Key Takeaways
- The market approach is a valuation method that uses recent sales of similar assets to determine an asset’s value.
- This method is particularly effective in markets with plentiful data on comparable sales, like real estate or publicly traded shares.
- Alternate valuation methods such as the cost approach or discounted cash flow analysis may be required when comparable data is scarce.
- Adjustments are often necessary because comparable assets are rarely identical, making these modifications key to accurate valuations.
- The main limitation of the market approach is its reduced effectiveness in unique markets with limited transaction data.
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What Is the Market Approach?
The market approach is a method for determining the value of an asset that accounts for recently sold similar assets. It is one of three popular approaches, along with the cost approach and discounted cash-flow analysis (DCF).
The market approach excels in situations where abundant data is available on comparable transactions. Alternative approaches may be required when that data is scarce. The market approach is particularly useful in areas like real estate appraisal and publicly traded shares.
Important
The market approach works best when there’s plenty of data on recent sales of similar assets.
How the Market Approach Works
The market approach aims to find the fair market value of an asset by looking at recent similar sales. Because these assets are unlikely to be identical to the one being valued, various adjustments will need to be made.
The market approach is easier to use in areas like real estate or stocks where lots of data is available. 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).
A major advantage of the market approach is its use of public data from comparable transactions, and the need for fewer assumptions. The market approach is less useful when few similar transactions exist, like with a private company in a niche market.
Applying the Market Approach: A Real-World Example
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 begin to suspect that if you make a fair offer, the seller might accept it even if it is below their asking price.
To that end, you set about determining the apartment’s fair market value by looking up examples of similar apartments in the same neighborhood that sold in the last year. You assemble your findings in a table, as follows:
| Comparable Transactions | |||||
|---|---|---|---|---|---|
| Transaction 1 | Transaction 2 | Transaction 3 | Transaction 4 | Transaction 5 | |
| Price | $250,000 | $175,000 | $150,000 | $315,000 | $225,000 |
| Square Feet | 900 | 800 | 1,100 | 1,800 | 1,600 |
| Price Per Square Foot (Rounded) | $275 | $220 | $135 | $175 | $140 |
| Bedrooms | 2 | 2 | 1 | 2 | 2 |
| Bathrooms | 1 | 1 | 1 | 2 | 1 |
| View? | Yes | Yes | No | Yes | No |
| In-Suite Washer and Dryer? | Yes | No | Yes | No | No |
| Renovations Required | None | None | Minor | None | Minor |
Looking at these results, you begin to draw some general conclusions. To start with, you see that the apartments’ price per SF ranges between $140 and $275, with the 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 SF and has fewer of these features than even the cheapest priced 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.
The Bottom Line
The market approach appraises the value of an asset using recent selling prices of similar assets. It’s a particularly useful valuation method when lots of data on comparable transactions is available. It isn’t helpful when data is unavailable. In such cases, other valuation methods like the cost approach and discounted cash-flow (DCF) analysis can be used.
You can use the market approach yourself as a tool to determine an asset’s value and for better informed purchase decisions. Just remember that ample data is the key to its effectiveness.
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