Basic Principles Underlying the Market Approach

A. These basic principles should guide decisions made in applying the market approach.

B. Comparability – In order for the market approach to be properly applied, the subject company must be comparable to the companies that it will be compared to.

Comparability is generally considered with respect to the following:

1. Industry – The guideline companies should be in the same or a very similar business as the subject.

2. Size – Size can be expressed in terms of sales, total assets or market capitalization.

Numerous studies indicate that smaller companies have lower pricing multiples than larger companies, primarily because of differences in business and financial risk.

3. Growth expectations – The prices of public companies are strongly correlated with

growth expectations. It is important to research analyst growth expectations for potential guidelines and to look at their historical growth. The subject company may have higher or lower growth expectations, but often cannot finance the same level of growth because of its more limited access to capital.

4. Business risk – Qualitative factors such as market penetration, distribution channels, and geographic diversification also have a substantial impact on comparability.

Another factor is how long the company has been in business. Relatively new businesses tend to have lower multiples because there tends to be more uncertainty about their future and they are more risky.

5. Financial risk – The guideline companies should be as similar as possible in their financial metrics. It may be necessary to adjust the financial statements of both the guidelines and the subject so they are on a similar basis (e.g., eliminating non-recurring items and adjusting LIFO to FIFO inventory accounting method) before making comparisons.

6. The guideline public company method of appraisal is based on the premise that pricing multiples (a relationship between the price of a publicly traded stock and some other variable, such as earnings, sales, book value, etc.) of publicly traded companies can be used as an indicator of value to be applied in valuing the closely held appraisal subject. Using multiples of public companies in this manner is suggested in Revenue Ruling 59-60 in the famous eight factors to consider (at a minimum). The Revenue Ruling tells us to consider the market price of stocks of corporations engaged in the same or similar line of business having their stocks actively traded in a free and open market either on an exchange or over the counter.

7. The merger and acquisition method uses the same concept in establishing multiples but it uses transactions rather than a single share price.

8. The mechanics of the method require the valuation analyst to use the stock price of the public company in conjunction with some other factor (such as earnings, cash flow, book value, etc.), to create a pricing multiple. With certain adjustments, the pricing multiple is applied to the appraisal subject's similar factor to determine an estimate of value for the company. A price-to-earnings multiple would be applied to the company's earnings, a price-to-cash flow multiple would be applied to the company's cash flow, and so forth.

9. To use this method properly, the publicly traded companies that are used as

surrogates must be comparable to the closely held appraisal subject. The comparable companies will not be identical to the appraisal subject but should be similar enough to provide guidance to the valuation analyst during the appraisal process. The similar companies, formerly known as "comparative companies" or "comparables," a term taken from the real estate appraisal world, are known as "guideline companies" in our world. This terminology was suggested by the Business Valuation Committee of ASA to highlight the fact that no two companies are truly comparable, but rather, that similar companies can provide guidance about other companies in the marketplace.

10. In business valuation, the requirements for “similarity” are considered from an investment point of view. The factors that will be considered by the valuation analyst will vary from assignment to assignment. One concise list of factors to consider in determining the similarity of the guideline companies is impossible. However, some of the factors to consider have been included in the writings of Graham, Dodd, and Cottle¹; Stockdale²; and Bolten, Brockardt, and Mard³. The following are some of the factors to consider, though not necessarily in any special order:

a. Past growth of sales and earnings b. Rate of return on invested capital c. Stability of past earnings

d. Dividend rate and record e. Quality of management

f. Nature and prospects of the industry

g. Competitive position and individual prospects of the company h. Basic nature of the activity

i. General types of goods or services produced j. Relative amounts of labor and capital employed k. Extent of materials conversion

l. Amount of investment in plant and equipment m. Amount of investment in inventory

n. Level of technology employed

o. Level of skill required to perform the operation p. Size

q. Financial position r. Liquidity

1B. Graham, D. Dodd, and S. Cottle, Security Principles and Technique, 4th ed. (New York: McGraw-Hill, 1962).

2John J. Stockdale, “Comparison of Publicly Held Companies With Closely Held Business Entities,”

Business Valuation Review (December 1986), 3-9.

3Steven E. Bolten, James W. Brockardt, and Michael J. Mard, “Summary (Built-up) Capitalization Rates for Retailers,” Business Valuation Review (March 1987), 6-13.

s. Years in business

t. Financial market environment u. Quality of earnings

v. Marketability of shares w. Operating efficiency

x. Geographical diversification y. Similarity of business model

11. Various writings have created a substantial list of attributes to consider in determining whether the guideline companies are "comparable" enough to be used as good

surrogates in an appraisal. The guideline company must be "similar" and "relevant" to be used as a surrogate. Comparing the local hardware store with The Home Depot may involve similar businesses, but let's face it, where's the relevance?

12. How do we really identify guideline companies? In the real world, the search for guideline companies can be accomplished the old-fashioned way, by legwork at the library, or the modern way, sitting at your desk in front of a computer. Those of us who started in this business a long time ago did not have a choice. Today, we opt for the latter alternative. It's much faster and a lot less work.