Market Approach Definition and How It Works to Value an Asset
Market Approach: Definition and How It Works to Value an Asset
What Is the Market Approach?
The market approach is a method of determining the value of an asset based on the selling price of similar assets. It is one of three popular valuation methods, along with the cost approach and discounted cash-flow analysis (DCF).
Regardless of the type of asset being valued, the market approach studies recent sales of similar assets, making adjustments for differences between them. For example, when appraising real estate, adjustments might be made for factors such as the square footage of the unit, the age and location of the building, and its amenities.
Because the market approach relies on comparisons to similar assets, it is most useful when substantial data is available regarding recent sales of comparable assets.
Key Takeaways:
– The market approach is a method for determining the value of an asset.
– It is one of three popular approaches, along with the cost approach and discounted cash-flow analysis (DCF).
– The market approach excels when abundant data is available on comparable transactions, and alternative approaches may be required when data is limited.
How the Market Approach Works
As its name suggests, the market approach seeks to answer the question, "What is the fair market value of this asset?" To answer this question, the valuator needs to survey recent transactions involving similar assets. Because these assets are unlikely to be identical to the one being valued, various adjustments will need to be made.
In some markets, such as residential real estate or publicly traded shares, ample data is often available, making the market approach relatively easy to employ. In other markets, such as shares in private businesses or alternative investments such as fine art or wine, it can become quite difficult to find comparable transactions.
In situations where limited data is available, the valuator may need to rely on alternative methods such as the cost approach or discounted cash flow analysis (DCF).
The primary advantages of the market approach are that it is based on publicly available data on comparable transactions, requiring fewer subjective assumptions than alternative approaches. The primary disadvantage is that it can be impractical in situations with few comparable transactions, such as a private company operating in a niche market with few competitors.
Example of the Market Approach
To illustrate, suppose you are in the market to purchase a new apartment. You find a listing for an apartment in your preferred neighborhood being offered for $200,000. The unit is a 1-bedroom, 1,000 square-foot apartment with 1 bathroom. It is in good structural condition but requires some minor renovations. Although it is in a desirable neighborhood, its view is obscured and it does not have an in-suite washing or drying machine.
Although you like the apartment, you feel that the asking price is too high. Since the apartment has been listed for over a month, you suspect that if you make a fair offer, the seller might accept it even if it is below their asking price.
To determine the apartment’s fair market value, you look up examples of similar apartments in the same neighborhood that sold in the last year. You assemble your findings in a table.
The market approach relies on data from comparable transactions.
Looking at these results, you begin to draw general conclusions. The apartments’ price per square foot ranges between $140 and $275, with higher prices belonging to those with more bedrooms and bathrooms, better views, in-suite appliances, and no need for renovations.
By contrast, the apartment you are seeking to purchase is priced at $200 per square foot and has fewer of these features than even the cheapest apartment in your table. This seems to justify your intuition that the apartment is overpriced.
Based on this information, you decide to make an offer for $150,000.
The seller accepts your offer.
