing an internet company on its peers in 1999 would have given you a number that was perfectly reasonable at the time and absolutely horrific a year later.
- Data can be thin. A niche business may have no real public peers at all, and many private deals will never disclose their terms.
- Multiples contain assumptions. A 10.0x EBITDA multiple is quietly assuming a certain level of growth, a certain level of risk, and a certain level of capex. A DCF forces you to state those assumptions. A multiple allows you to omit them entirely (for better or worse).
Market Approach vs. Book Value Approach
One approach to valuation is to look at how much the market values the firm rather than how much it is worth on the accounting books. The book value approach (part of the asset-based approach) values the company on the balance sheet. Take total assets, subtract total liabilities, and what you're left with is the book value of equity.
The general logic behind this method is to determine the company's value after settling all its obligations.
Here is the formula below:
Assets - Liabilities = Equity (perceived company's value)
Now, let's also look at some differences between each method.
| Market Value Approach | Book Value Approach | |
|---|---|---|
| Simplicity | Complex calculation (involves researching the industry and adjusting for differences) | Simple calculation (take assets and subtract liabilities) |
| Relevance | Uses current market data | Uses non-market book data |
| Intangibles | Includes intangibles | Doesn’t include intangibles (e.g., brand reputation, trademarks) |
| Stability | Volatile due to the emotions of the market participants | Stable because it is based on the historical costs |
| Focus | Short-term focus | Historical focus |
Market Approach vs. Discounted Cash Flow (DCF) Method
There is also another method to value a company. It is called the discounted cash flow method.
The market approach estimates a firm’s worth based on market perception, whereas the discounted cash flow (DCF) method values a firm based on its projected internal cash flows.
A firm’s intrinsic value is based on the amount of cash the firm generates.
First, free cash flows (the money the firm can distribute to investors after operating expenses and capital expenditures) are calculated. These future cash flows are projected and discounted back to their present value using an appropriate discount rate to determine the firm's intrinsic value.
Below are the pros and cons of both valuation methods:
| Market Approach Valuation | DCF Method | |
|---|---|---|
| Influencing Factors | Market trends | The future cash-generating potential |
| Idea | Value-based on market perceptions | Value-based on the intrinsic profitability |
| Stability | Volatile | Relatively stable |
| Time Horizon | Short-term | Long-term |
Market Valuation Approach FAQs
Yes. It's one of the most common ways private companies are valued, but the results need adjusting.
Trading comps still work. Valuation professionals call this the guideline public company method: you compare the private company with public peers, then adjust for what public prices don't capture. Private companies tend to be smaller, more dependent on a few customers or key people, and their shares can't be sold easily. Analysts often reflect that by choosing a multiple toward the low end of the peer range or by applying a discount for lack of marketability.
Precedent transactions are especially useful here, because many past targets were private companies themselves. The catch is data. When a private company is sold, the price often isn't disclosed, so your set of deals may be thinner than you'd like.
Whether to keep the control premium depends on what you're valuing. If the question is what a buyer would pay for the whole company, precedent multiples with the premium built in are the right benchmark. If you're valuing a minority stake, which comes without control, the premium should come out.
Check your DCF first. A large gap between market value and DCF value is just as likely to be the result of aggressive or overly conservative assumptions as it is to be a sign of mispricing. Test your discount rate, your terminal growth rate, and your margin assumptions before you jump to any conclusions about the market.
If the gap survives that test, then the market may be mispricing the company or indeed the whole sector. If market value is substantially above intrinsic value, then the market may be pricing in growth that is unlikely to materialize. If it's substantially below, then sentiment may be excessively bearish. Either way, it's a reason to go further, not a reason to dismiss one approach.
How much weight each method carries is going to be determined by the purpose. The investor looking for mispriced shares is going to be most concerned with intrinsic value, as that's the whole basis of the investment. The banker advising on a sale can't afford to ignore the market, as the market prices and the current state of financing will determine what the buyer will actually pay.
Because acquirers are buying control. A trading multiple is what investors pay for a small, freely traded share. A takeover price will always contain a premium for the right to run the company, to cut costs, and to capture the synergies. The same business will therefore usually trade at a higher multiple on the stock market than it will in an acquisition.
EBITDA and earnings multiples are meaningless when the denominator is negative, so analysts will invariably move up the income statement to an EV/Revenue or EV/Gross Profit multiple.
For subscription businesses, they'll often use EV/ARR (annual recurring revenue). The downside, of course, is that revenue multiples ignore profitability entirely, so two companies can have the same multiple and very different paths to profitability.
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