Market Approach: Don’t Compare Apples to Oranges

Under the market approach, the value of a business is derived from comparisons between the subject company and transactions involving similar businesses. It hinges on the selection of reliable “comparables” — that is, businesses with similar characteristics to the company being valued. External comparables may be either: 1) prices of publicly traded stocks under the guideline public company method, or 2) sales of private businesses from proprietary databases under the guideline transaction (M&A) method.

Selection Criteria

No two companies are identical, so selecting comparable businesses can be subjective. U.S. Tax Court cases have identified several factors to consider, including:

• Industry,
• Product and service offerings,
• Nature of competition and marketing position of the subject company,
• Geographic location,
• Financial performance, including earnings and dividend-paying capacity,
• Capital structure,
• Business maturity, and
• Management depth and experience.

Under the guideline transaction method, it’s also appropriate to consider the timing of the transaction. In determining selection criteria, the goal is to ensure that the underlying economics that drive a comparable business closely match to those that drive the subject company.

Real World Application

When a valuation is prepared for litigation purposes, the parties should be prepared to defend their selections of comparable companies — or risk exclusion from evidence. There are no bright line rules regarding the number of comparables that an expert must use to derive value. But a small sample of closely related comparables will generally provide a more meaningful comparison than a large sample of loosely related ones.

For example, in Heck v. Commissioner, the Tax Court rejected use of the market approach to value a champagne producer based on a comparison to just two wine producers. The court acknowledged that, in prior cases, it had accepted valuations based on as few as two comparable businesses. However, those cases involved companies in the same line of business. The court explained, “As similarity to the company to be valued decreases, the number of required comparables increases in order to minimize the risk that the results will be distorted by attributes unique to each of the guideline companies.”

In Heck, the two comparable businesses weren’t sufficiently similar to the subject company. Although the comparables were involved in a similar line of business — the sale of wine — there were significant differences in size, product lines, profitability, growth and other factors.

Relevant Comparisons

Failure to apply relevant selection criteria when identifying a sample of comparables can result in an apples-to-oranges comparison, casting doubt on the reliability of the valuator’s conclusion. So, it’s important to get it right.