Understand the Market Approach in a Business Valuation

The market approach for business valuations is commonly used for business owners who are planning their exit strategy. This review discusses the market approach, highlighting what is included in a market approach valuation and why you should use this valuation strategy when you are selling your business.

What is The Market Approach for Business Valuations?

A market approach for business valuations, also called market-based business valuation, is a method employed by business brokers to determine the worth of your company. It is perhaps the most popular valuation method and is commonly used to determine fair market value for a business that is being sold. 

A market approach considers your company’s financial information, particularly your net income, gross profit, seller’s discretionary earnings (SDE), and earnings before interest, taxes, depreciation, and amortization (EBITDA). It also uses acquisition multiples, which record the calculated average of businesses sold within the same industry. 

How Does a Market Approach Business Valuation Work?

You can determine the value of your business with a market approach method by following the steps below. Keep in mind, conducting a market approach business valuation is relatively complex, and your valuation process may look different based on the specifics of your business. With this in mind, we recommend working directly with an experienced business broker to ensure the most accurate valuation. 

Step 1: Determine Your EBITDA and SDE

There are two primary metrics that business brokers use to determine your company’s value, which are your earnings before interest, taxes, depreciation, and amortization (EBITDA) and the seller’s discretionary earnings (SDE). To determine these valuation metrics, your business broker will need three years of your:

• Tax records
• Income statements
• Cash flow statements
• Balance sheets
• & other financial records

 

As the name implies, your EBITDA considers how much your company earned before it subtracts costs associated with interest, taxes, depreciation, and amortization. SDE goes one step further and adds back your ownership compensation, non-recurring purchases, and discretionary expenses. In some cases, accounting adjustments are applied as well. 

Step 2: Consider Acquisition Multiples (Rule of Thumb Data)

Acquisition multiples, also called rules of thumb or industry multiples, are the fastest way to receive a general idea of your company’s worth. Acquisition multiples take calculated averages of business sales within your industry. You then multiply your financial information by the multiple(s). 

For example, let’s say the acquisition multiple for your industry is 2.5 times the company’s seller’s discretionary earnings, and your SDE is $200,000. This would mean, based on the acquisition multiple, that your business is likely to be valued at around $500,000. Of course, this is far from an absolute method, and there are many additional considerations with the market approach method for professional valuations. 

Step 3: Adjust The Multiple as Needed

Your value based on acquisition multiples is just a starting point. Your business broker then adjusts the valuation based on several factors. These factors include:

• Industry and business type
• Unique competitive advantage
• Growth potential
• Barriers to competitive entry
• Quality of your workforce
• Quality of business operations
• Reason for selling

Step 4: Examine Similar Businesses That Have Sold Recently

Acquisition multiples take into consideration recently sold businesses that are of similar size as yours. However, it also helps to conduct a deep dive into recently sold businesses, looking for industry trends. The data of recently sold businesses are known as “comparable data,” a term you may be familiar with if you have ever bought or sold a home. Comparable data works similarly for businesses as it does with the real estate market.

Your business broker should have access to a range of resources that allow them to analyze recent sales data within your industry. This information is considered in your business valuation, especially when using the market approach method which seeks to find the fair market value for your company. 

Step 5: Establish Fair Market Value (FMV) for Your Company

After considering all factors, your business broker will provide you with your business value. For a market approach, this value is what they determine to be fair market value for your company. In some cases, you may receive offers above fair market value. Overall, the FMV baseline gives you a good sense of how fair an offer is from a prospective buyer. 

Why is Market Approach Used When Selling a Business?

A market approach valuation is used for a multitude of reasons, from justifying your company’s value during legal disputes to handling contract disputes and purchase disagreements among partners. However, most commonly, market approach valuations are used when selling a business. 

This valuation method is used for exit strategies because the value is determined through the examination of other similar businesses that have sold recently within the same industry. Consequently, the buyer can trust that a market approach valuation is accurate, and they know the fair market value of the company before they make an offer. For the seller, there are many benefits of a market approach business valuation for a business broker. These benefits include:

• The seller receives an impartial, objective valuation of their company
• The seller gains a better understanding of market conditions and their fair market value
• Buyers trust the market approach, which often leads to faster and more successful sales
• The seller can justify their asking price and subsequently has more leverage during negotiations

 

Moreover, the seller can determine if and when they sell their company. If the valuation comes in lower than the seller desires, then they may choose to work on their valuation by improving business operations and taking other measures to increase the company’s worth. 

Market-Based Business Valuation vs. Alternative Valuation Methods

There are three primary types of business valuations — market approach (market-based), asset-based, and income-based. All three are useful. Most notably, the purpose of your valuation determines which is right for you. As discussed, a market approach valuation is best if you are planning your exit strategy and desire to know how much a buyer would pay for your company. 

An income-based valuation may be recommended by your business broker if you are more interested in determining your financial projections. This method may also be employed when selling your business if you have strong earnings potential. Lastly, an asset-based valuation may be used for newer companies with little to no profit. In some cases, an asset-based valuation is used during the due diligence stage of a business sale. 

Work With The Experienced Business Brokers at Sigma Mergers and Acquisitions

Sigma Mergers and Acquisitions helps businesses like yours determine their value via a market approach analysis. Our job is to determine the maximum amount a buyer is willing to pay for your company, and in most cases, this is precisely what we can do. Schedule a consultation with us today to learn more and get started with a free, no-obligation business valuation.