Issues Associated with Market-Based Valuation Methods

As will all valuation methods, market-based valuation methods have negative aspects - particularly when they are used to value startup ventures. Some of the notable issues with market-based approaches are discussed below.

Comparable Companies, Transactions, Industries

The primary difficulty associated with using market-based, comparables to value the firm is the inability to identify truly comparable companies. 

For example, two companies may have very similar operational and structural characteristics, but the comparable ratios may be affected by the position of either company in its lifecycle. That is, one company may still be growing, while the other company has a flatter growth curve. These simple differences can lead to distortion of the comparable ratios. 

Also, the information leading to the valuation of other private companies is difficult to locate and the lack of transparency can lead to valuations that are unjustified by the relevant cash flow. 

Characteristics that make a company comparable include: similar markets, capital structures, operational characteristics, and market size. Identifying comparable companies is easier when the comparable company is publicly traded, as publicly traded firms must make more thorough public disclosures. Transactions or companies within an industry may be too distinct from the firm being valued to offer a valid method of comparison. Transaction and industry multiples should only be used as additional criterion in identifying comparable companies.

Discounts and Premiums

Another important issue is that comparable company valuations do not include the same discounts or premiums. Discounts and premiums are particularly important when valuing startups or closely-held businesses, as there are inevitably specific variables that either increase or decrease a target valuation. 

The most common discounts are result of limited marketability for the business equity and the control afforded to the investor. Consequently, the valuation must be adjusted for the anticipated premium in order to estimate accurately the actual purchase price. 

Another source of discount or premium may be the trapped capital gains or losses associated with a firm. Still other premiums unique to a company may be the synergies attributable to the combination of two firms. These synergies can greatly distort the valuation attributable to any individual firm. Discounts and premiums are relevant when using both market-based and income-based approaches.

Ratio Valuation Considerations

The next issue for market-based, valuation is the potential for widely-divergent, valuation ratios. Issues that commonly arise in ratios includes: using ratios from non-comparable businesses (size, financial structure, management, philosophy, growth-path, regulatory environment, location, etc.), using ratios based on accounting numbers, and irrational exuberance surrounding an industry.

 As such, the ratios produced by similar firms, in like industries, or in similar transactions often are poor points of comparison when valuing a firm. P/E ratios, for example, are generally only useful in comparing public companies. In startup companies, this ratio offers little insight to the value of the firm. Other ratios fail take into account key aspects of the comparable firm. 

For example, Price/Sales ratios fail to adequately consider the expense ratios of the comparable company. This ratio should only be used when the entire capital structures of the two firms are comparable. Other examples include the Market/Book ratio, which is subject to distortion from accelerated depreciation and differences in asset purchasing history of companies. 

A company with more recent purchases or newer assets will have a drastically different ratio than an otherwise similar company with older assets. Further, the book value may distort the value of goodwill on the balance sheet. For these reasons, ratios should be employed in combination when used to value a firm. 

Above all, however, one must work to find truly comparable firms from which to derive the characteristic-based ratio.