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Misconceptions, Misinterpretations, and Misapplications: Unraveling the Myth of the Market Approach

By Nick Backmann .

As business appraisers, Citrin Cooperman regularly consults with clients who own closely held businesses (CHBs). These engagements often begin with a simple question from our clients, “what multiple can I apply to my business to understand its value?” CHB owners, well-acquainted with their operations, sometimes conduct preliminary research on business valuation before consulting a valuation analyst.

A simple online search on “how to value a business” generates dozens of sources discussing all types of valuation multiples, ratios, and industry rules of thumb that can be overwhelming to a non-valuation analyst. These resources typically impress upon clients the need for a valuation multiple to assess their company’s worth. However, valuing a CHB is rarely as straightforward as applying online-sourced multiples and it is crucial to fully understand the online-sourced data points and their potential influence on the value of your CHB before arriving at any conclusions.

Understanding valuation multiples

A valuation multiple is a financial metric or ratio that can be applied to a particular benefit stream of a CHB to arrive at an indication of value. Some common valuation multiples are revenue multiples or earnings multiples. There are companies that mine financial data and create databases where they summarize this data which can be used to create a data set of valuation multiples. This data is often referred to as market data. Additionally, there are also business or rules of thumb reference guides that seek to provide valuation multiples by industry classification or type.

The consideration of multiples or rules of thumb falls under the market approach, one of three valuation approaches for CHBs, alongside the asset and income approaches. Sole application of the market approach may not always be appropriate for valuing a CHB. In fact, various valuation analyses should be considered before applying a valuation multiple from a database or reference guide. An experienced business valuation analyst should be determining if the market approach is applicable and what the appropriate data and adjustments to the data are necessary to arrive at a meaningful valuation conclusion for a CHB.

An exercise in using valuation multiples

Consider the following scenarios: A client owns an accounting practice that generates $1M of annual revenue and $500,000 in earnings before interest, taxes, depreciation, and amortization (EBITDA), which is a 50% EBITDA margin. The client refers to a business reference guide that has amalgamated some market data. In this hypothetical example, let’s assume the client determines that the rules of thumb for the industry indicate a 1x revenue multiple and 3x EBITDA multiple. In this example, the data from the business reference guide could suggest to the client that his or her accounting practice is worth $1M using a revenue multiple or $1.5M using the EBITDA multiple, which is a fairly wide range in itself.

Using the example above information, it would be ill advised for the owner of that accounting practice to simply accept that market data and that value range for their practice before speaking to an experienced valuation analyst. Valuation analysts are trained to drill down on these types of data sources to (1) understand if the data is relevant and applicable to the specific CHB and (2) if it is, analyze the underlying data to better apply it to the CHB.

Staying with the same hypothetical example, the valuation analyst would consult with the owner of the accounting practice and analyze the industry rules of thumb and multiples. Upon review, the valuation analyst discovered that much of the data that created the valuation multiples were for accounting practices that had revenue of about $1M per year and EBITDA of $250,000 per year, which is an EBITDA margin of 25%. This highlights that the rules of thumb and market multiples were developed from comparables that are similar in size as the subject company accounting firm (around $1M in annual revenue) but less profitable (50% EBITDA margin for the subject company versus a 25% EBITDA margin for the guideline companies). Applying the industry revenue multiple could result in a value conclusion that ignores the fact that the subject accounting firm is significantly outperforming the subjects of the market data, which is a major factor to consider when valuing a CHB.

The market data revenue multiple is illogical in this instance — the revenue multiple would value the subject company at $1M when the subject company is 2x more profitable than the guideline companies (i.e., a 50% EBITDA margin versus a 25% EBITDA margin). An experienced valuation analyst would understand that based on the above, further due diligence on the subject company is required to understand the best approach to value the subject company. Perhaps an income approach should be prepared to further assess the value of the subject company. Or maybe the market data could be further summarized to find better comparables that are more in line with the subject accounting firm’s profitability.

The importance of working with a valuation analyst

It is not enough to simply review market data and industry rules of thumb when it comes to valuing a CHB. While market data and rules of thumb can be excellent tools in the valuation process and certainly should be considered and can potentially be used to value a CHB, but like most sets of tools, they are best left in the hands of an experienced professional that can interpret and apply them appropriately for their highest potential.

Citrin Cooperman’s Valuation Advisory Services Practice is comprised of experienced and skilled financial analysts who can assist with the accurate valuation of CHBs. With expertise in business valuation, forensic accounting, and litigation support, our team is equipped to value CHBs in diverse industries for various purposes.

To learn more, please contact Nick Backmann or your Citrin Cooperman advisor.

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