Selecting
Comparable Companies/Transactions
Many appraisers prefer the guideline company method because of the quantity and
quality of data available about the selected company or companies. Some appraisers will review hundreds of
companies searching for the one most comparable to the subject company. This, however, is also the problem. We are lured by the data to over rely on one
or a few comparable companies.
It is impossible to know all of the factors contributing to one company’s value as of a given date by reviewing its financial data. Circumstances involving key personnel, large customers, proprietary technology, and the condition of equipment all may have influenced the share price or transaction value. Was the transaction hostile, or for the benefit of upper management? Did the transaction incorporate synergistic value which allowed the buyer to pay a premium to fair market value? Perhaps the most significant question would be: what were the short and long term growth rates of earnings expected by the investors? Far too many factors are unknown to pin an estimate of value to a single comparable. Valuing a company is not like valuing a residence or a piece of real estate. We can’t just walk through the place and have a look at the kitchen floor.
It is impossible to know all of the factors contributing to one company’s value as of a given date by reviewing its financial data. Circumstances involving key personnel, large customers, proprietary technology, and the condition of equipment all may have influenced the share price or transaction value. Was the transaction hostile, or for the benefit of upper management? Did the transaction incorporate synergistic value which allowed the buyer to pay a premium to fair market value? Perhaps the most significant question would be: what were the short and long term growth rates of earnings expected by the investors? Far too many factors are unknown to pin an estimate of value to a single comparable. Valuing a company is not like valuing a residence or a piece of real estate. We can’t just walk through the place and have a look at the kitchen floor.
The
risk of arriving at an erroneous conclusion of value (or, a highly erroneous
conclusion, given there is no ‘right answer’ in valuation work) is increased
due to information affecting transactions that is unknown to the appraiser. Therefore, the probability of unknown
information skewing an estimate of value derived from the Market Approach
increases as the number of companies compared to (‘the group’ of comparable
companies) decreases. The unknown
factors present in individual companies are diminished or ‘washed-out’ as the
size of the group increases, just as a diversified portfolio of securities
reduces the unsystematic risk associated with each security in that portfolio. This principle is true when applying either
the guideline company method or the transactional data method.
We
cannot claim to know all factors pertaining to an individual company, but we
can reasonably assess the conditions present in an average company given the
industry. We can more reliably estimate
the expected growth rate of earnings of an average company in an industry than
we can estimate the expectations of investors for a specific company when
limited information about that company is available. Today, due to expanding databases, we can
select a large group of companies with many factors similar to our subject
company; industry, size, profitability, etc.
Ten
to twenty companies is a sufficient size to substantially reduce the risk of an
individual transaction skewing the result.
It should be comprised of the most comparable companies identifiable. The subset of companies should be limited to
those in a reasonable size range and in a similar profitability percentage as
your subject company. Transaction date
is less significant than industrial similarity and size. According to Ibbotson’s Stocks, Bonds,
Bills, & Inflation, historic equity returns do not indicate clear
patterns or trends over their 80+ year period of data collected, and are better
characterized as a ‘random walk’ from year to year. For this reason, date range does not need to be
limited to transactions within a few years of the valuation date. Depending on the industry, ten years is a
reasonable maximum. Industry conditions
may change substantially in more than a decade.
Those changes could impact investors’ long-term perceptions of risk for
that industry.
Geographic
limitations should be applied judiciously based on the nature of the subject
company. If a company’s customers,
suppliers, and competitors are nation-wide, then geographic limitations may not
have an impact on the operation of the business. Unnecessarily restricting a search to
a geographic region could limit the number of companies in the resulting sample. This may cause the acceptance of a broader criterion of search characteristics (thereby
reducing the similarity of the comparable companies in your group to your
subject company) to achieve a reasonable group size.
Using the
Data
Many
experts will calculate key ratios or multiples (Price to Sales, Price to
Earnings, Price to Gross Margin) for each comparable company, and find the medians
and means of those ratios. Medians are
often preferred to means because medians are not skewed by outliers. Means are also useful because they allow for
the calculation of the average deviation percentage of the mean. This is a useful measure of the dispersion of
the data in the group.
The
less divergent the data is within the group, the more consistent and reliable
the median or mean produced. An average
deviation percentage less than 20% indicates highly consistent data, and above
50% is highly divergent. The degree of
consistency in the data is a measure of how reliable the estimate of value
arrived at using the Market Approach will be, and may indicate to the appraiser
the degree to which they may rely upon this approach in their final conclusion
of value.
The median and mean ratios are applied to data from the subject company to arrive at a transactional value.
Problem: valuing the subject
company based on an earnings multiple derived from the group, effectively
applies the group’s expected growth rate of earnings to the subject company.
Applying
a median multiple to the subject company may be applicable if the company’s
performance is comparable to the median company in the group. If this technique is used, adjustments to the
resulting value should be made for capital structure and excess assets to
arrive at an equity value comparable to other approaches. If the subject company has a short or long
term expected growth rate that is substantially different from the group, then
applying the median Price to Operating Income ratio of the group to the
expected operating income of the subject company may not produce a reasonable
estimate of value.
A
comparison which allows the appraiser to factor out growth can be derived by
taking the analysis of the median/mean comparable company a step further. In the following example, median/mean data of
the group was used to calculate a discount rate applied to the median/mean
company earnings. This discount rate can
be directly compared to the discount rate determined in the Income Approach as
a measure of reasonableness for both approaches. The company can then be valued using the
income approach formulae, except the discount rate applied to the future
expected earnings would come from the median or mean company data of the
comparable group. This technique allows
for variable rates of increasing or declining earnings to be accounted for
within the Market Approach. This is not
a blending of approaches, because the discount rate arrived at in the Market
Approach is completely independent of any other approach.
Example:
In
the table below, two ‘companies’ are created from the group, one representing
the median of the group, and the other the mean. Acquisition debt was estimated at one third
the purchase price. The anticipated
growth rate of net cash flows was estimated to be 4%, showing little growth
above long term inflation. Cost of debt
was estimated to be 7%. Using the Single
Period Capitalization Method, the Return on Investment (ROI) of the median
company is 25.7%, and is 17.2% for the mean company.
Return on
Investment Analysis
|
||
Median
|
Mean
|
|
Sales
|
4,146,305
|
7,048,142
|
Operating Income
|
654,856
|
1,130,277
|
Price
|
2,831,142
|
7,601,103
|
Price/Sales
|
0.68
|
1.08
|
Op Inc/Sales
|
15.8%
|
16.0%
|
Price/Op Inc
|
4.32
|
6.72
|
Est Aquisition Debt
|
934,277
|
2,508,364
|
Estimated Growth Rate
|
4.0%
|
4.0%
|
Estimated Cost of Debt
|
7.0%
|
7.0%
|
ROI
|
25.7%
|
17.2%
|
Given
the large range in size of the companies in the group, the largest companies
can have a significant impact on the group mean (company #18’s purchase price
is larger than the total of companies #1-12).
Further, the largest three companies’ ratios are all substantially
higher than the group averages. For
these reasons, the median company is a better representation of the group
overall.
Based
on the estimated return on investment of the median company in the 18 company
group of 25.7%, the 28.23% required return on investment for equity capital in
XYZ, Co. stock derived from the Income Approach appears to be a reasonable
basis for valuing earnings.
Brian
Murray CPA/ABV, CVA specializes in business
valuations and merger and acquisition consulting, and has served as an expert
witness in court. Please call (920)
225-6436 to find out more or visit our website www.murrayrobertscpa.com, and click
on the BUSINESS VALUATION link. Go to www.mycompanyvalue.com now for a fast and affordable business valuation report prepared by Brian Murray.
