Market Value: What Is It and How to Calculate It?
No-one wants to over pay for anything. I certainly don’t, and Im assuming neither do you. Getting a deal, or at the very least, paying the right price for something is crucial. If you buy a business what is the right price? How do you calculate It accurately, and what are the pitfalls to look out for?
I am a business broker and business valuer, and I have put a market value on hundreds of business over my 20 year career, using the this process. What exactly is market value, and why is it so important for business transactions? The following will give you an understanding of market value and show how it can make or break your business purchase.
It is critical to stop guessing the value of a business and learn how to calculate it accurately. Market value is a concept in business sales that defines the price at which a business would change hands between a willing buyer and a willing seller, both having reasonable knowledge of the relevant facts and neither being under any compulsion to buy or sell. At least that’s the official definition.
In practice market value is the price agreed upon where both parties are acting in their own best interests without any external pressures influencing their decision-making. This concept assumes a competitive and open market, making it particularly useful for determining the value of a business. For instance, if a business owner decides to sell their company, market value would be the price a buyer is willing to pay in the current market conditions, considering factors like industry, business model, products sold, profitability, and market trends.
How can you accurately determine the market value of a business, and what is the most common method used to calculate market value? By far the most often used method here in New Zealand is the Comparative Market Analysis or CMA. Because it is a requirement under New Zealand’s law to provide a CMA to all business owners before the business is listed for sale, it is the most widely used method. This law also applies to all Real Estate transactions, both residential and commercial, here in New Zealand.
Can you really know how much a business is worth on the open market? Comparative Market Analysis (CMA) aims to provide a realistic estimate of the market value based on actual market data. The core of a CMA involves examining past sales within the same industry. The sales data includes important information such as sale prices, revenue figures, profit margins, locations, and market conditions. Adjustments are then made to account for differences between the businesses being compared. These adjustments might consider factors like business size, market share, growth potential, and operational efficiency. The importance of past sales data in a CMA cannot be overstated. This data reflects the actual prices buyers have been willing to pay for similar businesses, offering a realistic picture of the market value. It helps in setting expectations for both sellers and buyers, providing a clear and data-driven basis for pricing strategies and negotiation tactics.
Lets use the example of an engineering business. The process begins by gathering data on recently sold engineering business within the same industry, focusing on those producing similar products. After identifying comparable businesses that were sold, the data shows profits ranging from $300,000 to $500,000, with sale prices ranging from $1 million to $1.5 million. By calculating the sales multiples (Sale Price / profit) for each, the multiples range from 2.5 to 3.0. A multiple is a number that we multiply the profit to come out with the total business value. We then apply a sanity test. In others words, do these averages make sense for the business we are valuing. As an example, if the business has a unique patented technology, this might justify a higher multiple, or if it has a single large dominant customer, a lower multiple would be appropriate. Adjustments are made for these differences. Based on this analysis, a value range for the business is given. If the business has annual profits of $450,000 and considering an adjusted multiple of, say, 2.8, the estimated value could be around $1.26 million.
What are the hidden traps in determining market value? How does market volatility impact the fair market value of your business? While market value is a valuable tool, several pitfalls can arise. Market volatility is a significant challenge, as rapid changes in the market can make it difficult to establish an accurate market value. Economic downturns or booms can significantly impact business performance, making it challenging to pinpoint a stable market value.
Are there inaccuracies when calculating market value? Yes. Bias plays a role in market value determinations. The process often involves subjective judgments, and different appraisers may arrive at different values based on their interpretations and assumptions. For example, two appraisers valuing the same business might come to different conclusions based on their views of the business. A lack of equal knowledge can also be a problem, as market value relies on both parties having reasonable knowledge of the relevant facts. If one party has more information than the other, the resulting value may not truly reflect the business market value. For example, in a case where a seller of a retail business knows about an upcoming roading project that might decrease foot traffic in the area, while the buyer does not.
Understanding market value is essential for making informed decisions as it provides a standardized way to value a business, and buyers and sellers can use it to compare other businesses for sale. Im always happy to talk about how the value placed on a business was arrived at.
Peter Nola is an Auckland based business broker, author and YouTuber with 20 years’ experience and over $100m of businesses sold, helping New Zealand business owners to buy and sell businesses.
Helping buy a business and sell a businesses without expensive mistakes
