Market Approach Valuation

What is the Market Approach to Valuation?

A market approach is a valuation method that is used to determine the appraisal value of a company, security, or asset by comparing the market prices of comparable companies or assets.

For example, if you are looking to value a fintech company that does unsecured lending, you would look at all the unsecured lending fintech companies that have raised capital at that specific milestone, for example, Series A or Series B.

Since the ownership of the companies is fairly similar, it further helps you to understand the intricacies behind performing a valuation - what dilution did the company raise at or what specific valuation did a similar company get acquired at?

Apart from the market approach valuation, the other two types of commonly used valuation methods are - intrinsic or the DCF method and the cost approach method.

While the DCF method takes into account a company's future cash flows, the market approach works on the principle of the law of one price, i.e., similar assets should sell at similar prices.

To rephrase this in simple words - a company that has similar revenue and growth drivers should approximately be worth the same.

How the Market Approach Works?

The Market Approach method asks us one simple question - what should be the fair market value of this company or the asset in question? To do this, a valuer needs to evaluate all the comparable transactions in the past and understand their multiples.

For example, suppose that you need to find the valuation of a fintech company that has a revenue of $1M.

Some of the comparable companies raised at a revenue multiple of 7X, 8X, 19X, 15X, 4X and 9X. You eventually find the mean and median for these numbers, which gives you a specific number that can be used to find the valuation of your fintech company.

Suppose the number is 10X. Thus, the valuation of your fintech company becomes the revenue multiplied by the revenue, which gives the valuation of the company as $10M.

In reality, the mean/median value won’t be always used for calculating the valuation. Private markets are scary, investors don’t intend to negotiate unless it's a really attractive company. If you rationalize a 10X revenue multiple, they would eventually settle for 7-8X.

Thus, what we mean to say is that the multiples are just plain numbers and support your justification for the valuation. In no way do they mean that the specific company should be valued at that particular revenue or EBITDA multiple.

Market Approach Methods

There are two methods to valuation method of market approach - the public company comparables and the precedent transactions.

1. Public Company Comparables

The public company comparables method looks at publicly traded counterparts for the one you are doing valuation. One thing in this method is certain - there would be a direct comparison between the company that you are valuing and the public entity.

Larger companies can have multiple product lines/services and operate in different domains. There’s another argument that public company comparables work the best when the company that you are performing the valuation for is in its growth phase.

The steady-state or the growth phase ensures that it is on a like-to-like basis to the public company and direct comparability can be achieved without any hassle.

If the company is in its early phase, say Series A or Series B, then comparing it to its public comparables would be a bad decision in terms of valuation.

The answer is pretty obvious - the company is in its growth stage, and you would be using the multiples for a ‘steady’ state public company, which would work in the favour of investors.

To avoid this, it is always better to spend considerable time understanding the company's stage so that it is easier to assign revenue/EBITDA multiples that might be acceptable to investors.

Remember, raising capital or performing M&A is an art, you have to arrive at mutually agreeable numbers that look lucrative to all the parties involved.

2. Precedent Transactions

Precedent transaction is another method that specifically looks at the previous transactions of similar companies in the industry.

While financial data is not always easily available, most news articles and websites provide tonnes of information about the transaction value and the revenue at which the transaction occurred.

Several websites and platforms offer valuation databases that can be examined for historical valuations.

The precedent transactions method is particularly useful in scenarios where a purchase or sale of a company is in progress, and the valuation of a company needs to be determined.

The only problem that emerges out of such exercises is that - the two companies are always different.

Although they might operate in a similar environment and have similar suppliers, product lines, same set of B2B customers, there could be other factors such as the pricing power, customer acquisition strategy, or even their brand value.

However, the objective of both exercises remains the same - find companies that are comparable in certain aspects and can be used to determine the value of the other companies by asking a set of questions such as

• What industry is the company operating in?
• Is the company serving B2B or the B2C customers?
• Where is the company located?
• What products and services do the companies offer?
• Are they on a similar revenue scale?
• How much capital have the competitors raised for those valuations?

Example of the Market Approach

A simple example of a market approach could be when you are looking to buy 1kg of apples. Suppose there are three different fruit stalls where you can buy the apples from.

Based on the data available, if you look to buy apples from a different stall, three things are clear-

1. The average price of the apples per kg is $15 so the seller should sell you somewhere around that. If the apples are overpriced, completely avoid them. If the apples are under-priced, know why they are. There has to be a reason, perhaps the quality, or they are good quality ones available at a lower price - then go for it.
2. The total quantity of apples that you should expect would be equal to 3. Anything more is a good deal, anything less might not be. But again, the aspect of quality also rises here.
3. The size of the apple should generally be medium for an average price per kg of $15. If the price is less than that, expect the size of the apple to be smaller as well.

Factors Influencing Market-Based Valuation

Several factors may influence the market-based valuation-

1. Industry trends

Industry trends can significantly affect the valuation of a company. A growing and expanding industry can get a favorable valuation due to higher demand and good market conditions.

However, on the other hand, an industry that is not growing fast will affect the valuation of the company due to lower demand.

2. Macroeconomic conditions

Macro-economic conditions such as GDP, and interest rates can also impact the valuation of a company or an asset. The people in countries with growing GDP have significant faith, and this in turn can be favourable for the companies or the asset.

Whereas, a growth or GDP stagnated nation can have trouble in attracting investments in their assets, which can even result in lower valuations.

3. Market conditions

The availability of capital can also have a significant impact on the valuation of the company. If there is abundant capital readily available along with a high demand, the companies can negotiate for a good valuation.

On the other hand, a low demand coupled with a shortage of capital can result in lower valuations of the company.

4. Financial performance

Financial performance is one of the most important factors that can influence the valuation of a company. For example, company ‘A’ has its revenue growing at 200% year-on-year while company ‘B’ has its revenue growing at 20% year-on-year.

Any investor would opt for the company ‘A’ due to their significant revenue growth, which also offers them enough room to negotiate for a higher valuation.

5. Competitive landscape

Another important factor that can influence the valuation of a company is the competitive landscape. Imagine that your company has a monopoly with 90% of the captured in a $500 M market size.

For such a company, the investors would offer a significant markup on the valuation and would readily offer to invest in such companies.

Whereas, if the company is in a crowded sector such as lending, its pretty obvious that the company may get a lower valuation which becomes even more difficult to justify.

Advantages and Disadvantages of the Market Approach

There are certain advantages and disadvantages to using the market approach of valuation.

Advantages of the Market Approach

1. It uses publicly available data
2. There are no forecasts or projections involved in this projection method.
3. The calculations aren’t rocket science and are pretty straightforward, so the entire process isn’t that time-consuming. 

Disadvantages of the Market Approach

1. The biggest disadvantage of the market approach is finding comparable companies. As we said earlier, no two companies are similar, and hence it becomes tough to find ample comparable companies for this exercise.
2. If the data is not readily available then the market approach valuation method becomes a bit too difficult.
3. If the market/sector has been overvalued or undervalued for the last few years, then the conclusion arising out of the valuation exercise can be skewed. 

In such a case, an additional valuation method such as DCF becomes necessary to find the correct valuation of the company.

Key Uses of the Market Approach

The Market Approach for a valuation can be needed in three different scenarios-

1. Suppose that you start a new company and looking to raise a seed round for the company. What valuation did other similar companies get for their seed round? How much did they raise for that particular valuation and what was the corresponding dilution?
2. Another scenario is when there is a legal dispute, and you need to justify your valuation. In this case, you can look at comparable companies and prepare a justifiable valuation report for your company based on your revenue scale and valuation multiples.
3. Finally, the valuation can be performed in case of a potential buyout or M&A. Valuations are not usually performed in case of hostile takeovers since no negotiations are involved. 

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Capitalization Rate
• Corporate Bond Valuation
• EVA – Economic Value Added
• Liquidation Value
• Mark to Market