The motivating principle of the market methods of appraising goodwill is simple and logical: if you can find recent comparable sales of companies similar to the firm then these sale prices ought to be useful in appraising the equity value of that firm. There are two widely used variants of the market appraisal approach, one is based on completed equity transactions reported on various databases such as Done Deals, Pratt Stats, Bizcomps and IBA Market Data (Institute of Business Appraisers). A second variant involves publicly traded companies.
All of the above listed databases contain information obtained from business brokers showing completed sales of closely held firms. The databases vary in level of detail, range of sectors covered, and the numbers of transactions reported. Service businesses with goodwill sell often in brokered transactions so they tend to be well represented in these databases. For example, a recent Bizcomp database contained nearly 100 completed exchanges of landscaping and lawn care contractors.
Conceptually this market appraisal method seems like an ideal way to value a closely held business if the firm has sufficiently similar operating characteristics to the firms reported in the databases. The logic is simple: if there were buyers willing to pay an average of say .45 times annual revenue for the firms sold in the database, and the firm operates at a similar scale, with similar operating results to the reported firms, then it is reasonable to suppose that there is another buyer out there who would pay .45 times the annual revenue of the firm. There are, however, both practical and conceptual problems with this appraisal approach.
A significant practical problem involves having enough information to determine if the firms reported in the database have sufficiently similar operating characteristics to the firm you are appraising. Call this the subject company (SC). With most of the reporting, there is simply not enough data disclosed to make such a determination.
A second practical problem relates to an even more profound question. By their very construction these databases report sales of firms that involved brokers. However, there are many equity exchanges of closely held firms that do not involve brokers. For example, many sales are between owners and key employees as part of a succession plan, or are between partners as part of a buy-sell agreement. In these cases, a degree of exit planning was likely done and this may betoken a degree of better management than exhibited by firms that failed to execute or implement such plans. Thus, it is perfectly possible that the failure to include non-brokered equity transfers distorts the picture of such transfers within a sector. Transactions reflected in these databases may in fact be unrepresentative of the sector.
There is also a major conceptual flaw in the use of databases. These databases fail to disclose the appraisal method the brokers, buyers and sellers utilized to determine the price of the equity. In negotiating a final transfer price, did the parties to the reported transactions utilize one of the rigorous non-market methods favored by credentialed appraisers or did they in fact use a widely known rule of thumb?
Based on my experience buying and selling accounting practices, I think the answer is obvious: the equity exchange values reflected in these databases, for the kinds of service businesses with goodwill, are almost certainly based on rules of thumb. Thus, this market method of appraisal gives us no more insight into the economic principles or conditions that should determine value than the rules of thumb themselves. The databases simply reinforce the hold of rules of thumb on most equity exchanges.
The Guideline Public Company (GPC) method is far more sophisticated and subtle than the utilization of transactional databases. The GPC approach assumes that if you can find a publicly traded company or groups of companies offering the same line of products or services as the SC, you ought to be able to utilize the pricing of these shares as a guideline to pricing the equity of the SC.
Example. An SC has earnings of $100,000. Assume that there is just one share of outstanding stock. Say the average selling price per share for a group of public traded companies thought to be in the same line of business as the SC is $36. Assume that the average earnings per share for the public group is $3 (earnings per share= net after tax profit/total commons shares). This entails that the average price/earnings ratio is 12 (the quoted per share market price $36 divided by the earnings per share, $3). Here is the algebra:
Ppc = Average price per share of guideline publicly traded companies = $36
EPSpc = Average earnings per share of guideline publicly traded companies = $ 3
EPSsc = Earnings per share SC = $100,000
Psc = Value of Shares of SC =?
The GPC method assumes that the ratio of the price to earnings per share of the SC ought to be the same as the ratio of the price to earnings per share of the public companies. Substituting the known values:
The GPC method offers clear advantages over the transactional database method. First, there are many more publicly traded companies in a given sector with current price per share data than there are reported transactions in the widely used databases.
Second, there is much more reliable and detailed data about publicly traded companies than the information available about closely held companies reported in the transactional databases. Unfortunately, these advantages exist only in comparison with the very unreliable database approach. Both the practical and conceptual problems involved in utilizing the GPC method are in an absolute sense insurmountable.
The key practical problem with the GPC approach is comparability. Most publicly traded companies operate on scales many times larger and offer far more diversified product and service lines than the smaller Maim Street firms. Operating at a larger scale, public companies possess economies of scale not available to smaller privately held companies. The greater resources usually available to public companies allow them to better sustain economic downturns or unusual disruptions. The diversification of product and service lines also call into questions whether or not a public company is truly in the same business sector as an SC. The fact is that it is well-nigh impossible to find virtually any publicly traded companies with sufficiently similar operating characteristics to smaller closely held firms.
Finally, and most critically the price per share of the public companies that is used as a benchmark for the method is the price associated with very small fractional minority shares in the company. The equity positions we attempt to appraise for smaller closely held firms are usually majority control positions. There are literally thousands and thousands of potential buyers for the minority shares of the publicly held companies, while for most SCs in our sectors of interest there are rarely more than a handful of potential buyers in any given local market. This disparity in the number of potential buyers alone creates a significant enough difference in market structure that should motivate us to completely avoid using the GPC method.
Alas, not everyone in the appraisal community has been daunted by the overwhelming challenges of comparing large publicly traded apples to small closely held oranges. Many specialized theories and methods have been developed to convert the apple into to an orange. These include the development of specialized adjustments known as “control premiums” or “scale and growth adjustments.” All of these methods are based on the hopeful premise that we as appraisers can second guess the publicly traded market. These tinkerers attempt to assess how much of an adjustment would be needed to convert a minority share price into a majority share price, or how much of an adjustment would be needed to reflect the differences in scale and/or differences in growth rates. Deciding which of these arcane adjustment methods is optimal is a hotly contested region of appraisal theory that can and should be ignored by anyone seriously concerned with appraising smaller closely held businesses.
I need to raise a more fundamental conceptual concern about the GPC method, that in a very real sense echoes the concern raised about the database approach: namely that reported prices may only reflect rules of thumb or some other less than fully rational basis for valuing the equity. I am not saying that share prices of guideline public companies reflect rules of thumb (though they often probably do). Rather I am saying that it is an assumption, and a big one, that these GPC market prices reflect a fully rational basis for the valuation of these companies.
Copyright 2018 Michael Sack Elmaleh