The Market Approach of Valuing a Business for Sale
In Part 4d of our series “The Components of a Business Purchase and Sale from the Buyer’s and Seller’s Perspective” we will examine the “Market Valuation” approach as the third and final valuation method for buying a business. The two other valuation methods, the income valuation method and the asset valuation method, have been discussed in detail in our previous blogs 4a through 4c.
The last valuation method that we will discuss in this blog series, the market method, is typically considered the most subjective of the three methods. Rather than focusing on how much income or assets the company has (which often times can be a readily obtainable number), the market method of valuation focuses on the more nebulous question, “How much is a buyer willing to pay for the business”. The old adage “Beauty is in the eye of the beholder” is a particularly effective analogy when applied to the market valuation method.
Going back to our example over the past few blogs of Sal’s Ice Cream Shop, if a buyer is willing to pay Sal $1,000,000.00 for Sal’s Ice Cream Shop, which only has $100,000 in gross sales annually and only $50,000 in tangible assets, my guess is that Sal will likely not complain, but rather would take the money and run. The real question would likely be, why would a buyer be willing to pay so much for Sal’s business? Could it be that the buyer is a competing ice cream shop and more than buying Sal’s shop to acquire the business, the buyer wants to buy the shop to stop Sal, its biggest competitor? Could it be that the city in which Sal’s business operates has put a moratorium on issuing permits to new ice cream shops and the only way to operate an ice cream shop is to buy an existing one? Could it be that the buyer really cares nothing about the business itself but has determined that the secret recipe for Sal’s Special Salty Salmon Sorbet could, if in the right hands, become the “next big thing” and the buyer believes Sal’s secret recipe alone is worth millions? These could explain why the buyer is willing to pay much more for Sal’s business than a purchase price reached by using an income or asset approach for valuation. While all of the examples provided are a bit outlandish, they are all related in part to actual reasons for a buyer determining a purchase price for a business. Again, when looking at the market valuation method, the value of the business is determined in large part by what the market of buyers is willing to pay for the business.
A somewhat more objective use of the market valuation method would be based on what businesses similar to the Seller’s business have sold for. When searching businesses to use in formulating a valuation, it is important to find businesses that are similar not only in type, but also in size, earnings, assets and even location. Sal would be foolish to use the sale of the entire national chain of ice cream stores such as Baskin Robbins or Marble Slab as a basis for the value of his sale of a single store located in a town of 20,000 people. Likewise, Sal would most likely not receive a purchase price for his shop as a similar sized ice cream shop located in downtown New York City or San Francisco.
The biggest challenge in using the market valuation method is 1) determining the price that an actual buyer interested in buying the business is willing to pay for the business or 2) locating a reasonably similar business, in a similar market that has recently sold and finding out that purchase price. Fortunately, a good and well-connected business broker can assist you with locating those two things: a willing buyer and some data and numbers on recent similar sales.
As discussed throughout the entire blog series regarding determining a purchase price, not every method will be the best or even most applicable method to use in valuing a business for sale or purchase. This is why it is critical when considering buying or selling a business, that you employ the services of business professionals to assist you in the process. At the Strong Firm, we assisted hundreds of clients every year with buying or selling their businesses and we would be glad to do the same for you.
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