What’s My Business Worth? Part 2: The Market Method
“What’s my business worth?”
Last week, in Part 1 of this three part “What’s My Business Worth?” series – inspired by an article that I recently read – I discussed the Asset Approach of valuation.
I mentioned that the article contained too many errors and misconceptions to be of much help to anyone – and, if some of the guidelines were followed, could very likely produce disastrous results.
This series is essentially for business owners, but I know that a lot of business brokers could benefit from what is discussed because it not only gets into the “how” but also the “how not” of valuing businesses.
And speaking of errors and misconceptions… In one part of last week’s post, I mentioned that this week’s post would be on the Income Approach. In another part of that same post, I said it would be about the Market Approach. Well, it can’t be about both, so I apologize for the confusion.
This post – Part 2 of the series – is about the Market Approach to business valuations. Next week in Part 3, I’ll tackle the Income Method.
There are actually two things to consider when using the Market Approach to value.
The most meaningful is also the most daunting because it requires an enormous amount of research. The article I read suggests that, in order to determine the value of a business using the Market approach, you need to compare the subject business to similar public companies that have been recently sold.
Once you find similar companies, compare them with the business you’re trying to find the value of in terms of how long they were in business, how similar the customer base is, are the risk factors similar, how similar is the level of profitability and maybe a dozen other metrics. This is what I mean by “an enormous amount of research”.
But the real issue with this advice is the term “public companies”.
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To most people, “public companies” are those that trade on one or more of the public stock markets.
As I write this – 1 January 2021; New Year’s Day – the average company in the S&P 500 Index is selling for 37.5 times its earnings. On the broader Nasdaq market, that multiple is about 25. I know of no Main Street or Lower Middle Market businesses that have ever sold for anything near such multiples.
The Market Approach to valuing a private business requires comparisons to similar private businesses, not public ones. The key is to figure out how to find what “the market” paid for these other businesses.
To find the answers to all these questions, you can start with random internet searches using SIC or NAICS numbers; contacting trade associations; thumbing through trade journals and other similarly broad approaches to the task. It’s a time-consuming slog and unrealistic for most business owners. After all, they have to run their business while doing all this research.
Or, you could do this the easy way and contact a professional business broker who, by virtue of their professionalism, has access to databases with the financial details of thousands of private company transactions. Those details will go a long way toward helping you determine the Most Probably Selling Price of any business.
What is “The Market”?
Specifically, once we do our comparisons and have our numbers, we take a look at the market the business we’re valuing operates in. We want to see if there’s any pending event in that market – geographic, political, regulatory, industry channel, etc. – that would likely impact the the value we just arrived at.
We use an example in our course of a convenience store that has been serving its neighborhood for 10 years with steady but modest annual growth.
We do our comparisons and arrive at the Most Probable Selling Price using the Market Approach. We then start nosing around.
If we find that a 400-unit apartment complex has just been approved for the 30-acre parcel across the road, we know that the “market” is about to add significant value to the business. We go back to our offices, crunch some numbers and come up with a new, more accurate – and to our client, the seller, more appealing – valuation.
Likewise, if we find out that that 30-acre parcel has just be approved for a landfill, we head back to our offices, crunch the numbers and end up with a valuation that will likely be somewhat less appealing to our client.
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Another example would be minimum wage legislation.
If the business you’re valuing is located in an area with a government threatening to increase the minimum wage rates, the business’ bottom line – and, thus, value – will likely be negatively impacted – at least until the business is able to increase the prices of its products or services to offset such increased employment costs.
Both those examples would fall in the geographic or regulatory categories. But what about an industry-specific example?
In the United States, two industries made up of small businesses have been threatened on and off by politicians: payday loan companies and gun shops.
Both types of businesses are almost universally small.
We have a client in the payday loan business. His business has been providing loans to high-risk individuals who otherwise would never have the ability to borrow for a car or an appliance or equipment to expand their own small business. One state in which he has operated for many years has just regulated him out of business within that state’s borders.
Another client owns a euphemistically named “outfitters” business offering supplies for hunters, fishermen and other outdoors-centric consumers. Along with firearms for hunting, his business offers firearms for self defense.
If a political decision is made to prohibit the sale of firearms not used in hunting in the state that our client operates in, the “market” will impact the value of that business.
Yes, both of THOSE examples can be considered geographic or regulatory or political. But what about technological or industrial?
An example of industrial is the value of private book sellers in the age of Amazon or the impact on office furniture dealers as businesses realize the benefit of having their employees working remotely.
One classic and easily-grasped example is the fate of street cleaning businesses in major cities in the early 20th Century when the mode of transportation shifted from horses to Fords.
You’ve got to know what’s going on in the market the business operates in.
The Bottom Line
We use the Market Approach on every valuation. The key points to remember are that there are two ways to look at “the market” and both have to be considered.
The issue I took with the information in the article is that the author advised looking at public companies. The market for pubic companies is, of course, the public market. That market is huge with hundreds of thousands of buyers each buying a tiny share or any given company making it easy to determine what any public business is worth. Each such purchase establishes that business’ value based on the “market”; the “market value”.
The market for private businesses is tiny by comparison. But that’s where we have to look for our comparable numbers.
But you have to also consider the other “market method”; what’s happening in the business’ market because such events can – and will – impact how “the market” will value a business.
If you have any questions or comments on this topic – or any topic related to business – I’d like to hear from you. Put them in the comments box below. Start the conversation and I’ll get back to you with answers or my own comments. If I get enough on one topic, I’ll address them in a future post or podcast.
I’ll be back with you again next Monday. In the meantime, I hope you have a safe and profitable week.