Correcting the 7 most common errors in the market approach today

BVWireIssue #119-5
August 29, 2012

“Ignoring the market evidence during periods of recession is a recipe for poor quality service,” said Rob Schlegel (Houlihan Smith & Co.), during BVR’s recent webinar on The Market Approach Today: Deciphering Messages from Markets, Courts, and Common Appraisal Errors.We just cannot do this. Yet understanding the market results during these periods of particularly high growth or high shrinkage is much more difficult than during stable periods.”

In fact, “market methods themselves yield insight into the economic and industry influences on the buyers and sellers,” Schlegel added. “This is the pressure we see in the actual marketplace that strains the hypothetical exchange between the willing buyer and willing seller. Knowing this information in the market helps us to defend discount rates [and] cap rates. Shrinkage of market value of equity during the periods of recession accentuates debt proportions, unless of course the debt is revalued, and distorts your WACC inputs, so be careful of that, even if [you] choose not to apply market evidence directly, only as a sanity check.”

In any application of the market approach today, co-presenter Alina Niculita (SPV) cautioned against the following most common errors in appraisals:

  • Using guideline companies that are not truly comparable;
  • Comparative analysis is missing or inadequate;
  • Automatically applying the mean or median valuation multiple from the comparables;
  • Automatically adjusting all multiples by the same percentage or by the same mechanism, without sufficient explanation;
  • Failing to apply a multiple in the same manner in which it was calculated;
  • Failing to conduct a site visit and/or management interview, whenever possible; and
  • Failing to apply the discounts and premiums after the market approach to reach the appropriate indication of value.

In sum, the third presenter, Chris Treharne (Gibraltar Business Appraisals) said, “The income approach is just an extension of the market approach.” After all, “where do we get the discount rate data? It is from publicly traded guideline companies. As Howard Lewis [former head of IRS engineering and appraisal team] likes to say, we only have one approach and that is the market approach.”

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