Posted in Finance, Accounting and Economics Terms, Total Reads: 1156
Definition: Market-Based Approach
In the Market-Based Approach, the value of an asset is determined by comparing it with the market prices of recently sold similar sized assets in recent time period like a quarter. This approach can be used to determine the value of tangible as well as intangible assets e.g. a house, car or a stock traded in stock market. For example, in the housing industry, the value of a house can be calculated by taking in account of similar sized houses sold in past 3 months.
Method of Comparables – This method follows the principle that 2 identical assets should sell at the same price. It uses a price multiple (ratio) to determine if an asset is fairly valued, undervalued or overvalued in comparison to a benchmark value.
Rule of Thumb/Industry Average – This method is simple and cheap for selling relatively small businesses. It is based on the industry standards for similar businesses and does not consider any unique factors of your business.
P/E ratios – Price to earnings ratios of public companies are widely available and can be used in comparing the prices of liquid stocks of larger companies. But it would be unreasonable to compare the P/E ratios of small companies with that of large companies as stocks of large companies command a premium since they enable diversification of risk.
The difficulty of this approach lies in finding companies which can actually be compared. Since a private company’s equity will be less liquid in comparison to a public company, the value of such a private company would be lesser than the actual value obtained by a market-based approach.