It’s all in the Approach:
Using the Market Approach to Determine Fair Market Value
The Market Approach
In this blog, we delve into the intricacies of the market approach to determine fair market value and the distinct subsets within it.
This is the third blog in Davis Martindale’s “Standard Processes in Valuing Your Business” series.
Comparing apples to oranges – everyone knows the phrase when someone is trying to compare one thing to another even though it just doesn’t make sense. It would be like comparing a McDonald’s to Diane’s Corner Diner – yes they are both restaurants, however characteristics such as their size, operations, sales and geographical reach are significantly different from one other. These are all characteristics a Chartered Business Valuator (“CBV”) may take into consideration when using the market approach to determine the fair market value of a business. This blog will delve into the intricacies of the market value approach and the distinct subsets within it. It will go over when to use it, the difficulties that arise when using it and the differences between price and fair market value.
What is the market approach?
The market approach is a valuation method used to determine the value of a subject business by comparing it to other similar businesses in the marketplace. It is imperative that when doing so, you ensure the companies are similar. For example, you would not compare Anheuser-Busch to a locally owned craft brewery, however it may be reasonable to compare Anheuser-Busch with Molson Coors Beverage Company. Revenue, geographical location, industry, size, and products are only a handful of the many common characteristics that can be used in determining similarities between the subject company and those in the marketplace.
What are common issues that arise when using
the market approach?
Comparable, up-to-date data is important to obtain when using the market approach, however this information can be difficult to come across. Specifically, it is often more difficult for private corporations to find reliable comparable data as it is not as readily available. Public companies are required to disclose an annual financial report making their information more easily accessible, however private companies are not required to do so, making it more difficult to find. Another challenge with the market approach is in regards to the number of comparable companies within the market. If the subject company produces ice resurfacing machines (commonly referred to as Zambonis), it may be difficult to come across a large number of comparable companies. Here the data may be limited making it difficult to apply the market approach.
Price vs. Fair Market Value
Value under a market approach is determined based on the share price of other comparable companies, or the actual price dictated by a recent transaction. How does this fit with what a CBV considers value to be? In an earlier blog, “Fair Market Value vs. Price?”, we contrast price and fair market value. Price is determined in an open market through negotiations between a buyer and a seller that satisfies both parties. Fair market value (“FMV”) is hypothetical, and is defined as the highest price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts. The determined fair market value may differ from the actual price paid for a share due to other factors which have influenced the price.
A valuator must take caution when employing a market approach as either a primary or secondary approach to valuing a business. One of the notable issues with the market approach is that price may not always be a good indicator of value. Price may be influenced by uneven negotiating skills, difference in information available, the compulsion to act, payment terms, financial strengths, etc. This is prevalent when using comparable public transactions or transactions specific to a corporation to determine value. A valuator should also be careful that when using the value of a comparable public corporation or comparable public transactions, the subject corporation must be comparable to the business they are seeking to value.
Valuation Approaches and Professional Judgement
Valuators have a number of valuation approaches that they may choose to use. Professional judgement will determine which valuation approaches to use in each unique situation. It is important to note that if the market approach is employed to determine the fair market value of a subject company that the information used is comparable, readily available, and up-to-date. If you need help navigating the complicated area of business valuation, the experts at Davis Martindale can help you. Give us a call today for a personalized discussion.