The Direct Market Data Method: Theoretical Underpinnings

The DMDM is one valuation method under the Market Approach. All valuation methods within the Market Approach rely on the fundamental Principle of Substitution. This principle states that the economic value of an item tends to be determined by the cost of acquiring an equally desirable substitute. In other words, no rational person would knowingly pay more for something than it would cost to obtain an equally desirable substitute.

What is an "equally desirable substitute" such that the item being appraised is said to be "comparable?" Selection of guideline transactions is an attempt to identify "equally desirable substitutes" for the business being appraised. The key words are "equally desirable." That is, the Principle of Substitution does not require identical businesses as substitutes for the subject business. Rather, this principle requires investments whose desirability is equivalent to that of the subject business. If the guideline businesses are not equally desirable substitutes for the subject business, then they are not useful in the appraisal process .

To be an equally desirable substitute for the subject closely held businesses, the guideline business must be both similar and relevant.

"Similar" refers to the nature of the business being appraised. It encompasses such business attributes as:

business size
markets served
depth of management
information processing systems
level of technology utilization
probable future earnings growth etc.

"Relevant" refers to the desires and expectations of the probable "willing buyer" or investor. This includes:

risk tolerance (degree of risk assumed)
liquidity of investment
degree of management involvement
probable holding period, etc.

It can be easily understood why large publicly traded businesses are not equally desirable substitutes for small to mid-size closely held businesses. Large publicly traded guideline businesses are neither similar nor relevant to mid-size closely held businesses.

From a theoretical perspective, it is hard to justify utilizing a typical publicly traded corporate P/E ratio of 20 to value a small to mid-size closely held business. Because P/E ratio is the inverse of capitalization rate, a P/E ratio of 20 corresponds to a capitalization rate of 5 percent. The capitalization rate for the future earnings stream of a business is equal to the discount rate less long term sustainable growth of this earnings stream. The Ibbotson studies give evidence of a discount rate of 15 to 20 percent for a large publicly traded businesses. Accordingly, a 5 percent capitalization rate, requires that long term sustainable growth be in the 10 to 15 percent range. Whether this is possible in the public markets depends on whether these public markets are rational or whether they are "irrationally exuberant." However, this degree of sustainable long term growth is not possible for most small to mid-size businesses.

From a procedural standpoint, how does a business appraiser get from a P/E ratio of 20 for a large publicly traded business in the same industry as the subject closely held business to a more rational P/E ratio of between 3 and 6? The answer is, "not easily." A large subjective adjustment for "my best professional judgment" is required.

How many transactions are needed to apply the DMDM effectively?

There is a limited amount of specific information about individual transactions listed in the database. The relevant assumption is that there are enough transactions for the subject industry such that general market trends within the industry can be discerned.

How many transactions are "enough"?
Minimum of four to seven "good" guideline companies. Shannon P. Pratt, Robert F. Reilly, and Robert P. Schweihs, Valuing a Business - The Analysis and Appraisal of Closely Held Companies, third edition, page 215.

"It will be seen . . . that there is relatively little change in the range of uncertainty as the size of the sample decreases from more than 20 to about 10. As the number of transactions falls below 10, however, the range of uncertainty becomes greater. Then, below about 5 transactions, the range of uncertainty begins to increase rapidly until, with only a single guideline transaction, the range of uncertainty is infinite." How to Use the IBA Market Data Base, Part VIII, IBA News, Volume 17, no. 2.

Estate of Joyce C. Hall, 1992 T.C. No. 19 (1989). The court rejected the appraiser's reliance on one guideline business, stating that, "One company does not a market make".

The following graph shows the level of uncertainty as a function of number of guideline transactions.

Exactly what is transferred and reflected in the P/E and P/G multiples in the IBA Transaction Database?

It is not always clear whether reported database sales are asset sales or stock sales. However, given the size of the businesses in the database, the vast preponderance of the sales are almost certainly asset sales.

The exact combination of assets and liabilities transferred in individual transactions in the database is indeterminate. However, it can be assumed that, in general, the combination of assets and liabilities transferred corresponds to what is typical in the subject industry. In some instances, it may be appropriate to contact a broker who customarily sells businesses in the subject industry for information about the content of a typical sale.

If assumptions 1. or 2. above are incorrect with respect to some individual transactions, the effect on the statistical analysis of the market should be negligible provided the total number of transactions in the market sample is relatively large.

When the IBA Transaction Database is utilized to value the equity of the subject business, adjustments will usually be required.