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Market Approach > Business Valuation | Phasecorp Business Conulting Group in Chicago and Suburbs |
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| | | The market (or price/earnings) approach uses the price/earnings ratios of similar businesses to establish the value of a company. The buyer must use businesses whose stocks are publicly traded to get a meaningful comparison. A company's price/earnings ratio (or P/E ratio) is the price of one share of its common stock in the market divided by its earnings per share (after deducting preferred stock dividends). To get a representative P/E ratio, the buyer should average the P/Es of as many similar businesses as possible. To compute the company's value, the buyer multiplies the average price/earnings ratio by the private company's estimated earnings.
The biggest advantage of the market approach is its simplicity. But, this method suffers from several disadvantages, including the following: - Necessary comparisons between publicly traded and privately owned companies. The stock of privately owned companies is illiquid, and, therefore, the PIE ratio used is often subjective and lower than that of publicly held companies.
- Unrepresentative earnings estimates. The private company's net earnings may not realistically reflect its true earning potential. To minimize taxes, owners usually attempt to keep profits low and rely on fringe benefits to make up the difference.
- Finding similar companies for comparison. Often, it is extremely difficult for a buyer to find comparable publicly held companies when estimating the appropriate P/E ratio.
- Applying the after-tax earnings of a private company to determine its value. If a prospective buyer is using an after-tax P/E ratio from public companies, he also must use after-tax earnings from the private company.
Despite its drawbacks, the market approach is useful as a general guideline to establishing a company's value.
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