Using the DMDM to Arrive at a Value Estimate: Steps One and Two

Step one: Gather information on a large number of actual sales transactions or comparable businesses.

Telephone IBA at 954.584.1144 or

E-mail your request to data@go-iba.org and ask for the relevant IBA Transaction Database printout for the subject closely held business.

You might also ask for the case study which has been developed illustrating the application of the DMDM, or the 60-page booklet, Introduction to the Direct Market Data Method, which is available for purchase.

Step two: Select a performance measure to be used as a basis for comparison. Because of the practical impossibility of finding comparable businesses that are exact substitutes for the business being appraised, performance ratios are used as surrogates for business performance. Possible candidates for use as performance surrogates include:

Selling price to earnings ratio, or P/E
or

Selling price to gross (revenue) ratio, or P/G.

It is reasonable to assume that, because the prospect of earnings (profit) is the usual motivation for buying or owning a business, price to earnings ratio would be a good choice as a performance surrogate. However, empirical data also indicate that price to revenue (gross) ratio is significant as a performance surrogate. Other possible choices as performance surrogates, including price to book value, show negligible correlation, and accordingly, can be disregarded as possibilities.

As between price to earnings, P/E, and price to gross, P/G, ratios, it would ordinarily seem that P/E ratio would be the preferable choice, since it relates more directly to buyer and owner motivation. However, practical problems in data gathering and interpretation tend to limit the usefulness of P/E ratio as a measure of market performance. As one skilled financial analyst noted, "The most unbelievable number from an economic perspective on the financial statements of a closely held business is net income".

Problems with the P/E ratio include differing interpretation by persons who furnish data as to what constitutes "earnings." Earnings data, and consequently P/E ratios, are therefore somewhat less reliable than are price to gross ratios, the interpretation of which is not subject to much variation.

Another limitation of P/E ratios as surrogates for business performance is that not all transaction records include earnings data, whereas essentially all transaction records do include revenue data. Remembering the importance of number of transactions as related to statistical confidence, this suggests that P/G ratio may play as large a part, or possibly a larger part, than P/E ratio in describing markets.

Because of the foregoing considerations, P/E ratio will sometimes be less useful as a measure of the market than P/G ratio. Which of the two ratios is chosen will depend on the circumstances of each situation.