Why Market Value Is Important
Updated December 20, 2022
In business transactions or any transaction that involves the transfer of an asset, you must have a realistic idea of what the asset is worth. One method of finding what the asset is worth is by determining the market value. In this article, we outline the concept of market value and describe how it is determined and where it is used.
What is market value?
Market value is the price buyers are willing to pay for an asset in the marketplace. In the case of publicly-traded assets or entities, it is also known as market capitalization and is calculated by multiplying the current price by the number of outstanding units. There are a few components that go into calculating the market value of some assets such as businesses and with real estate, it involves a lot more than knowing about share prices. The business market value determination can also take components such as the value of intangibles and the future value of related assets into consideration. Market value is more than a price but denotes the true underlying and not only the perceived value.
Why is market value important?
One of the main reasons why market value is important is because it provides a concrete method that eliminates ambiguity or uncertainty for determining what an asset is worth. In the marketplace, customers and sellers often have different perceptions of the value of a product. Buyers will wish to pay less, while sellers hope to receive more. The primary goal of determining market value is to provide a fair assessment of the worth or value of the asset. In simple terms, it is the price at which the item would normally be sold. Buyers have the option of paying, while sellers also have the option of accepting more or less than market value.
How does market value work?
Market value is applied in different ways in different markets. In the world of business or of publicly traded companies, the market value term which is otherwise known as fair market value or market capitalization is calculated by multiplying the current share price by the number of outstanding shares. This implies that when prices are volatile, the market value is also expected to be volatile. In real estate, there are three different approaches to calculating market value:
Sales comparison approach: The market value is based on what similar properties have recently sold for in the same market.
Cost approach: The cost approach is favored for newer construction and begins by calculating the cost to rebuild a property with similar amenities and features, but with modern construction materials. Depreciation is then deducted from the calculated cost to arrive at a market value.
Income approach: The income approach is used for properties that produce rental income.
When businesses determine the market value of a product or service, they use a number of different strategies, and very often, the market value will not always be reflected in the selling price. There may be a focus on achieving a certain profit, and this will depend on associated costs. Market value will also be often based on perception, and in price-driven strategies, the higher prices are perceived to offer more value. In these situations, prices may not always reflect associated market value.
Market value is also useful in targeting specific markets. With higher valued products, that are recognized for improved quality, the target market is likely to be customers with higher incomes. For products that are perceived as having a lower market value, the target market is likely to be the budget-conscious who prefer lower prices. Another strategy invoking market value is to establish a value that attracts middle-income buyers with prices that reflect a balance of affordability and acceptable quality.
Market value examples
The seller lists the property at a price of $750,000. This is based on the prices for which similar properties in the area have been sold, however, buyers are not willing to offer more than $600,000. The market value of the property is then determined to be $600,000.
Market value of a business
With publicly traded shares of a company, the easiest way to calculate the market value is to multiply the number of outstanding shares by the current price. As an example: the business has 1,000,000 common shares outstanding. The share price is currently $43 on a major stock exchange. Its market value is calculated at $43,000,000. In cases where there is a lower amount of outstanding shares, an alternate strategy is to value the company based on the ratio of sales to the market value of similar businesses. With sales of $6,000,000, when the sales to market value ratio of similar businesses is 0.5 to 1. The market value of a company being measured is $3,000,000. (0.5 * $6,000,000)
Privately held companies
With privately held companies, estimating the market value of the company involves looking at the prices of similar businesses.
If your business is in IT, one example might be:
Three mid-sized Information technology companies recently sold for $9,00,000, $17,100,000, and $12,500,0000. Averaging these three prices yields roughly $12,870,000, which may be an appropriate market value of your business, if these businesses were of similar size and structure.
The most suitable method for determining the market value of small businesses is the multiplier method. This method includes data such as income, gross sales, inventory, or net profit, which is multiplied by a coefficient to produce the business market value.
The coefficient or multiplier for mid-sized accounting firms is 1.5
After collecting the financial data, the annual revenue is determined to be $2,500,000
The market value of then business is estimated at $3,750,000: (1.5 * $2,500,000)
This method provides very rough estimate as many more important factors for determining the actual value of a company are ignored.
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