http://www.valuadder.com/blog/2010/12/22/valuation-multiples-and-guideline-public-company-method/Overview of the Market ApproachBusiness valuation techniques are often characterized as being based on one of threeapproaches: the cost or asset approach, the income approach, and the market approach.Thus, the market approach undoubtedly is one of the standard methods/approaches ofvaluation. The market approach to business valuation is rooted in the economic principle ofcompetition: that is in a free market the supply and demand forces will drive the price ofbusiness assets to a certain equilibrium. Buyers would not pay more for the business, and thesellers will not accept less, than the price of a comparable business enterprise. This methodgenerally involves finding a representative multiple of value to a financial measure from a setof guideline (or peer or comparable) companies and applying that multiple to the financialmeasure of the company being valued.While there are no definitive guidelines on how to implement the market approach, thegenerally accepted series of steps can be listed as follows: first, the appraiser selects publiclytraded companies that he or she believes are similar in nature to the company being valued.In addition to selecting companies, the appraiser may also examine transactions in which acompany was purchased. Next, the appraiser selects relevant financial measures for thereference or guideline companies, such as revenues, earnings, or EBITDA. Then he/shefinds the multiple for each financial measure (i.e., the ratio of company value to the level ofthe financial measure for that company) for each guideline company. This process gives theappraiser a dataset of multiples, from which he/she can select a representative multiple, suchas the mean, median or any other reasonable statistical measure of central tendency of theguideline companies’ multiples.The appraiser then takes this representative multiple and applies it to the financial measureof the company being valued. If necessary, he/she adjusts that financial measure to accountfor extraordinary events. Finally, the appraiser considers whether any premiums ordiscounts, such as control premiums or discounts for lack of marketability, are warranted.
The Selection of Guideline Companies or TransactionsAs discussed above, the selection of guideline companies or transactions is often consideredthe first step in a market approach to valuation. In practice, the guideline companies aregenerally chosen by an appraiser using his or her knowledge of the company to be valued,any knowledge they have about the industry, and a great deal of subjective decision-making.For this purpose, usually valuators define guideline public companies as companies similar tothe subject company that trade freely in the public market on a daily basis—with similaritymeasured by comparable nature of the operations and comparable key financialcharacteristics. As a publicly traded company, the guideline company provides a value basedon active daily trading. Combining this pricing objectivity with the regulatory reportingrequirements and analytical information required of publicly traded companies, muchinformation can be known about a public company. If it can be determined that the subjectcompany is comparable, an argument can be constructed asserting that the guideline publiccompany’s daily trading price provides a reasonable basis for an opinion of value for thesubject company.This method entails a comparison of the subject company to publicly traded companies. Thecomparison is generally based on published data regarding the public companies’ stock priceand earnings, sales, or revenues, which is expressed as a fraction known as a “multiple.” Ifthe guideline public companies are sufficiently similar to each other and the subject companyto permit a meaningful comparison, then their multiples should be similar. However, inpractice such is not the case to be found. The public companies identified for comparisonpurposes should be near similar if not identical to the subject company in terms of industry,product lines, market, growth, margins and risk.Thus, the underlying objective of the guideline public company method is to derive multiplesto apply to the fundamental financial variables of the subject company. These fundamentalfinancial variables may be either balance sheet amounts or operating variables derived fromincome statements. Based on the comparative analysis between the guideline and subjectcompany, as well as site visits, management interviews, and the nature of the industry, thevaluator chooses the valuation multiples to rely on.
There are, however, fundamental differences between publicly traded and privately ownedcompanies. These differences are frequently too significant to allow for the properapplication of this methodology. Four of the most significant differences are: • Public stock prices are marketable, minority ownership interests. The share price reflects the value to a minority interest owner who exercises no control over the company’s operations. By contrast, many small businesses are wholly owned and controlled by a small number of investors. A single investor can exert significant control over the company’s operations. • Public companies are run by boards of directors and professional managers. Corporate objectives are clearly stated and designed to maximize shareholder value. By contrast, a family owned business may have a narrower corporate objective to minimize taxes or maintain key supplier or customer relationships. • Public companies typically have better access to capital allowing for maximization of growth potential and diversification opportunities. A small business without similar access to capital may not be able to achieve the same growth and diversification opportunities. • Public companies maintain detailed information systems to document goals, directions, and expectations. Detailed budgets and strategic plans are prepared for the next one, five, and ten years. A small business may have a one-year operating budget and a “wish list” capital budget. Comparing the public company’s historical and projected results to the subject company’s historical and projected results may not be possible due to lack of subject company information.Frequently, valuator experience and professional judgment can be applied to reconcile thesedifferences. Discussions with management can lead to mining valuable data necessary toestablish the subject company’s comparability to the public company. This effort to establishcomparability will allow the public company to serve as a guide in determining the subjectcompany’s value.However, the difficulty lies in identifying public companies that are sufficiently comparableto the subject company for this purpose. Also, as for a private company, the equity is less
liquid (in other words its stocks are less easy to buy or sell) than for a public company, itsvalue is considered to be slightly lower than such a market-based valuation would give.The Selection of MultiplesOnce the selection of the guideline companies or transactions is made, appraisers often nextturn to the selection of the relevant financial measures for computing multiples.This method takes into account the traded or transaction value of comparable companies inthe industry and benchmarks it against certain parameters, like earnings, sales, etc. Two ofsuch commonly used parameters are:· Earnings before Interest, Taxes, Depreciation & Amortizations (EBITDA).· Sales/RevenuesAlthough the Market Multiples method captures most value elements of a business, it isbased on the past/current transaction or traded values and does not reflect the possiblechanges in future of the trend of cash flows being generated by a business, neither takes intoaccount the time value of money adequately. At the same time it is a reflection of the currentview of the market and hence is considered as a useful rule of thumb, providingreasonableness checks to valuations arrived at from other approaches.There is often little discussion of the process for selecting the financial measures, and someor all of the usual suspects—revenue, earnings, and EBITDA—tend to appear in mostvaluations. Once the financial measures and the representative multiples are selected,appraisers typically derive valuations for each of those measures.For example, there may be an estimate of value based on revenue multiples, one based onearnings multiples, and one based on EBITDA multiples. The final valuation conclusion isoften drawn by examining the individual valuations, either taken as a range or, with the
selection of a central measure of those individual valuations (e.g., the mean or the median, ora weighted average), as the point estimate of the valuation.Selecting the Representative Multiple: Potential Problems withMaking Subjective AdjustmentsAnother issue that arises in the selection of representative multiples is what to do when theappraiser wishes to depart from some measure, such as the mean or median, of the “center”of the distribution of guideline company multiples. This is possible when an appraiserbelieves that a private company should be valued at a discount to the measures of centraltendency of a selected guideline group.One way to accomplish this task would be to select a statistical measure other than themedian as the base multiple. For example, an appraiser might, based on comparisons ofrevenues, growth, margins, leverage, or other factors, conclude that a private companyshould most appropriately be compared with a specific portion of the entire guideline group,for example, the lower half or the upper half of the group’s multiples, rather than the entiregroup.Now, because the representative multiple is derived from the bottom half of the multiples itwould result in a lower valuation than taking the median multiple, there should be a goodjustification for ignoring half the data. This also begs the question of why the appraiser isfocused on the bottom 50% of the multiples, as opposed to the bottom 75% or the bottom25%.Ultimately, in this case how far the appraisal will be pushed down depends on how much orhow little of the bottom of the set of guideline companies the appraiser uses in his or hercalculation of the representative multiple.
In response to the concerns discussed above regarding what financial measures to examine,one could use accepted statistical measures to see if the financial and other measures such asrevenues, growth, margins, or leverage do affect multiples in the guideline group. If so, thenan objective, statistically based adjustment could be made to the representative multiple,based on the measures of those characteristics in the company to be valued. This type ofprocedure would considerably reduce the subjectivity of the adjustment, and because itwould be performed under the controlling standards of a statistical analysis, it would yieldpotential error rates.