We continue our discussion of business valuation standards as they related to marketability discounts with a discussion of valuation methods under the market approach.

Valuation Methods Under the Market Approach

The AICPA’s Statement on Standards for Valuation Services (SSVS)-1 (p. 18) notes three frequently used valuation methods under the market approach that relate to the appraisal of businesses, business ownership interests, securities and intangible assets, including the Guideline Public Company Method, the Guideline (Company) Transactions Method, and guideline sales of interests in the subject entity (such as business ownership interests or securities).

The Business Valuation Standards of the American Society of Appraisers (ASABVS) has, in addition to BVS-V Market Approach to Business Valuation, two Statements on Business Valuation Standards (SBVS) that contain guidance on the use of the methods mentioned in SSVS-1.  Specifically, the ASABVS has:

• SBVS- 1 Guideline Public Company Method (ASABVS, pp. 33-34).  SBVS-1 addresses the use of transactions in the securities of public companies to provide valuation guidelines for the appraisal of subject businesses, business interests, securities or intangible assets.
• SBVS- 2 Guideline Transactions Method (ASABVS, pp. 35-36.  SBVS-2 addresses not only transactions in comparable, or guideline, companies in the private (or public) mergers and acquisitions markets where whole companies (or controlling interests in them) are sold.  SBVS-2 also addresses the consideration of transactions in interests of subject companies being valued as a basis for valuation guidelines.

SBVS-1 and SBVS-2 are similar in structure and guidance, even though they relate to different markets.  For purposes of this discussion, we focus on SBVS-1 Guideline Public Company Method.

This Statement is of particular importance in our ongoing discussion of developing marketability discounts.  In particular, readers should keep in mind the following methods as we discuss the requirements of SBVS-1:

• Using restricted stock data bases regarding guideline transactions in public companies.
• Using pre-IPO transaction data bases regarding companies that were privately owned but engaged in initial public offerings (IPOs).
• Using LEAPs (long-term equity anticipation securities) transactions data bases regarding limited transactions in the shares of public companies.
• Using any other data bases where comparisons might be made between the transactions in them and illiquid or restricted shares of a subject enterprise.

All the above valuation methods fall under the guidance of SBVS-1.  Transactions like the above can provide objective, empirical data for deriving valuation ratios for use in the valuation of businesses, business ownership interests, securities or intangible assets.

Conceptual Framework for Guideline Transactions

Quotations below are from SBVS-1 and refer to ASABVS (pp. 33-34).  Emphasis in the quotations is added.

The development of valuation ratios from guideline public companies should be considered in the valuation of businesses, business ownership interests, securities and intangible assets to the extent that adequate and relevant information is available.

Guideline transactions should be considered if “adequate and relevant” information is available.  There are perhaps 15 thousand public companies in the United States, of which about one-third are traded on the major stock exchanges and the remainder are traded in some form of over-the-counter market.  It can be difficult, even with this large number of public companies, to find with appropriate similarities to a subject enterprise as to provide “adequate and relevant” information.

Guideline public companies are companies with shares traded in the public securities markets that provide a reasonable basis for comparison to the investment characteristics of the company (or other interest) being valued. Ideal guideline companies are in the same industry as the subject company; however, if there is insufficient market evidence available in that industry, it may be necessary to select other companies having an underlying similarity to the subject company in terms of relevant investment characteristics such as markets, products, growth, cyclical variability, and other relevant factors.

Guideline companies should provide a reasonable basis for comparison in relationship to a subject guideline company.  It makes little sense to use FedEx, with some $43 billion in annual revenue, as a “guideline company” for Intercity Bicycle Express Company, a company with a dispatcher  and a dozen bike riders who carry documents between law firms and other businesses.  In this example, FedEx so dwarfs Intercity in size and scope of operations as to be irrelevant.

In the event that identical, or even directly similar companies cannot be found, it may be appropriate to use other bases of comparison, for example, based on similarities in markets, products, growth, cyclicality, or other factors.  Quite often, it is not possible to find sufficiently comparable companies for reasonable use of the guideline public company method [or for the guideline transactions method].

Search for and Selection of Guideline Companies

It is necessary to engage in a thorough and objective search for guideline public companies.  The search procedure must include criteria for screening and selecting companies to be used as guidelines.  Ideally, the search criteria will be outlined and the companies that are excluded or included can be examined in light of the criteria.  Search criteria can include line of business, size, profitability, business models, and others.

Financial Data of Guideline Public Companies

SBVS-1 states that analysts must obtain and analyze financial and operating data on selected guideline companies if it is available.  In today’s world substantial financial and operating data is available on virtually every public company.

The guidance suggests examining adjustments to the financial data of the guideline public companies to minimize differences in accounting treatments.  For example, if the industry standard for inventory accounting is LIFO and two companies in a selected group prepare their financials on a FIFO basis, it may be appropriate to adjust the income statements and balance sheets of the two companies with different accounting treatment.

Finally, the guidance of SBVS-1 states that unusual or nonrecurring items in the public company financial statements should be examined and adjusted, if appropriate.  Even in today’s world of financial information availability (YahooFinance, GoogleFinance, SEC Edgar, and other data bases), it can be difficult to satisfy the guidance of SBVS-1.

Valuation Ratios Derived from Guideline Public Companies

Typically, valuation ratios are developed from groups of guideline public companies and a median, or typical ratio is applied to the corresponding valuation metric (sales, EBITDA, net income, etc.) of a subject company.  Guidance from SBVS-1 regarding the use of valuation ratios includes:

Comparisons are made through the use of valuation ratios. The computation and use of such ratios should provide meaningful insight about the value of the subject company, considering all relevant factors. Accordingly, care should be exercised with respect to issues such as:

1. The selection of the underlying data used to compute the valuation ratios
2. The selection of the time periods and/or the averaging methods used for the underlying data
3. The computation of the valuation ratios, which may be derived by relating prices of the guideline public companies to the appropriate underlying financial, operating, or physical data of the respective guideline companies
4. The timing of the price data used in the valuation ratios (in relationship to the effective date of the appraisal)
5. How the valuation ratios were selected and applied to the subject’s underlying data

The actual selection and computation of valuation ratios is important.  SSVS-1 does not provide as much detail in its treatment of the market approach, its focus is on comparability (see SSVS-1, pp. 18-19).  SSVS-1 calls for the valuation analyst to conduct appropriate qualitative and quantitative comparisons.  In addition, the analyst is asked to examine whether the pricing of transactions represents arm’s length negotiations.  And finally, SSVS-1 requires, like SBVS-1 above, that the analyst should consider: “The dates and, consequently, the relevance of the market data”.

The American Society of Appraiser’s Procedural Guidelines (PG-2 Valuation of Partial Ownership Interests in the ASABVS (p. 45)) provides limited guidance for methods under the market approach:

Market data on transaction in similar market, if any.  Potentially similar markets might include private placements in publicly or privately syndicated entities (including restricted stock transactions, pre-IPO transactions, and transactions in publicly traded limited partnerships) or tenants-in-common arrangements, etc.

We will keep this guidance in mind in our examination of valuation methods for developing DLOMs that fall under the market approach.

Our next post covers valuation methods under the income approach.