Financial valuation Applications and Models phần 3 pdf

SOURCES AND CHARACTERISTICS OF GUIDELINE COMPANY DATA Guideline Company Transactions Guideline company transactions refers to acquisitions and sales of entire companies,divisions or lar

Market Approach

OVERVIEW

The idea behind the market approach is that the value of a business (often a small,privately held firm) can be determined by reference to “reasonably comparableguideline companies” (sometimes called “comparables” or “comps”), for which val-ues are known The values may be known because these companies are publiclytraded or because they were recently sold and the terms of the transaction were dis-closed While data sources that provide financial and other information aboutguideline companies in a particular industry are useful for understanding industrynorms, they are useful for valuing businesses only if the underlying values of thebusinesses are known

The market approach is the most common approach employed by real estateappraisers Real estate appraisers, particularly those who specialize in residentialreal estate, are fortunate in that they generally have tens or even hundreds of compsfrom which to choose For a business valuation professional, a large set of compsmay be half a dozen

Questions to Consider

What does “comparable” mean? Does it imply being in the same industry as the

subject? How important is size, and what measurement of size is relevant: sales,profits, assets, market capitalization? Is location a significant factor? How muchweight should be given to financial ratios (i.e., profit margins, current ratios, etc.) inthe selection of guideline companies? What about business and financial risks?

What are the key value indicators? What do buyers of these kinds of businesses

look at when determining what they will pay? On what types of factors do investors

in publicly traded companies focus: revenues, income, cash flow, number of clicks,

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How much weight should be placed on the market approach in the overall ation? The market approach is often one of several approaches used in a valuation

valu-analysis The valuation analyst must decide how much importance the value derivedfrom the market approach will have in the overall assessment of value This judgmentnormally is based on the number of guideline companies and the quantity and quality

of the data Sometimes the value from the market approach might be used simply as asanity check on the other values, and is not explicitly included in the final assessment.Quantitative and Qualitative Factors

As with other valuation approaches, the market approach does not exempt the uation analyst from having to exercise professional judgment The use of guidelinecompanies is a starting point in that they provide analysts with some objective,quantitative guidance; these value indications must, however, be tempered with con-sideration of qualitative factors, such as product quality, depth and breadth of man-agement, and employee turnover—factors that can be ascertained only from a solidunderstanding of the subject company and the experience of the business appraiser.Market Approach Is Forward Looking

val-Some people contend that the market approach, unlike other valuation approaches,

is not forward looking (e.g., forecasts) This is absolutely incorrect The value of abusiness is not a function of how it performed last year or the year before; rather it

is a function of its perceived future prospects Historical balance sheet and incomestatements, from which many of the ratios used to value companies have been devel-oped, can help tell where a business has been More important from a valuation per-spective, they provide the necessary foundations from which forecasts can bedeveloped Yet these are only some of the many pieces of information investors con-sider when establishing a price For example, biotechnology start-ups, which mayhave no sales and negative earnings, can have positive market values simply becauseinvestors believe that firms will show positive earnings and cash flows in the future

TYPE OF VALUE OBTAINED

The value obtained using the market approach is a function of the type of guidelinecompany information used When sales transactions are the basis of the value, thisvalue generally represents a controlling, nonmarketable value It is controllingbecause it is based on acquisitions of entire companies, and it is relatively nonmar-ketable because the transactions represent sales of private entities, for which no

The prices paid for businesses and business interests reflect investorexpectations Consequently, any valuation methods that use stock orsales prices of businesses, including the market approach, must neces-sarily be prospective in nature

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immediate and ready market exists (as compared to the liquidity of public stocks).However, it is marketable relative to how long it takes to sell the company as com-pared to a peer group of transactions The value obtained using publicly tradedcompanies often is considered a noncontrolling marketable value It is noncontrol-ling because most of the trades are of small, minority blocks of stock,1 and it ismarketable because the stocks of publicly traded companies can be bought and soldquickly without significant transaction costs (relative to what is involved in the sale

of a private company)

The value indications, however, may be different from those given above if, forexample, there has been some modification to the subject company’s financial infor-mation These issues will be discussed in more detail later

ADVANTAGES AND DISADVANTAGES OF THE

MARKET APPROACH

As with any valuation approach, the market approach has its advantages and advantages, whether perceived or actual

dis-Advantages

• It is fairly simple to understand Companies with similar product, geographic,

and/or business risk and/or financial characteristics should have similar pricingcharacteristics People outside of business can understand this logic

• It uses actual data The estimates of value are based on actual stock prices or

transaction prices, not estimates based on a number of assumptions or judgments

• It is relatively simple to apply The income approach requires the creation of a

mathematical model The market approach derives estimates of value from tively simple financial ratios, drawn from a group of similar companies Themost complicated mathematics involved is multiplication

rela-• It includes the value of all of a business’s operating assets The income approach

also has this advantage Using the asset approach, all of a business’s assets and bilities must be identified and valued separately—both tangible and intangibleassets and liabilities Many of the intangible assets may not appear on the balancesheet (e.g., customer lists, trade names, and goodwill) This is one of the reasons theasset approach is often not used to value ongoing businesses, but rather businesses

lia-on a liquidatilia-on basis, where the value of these intangible assets is small or zero

The values derived from both the market and income approachesimplicitly include all operating assets, both tangible and intangible

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1 Analysts are not in agreement on this point Some contend that when public guideline tiples are applied to closely held companies, the resulting value does not only represent a minority position, since many public companies are run very efficiently and a control buyer would not pay any more for the business unless he or she could realize synergies; thus minor- ity and control values are equal.

mul-• It does not rely on explicit forecasts Sometimes an Achilles’ heel of the income

approach is the set of assumptions used in developing the forecasted cash flows.The market approach does not require as many assumptions

Disadvantages

• No good guideline companies exist This may be the biggest reason the approach

is not used in a valuation; the analyst may not be able to find guideline nies that are sufficiently similar to the subject Some companies are so unusual

compa-or so diversified that there are no other similar companies

• Most of the important assumptions are hidden Among the most important

assumptions in a guideline price multiple is the company’s expected growth insales or earnings

Unlike in the income approach, where the short-term and perpetual growth ratesare listed as assumptions, there is no explicit assumption (in the multiple) aboutthe subject company’s growth Consequently, the implicit subject companygrowth will be a function of the growth rates built into the prices of the guide-line companies, on which the value of the subject is based Other importantassumptions such as risk and margins, are not explicitly given

• It is not as flexible or adaptable as other approaches Unlike the income

approach, in the market approach it is sometimes difficult to include uniqueoperating characteristics of the firm in the value it produces For example, a shift-ing product mix, resulting in higher future margins, may not be easily incorpo-rated into a market approach analysis because there may be no other guidelinecompany whose product mix is expected to change in a similar fashion.Likewise, synergies cannot be easily factored directly into the analysis To esti-mate the value of these two types of situations, either a combination of the mar-ket and income approaches is necessary, or the analyst will have to useprofessional judgment to adjust the value outside of the parameters suggested bythe guideline companies Furthermore, the market approach typically cannot beused to value a number of unusual or intangible assets (e.g., customer lists, mort-gage servicing rights, and noncompete agreements)

BASIC IMPLEMENTATION

As discussed earlier, one of the advantages to the market approach is the apparentsimplicity in implementing it At its simplest, it requires only multiplication and per-haps some subtraction, depending on the multiple selected The basic format is:

Implicit in the prices of publicly traded companies and transactions issome assumption about growth Generally, the higher the expectedgrowth, the higher the value, all else being equal

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PriceValueSubject
[( _) ParameterSubject] DebtSubject*

Parameter comps

*Invested Capital Multiples

“Parameter” might be sales, net income, book value, and the like ThePrice/Parameter multiple is the appropriate pricing multiple based on that parame-ter (e.g., price/sales, price/net income, price/book value) and taken from the guide-line companies In some cases (invested capital multiples) the debt of the subjectcompany may have to be subtracted

SOURCES AND CHARACTERISTICS OF GUIDELINE

COMPANY DATA

Guideline Company Transactions

Guideline company transactions refers to acquisitions and sales of entire companies,divisions or large blocks of stock of either private or publicly traded firms

INFORMATION SOURCES

A number of publications collect and disseminate information on transactions.Most publications make their databases accessible on the Internet for a fee Amongthe most widely used are:

Guideline company information can be drawn from two distinct pools

1 Guideline company transactions

2 Guideline publicly traded companies

Understanding the value implications of using these different types ofdata is crucial in properly applying the market approach

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actions, with a median selling price of $115,000 The median revenue of the panies included was $325,000.2

com-In 2001, Pratt’s Stats™ included over 3,400 transactions The companies

cov-ered tend to be considerably larger, with a median revenue of $5 million and amedian selling price of $6.4 million There were 391 transactions that had a saledate within the last 12 months These companies had median revenue of $1.4 mil-lion and net income of $18,000 The median equity/net income multiple was 8.8,but the range was very large The information provided for each transaction is muchmore detailed than it is for either the BIZCOMPS®or IBA databases

The Done Deals and Mergerstat data sets generally include transactions where

one of the companies is/was publicly traded (Pratt’s Stats™ also include some

pub-licly traded transactions.) As a consequence, readily available financial statements(8-Ks or 10-Ks) may be used to find additional information about these transac-tions, if needed

Done Deals had approximately 5,000 transactions as of October 2001 Themedian sales price for the latest 12 months’ transactions was about $14.5 million,implying a median price to earnings multiple of 18.3 As with the other databasescovering actual transactions, the range of observations is very large

ADVANTAGES AND DISADVANTAGES OF THE GUIDELINE

COMPANY TRANSACTION METHOD

Guideline company transaction information can be useful in the case of a plated sale or purchase, or where the ownership characteristics of the subjectmatches those of these transactions—typically controlling and nonmarketable (thelatter characteristic would not necessarily be true for the publicly traded companytransactions, where a publicly traded company was acquired)

contem-The application of these data to the subject company is complex because of thedifficulty determining whether a transaction is truly comparable given the limitedinformation available in the database This is one of the major disadvantages ofusing guideline company transaction information

Advantages and Disadvantages of the Guideline Company Transaction Method 189

2Shannon Pratt’s Business Valuation Update, Vol 7, No 8 (August 2001), p 8.

When using the market approach to value a very small business, theguideline company transaction method is usually a better method thanguideline publicly traded company analysis Comparable transactioninformation is often available for very small businesses, but even thesmallest guideline publicly traded company may be vastly larger thanthe subject

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Some examples of information difficultes are as follows: Were there anyexpected synergies in the price paid for a particular business, or was the buyer afinancial buyer? Was there a noncompete agreement, employment contract, prom-ises of perquisites, terms, or other aspects to the transaction that would affect theactual price paid for the business? While some databases contain this type ofinformation, it may not be sufficiently detailed to compute a “true” purchaseprice.

PUBLICLY TRADED COMPANIES

Publicly traded companies are companies whose securities are traded on any of themajor exchanges: New York Stock Exchange (NYSE), American Stock Exchange(AMEX), or National Association of Securities Dealers Automated QuotationSystem (NASDAQ) As currently more than 10,000 such companies exist, they pro-vide a rich source of information for valuations

Information Sources for Financial Statement Data of

Publicly Traded Companies

Publicly traded companies are required to file their financial statements cally with the Security and Exchange Commission (SEC) These filings, made underthe Electronic Data Gathering, Analysis, and Retrieval (EDGAR) program are pub-

electroni-lic information and are available on the SEC website at www.sec.gov.

Edgar documents can also be obtained from a number of commercial vendors,who add value by allowing the user to extract selected items (i.e., the balance sheet,income statement, etc.) or to search all filings for those meeting certain criteria Inaddition, vendors put the data for most or all publicly traded companies in a stan-dardized format A partial list of those vendors who reformat the data into stan-dardized formats is:

The lack of detailed information on comparable transactions is themajor disadvantage of this approach It is difficult to know the struc-ture of the transactions or the motivation of the buyer or seller

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Detailed financial statements of the acquired company are usually notavailable, so it is impossible to make certain adjustments to the dataunderlying the pricing multiples, assuming such adjustments arenecessary

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stan-Standardization of Data

Standardization of the data in the publicly traded company’s financial statements isbeneficial for the analyst because most financial concepts are uniform across allcompanies One of the trade-offs of data standardization across companies is theloss of detail For example, operating profit for IBM is composed of the same sub-accounts as it is for Dell; however, the detail of what is in these subaccounts is usu-ally not available in these databases

In some cases, the data vendor must make judgments about how to computethe numbers to present certain concepts These may not be the same judgments theanalyst would make if presented with the same information Last, because parame-ter definitions differ across databases, one data set is often used for all portions ofthe analysis to lessen the likelihood of glaring inconsistencies

Restatement of Data

Another issue to consider when using a standardized, publicly traded company cial statement database is how the restatements are treated The financial statementsprovided by Compustat, OneSource, and Market Guide are restated; restated financialstatements replace the originally issued ones Mergent and Disclosure provide the state-ments as they were originally issued, without any restatements Restated financials are

The valuation analyst may have to consult with the publicly tradedcompanies’ filings with the SEC for the underlying detail The amounts

in these electronic databases are good starting points, but the data mayhave to be adjusted to consistently reflect the financial position and per-formance across the companies analyzed

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important when the valuation date is current and comparisons are being made acrosstime for each of the guideline companies They can be problematic, however, if the val-uation date is in the past and financials known as of that date are required.

Periodicity of Data

Finally, the dates in these financial statement databases are a function of the panies’ reporting periods and how quickly they release their financial results afterthe financial reporting period The latest quarter, the latest 12 months, or the latestfiscal year may represent different time periods for any two companies For exam-ple, Company A’s latest available quarter might end on February 28, 2002, whileCompany B’s might be as of November 20, 2001 If the analyst were to compareresults for the latest available quarters, in this case, he or she would actually be com-paring data three months apart Finally, there is a lag time between when the finan-cial statements are released (in 10-K or 10-Q SEC filings) and when they areupdated in these data sets

com-INFORMATION SOURCES FOR INDUSTRY “COMPS”

Other vendors provide information that can be useful in identifying publicly tradedcompanies in the same industry as the subject A partial list of such vendors includes:

• Hoover’s Online

• Ibbotson Associates’ Cost of Capital Yearbook

• PricewaterhouseCooper’s EdgarScan™

Hoover’s provides a list of companies that it considers to be similar to one

another The Cost of Capital Yearbook has a list of pure-play companies by SIC

code in its appendix.3EdgarScan™ lists companies within SIC codes

STOCK PRICES AND NUMBERS OF SHARES OUTSTANDING

Sources for stock prices are generally different from those for financial ment data The main reason for this is that the analyst usually relies on the stockprices for the guideline companies on or close to the valuation date, whereas thefinancial information used might be months prior to the valuation date.4

state-The number of shares used to compute the market value of equity for guidelinecompanies (and for the subject company) should be the number of common sharesoutstanding net of any Treasury shares on a date nearest the valuation date.Therefore, information on number of shares outstanding should almost always betaken directly from one of the publicly traded company’s filings, since the reportingdate for the number of shares outstanding may be closer to the valuation date than

it is to the company’s quarter or year end.5

3 Ibbotson Associates considers a pure-play company to be one for which 75 percent of its sales fall within a particular one-, two-, three- or four-digit SIC code.

4 This difference in dates is not a problem from a valuation perspective The market only has this “old” financial data when it prices companies; therefore, the prices do reflect the infor- mation available at the time.

5 The first page of the 10-K or 10-Q has the number of outstanding shares outstanding ally net of Treasury shares) as of a later date than the quarter or year end This later date may

(usu-be closer to the valuation date.

ADVANTAGES/DISADVANTAGES OF PUBLIC COMPANY DATA

Because of disclosure laws, the universe of publicly traded companies provides awealth of information on a very large scale (approximately 10,000 public compa-nies from which to draw information) This means:

• the availability of larger potential samples than those from transaction data

• readily available, detailed financial statement and pricing data

• fairly consistent data across companies (i.e., in accordance with GAAP)

• accurate depictions of the financial condition of the firms

CHARACTERISTICS OF PUBLICLY TRADED COMPANIES

Exhibit 6.1 provides various summary measures for publicly traded companies,demonstrating the wide variety of companies from which to draw data.6

Note the small size of most publicly traded companies In particular, the median(the halfway point) is $90 million in sales; this means that one-half of publiclytraded companies have sales of less than $90 million However, many of these arenot actively traded

Exhibit 6.2 shows the distribution of public companies by size and broadindustry classifications

With the exception of those divisions where there are few companies in total (Aand C) and division H, there are reasonably large groups of companies of all sizes,including the “$10 million and under” category

6 This data was obtained from OneSource and represent over 7,000 U.S companies, with sales and market capitalization of at least $100,000 for the latest 12 months Mutual funds and certain holding companies are excluded from this group The data are the most recent available at the beginning of the fourth quarter of 2001.

16 percent of all publicly held companies had sales of $10 million orless in the period studied

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Some analysts believe that publicly traded companies are much toolarge to be used as comps in many situations While this may be truefor the smallest of subject companies, such as mom-and-pop opera-tions, small professional practices, or sole proprietorships, there is usu-ally enough size variation among publicly traded companies that theyshould be considered for most other valuations

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Exhibit 6.1 Summary Measures for Publicly Traded Companies’ Sales

These divisions, as taken from the 1987 Standard Industrial Classification Manual, are:

A Agriculture, forestry, and fishing

The four-digit SIC codes with the largest total market capitalizations are shown

As shown in Exhibit 6.7, median P/E ratios appear to be highest for servicecompanies, at 20, with the remaining industries, except for mining, hovering inthe mid-teens The number of companies included in A and C may be too small

to have high confidence in their medians Of course, the ranges of P/E multiples,which are not shown here, is very large for each industry group Furthermore, therelationships shown here will almost certainly change as economic conditionschange

The median asset size is also surprisingly small at $161 million, with

13 percent of all publicly traded companies having assets of $10 lion or less

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Median equity market capitalization (the total market value of all mon equity) is only $62 million One-quarter of all publicly tradedcompanies have market capitalizations of $11 million or less

mar-Exhibit 6.4 Top 10 SIC Codes with Market Capitalization

7373 Computer Integrated Systems Design 161 37,661.6 0.0 4,445.9

1311 Crude Petroleum and Natural Gas 159 514,582.8 0.0 286,867.6

7375 Information Retrieval Services 153 172,728.8 0.0 148,839.6

3674 Semiconductors and Related Devices 147 438,129.9 0.6 167,930.9

4813 Telephone Communications,

except Radiotelephone 121 545,352.9 0.0 145,873.5

1311 Crude Petroleum and Natural Gas 159 514,582.8 0.0 286,867.6

6331 Fire, Marine, and Casualty Insurance 66 456,375.3 0.6 225,736.1

3674 Semiconductors and Related Devices 147 438,129.9 0.6 167,930.9

3511 Steam, Gas, and Hydraulic Turbines, etc 5 383,038.8 4.9 382,193.7

3571 Electronic Computers 46 340,360.3 0.1 176,878.8

5311 Department Stores 14 294,186.5 13.6 237,374.3

CHOOSING GUIDELINE COMPANIES

Understanding the Subject Company

The first step in performing any valuation analysis is to understand the business ofthe subject company This includes its main products, clients, markets served, modes

of distribution, and so forth Of equal importance is an understanding of its plans,expected growth, and other factors pertaining to the future Analysts also look atlines of business, and how important each of the business segments is to the overallcompany in terms of assets, sales, or profits

A common difficulty in analyzing larger companies is the presence of morethan one distinct line of business If the subject has one major line of business and

a number of other relatively small ones, the value of the overall company will bedriven by the major business segment If, however, the subject comprises numer-ous business segments that are relatively close in size, then its value is really that

of a composite company Finding comparable companies with similar businesslines can be tricky The valuation professional can try to find companies engaged

primarily in the main business of the subject—sometimes referred to as pure-playcompanies In the case where companies have multiple lines of business, it isunlikely that other companies could be found with the same business as the sub-ject Therefore, pure-play companies in all of the subject’s lines of business mayhave to be considered.8

Sources of Information about Potential Guideline Companies

Finding a good set of potential guideline companies is one of the most important yetmost time-consuming aspects of implementing the market approach There are sev-eral ways to identify such companies, but no single way that is best for allvaluations

Industry Classifications

Since there are so many publicly traded companies from which to choose, the lyst must develop some way of quickly reducing the set of potential comparablecompanies One of the most common ways is to choose companies in the sameline(s) of business (or industry) as the subject Presumably these companies will beaffected by many of the same economic and business factors as the subject, and theirprices will reflect these influences This line-of-business criterion is just one way ofincorporating the subject company’s outlook as well as its business and financialrisks into its price Of course, other characteristics influence price However, similarbusiness lines is the characteristic that typically is used in the initial screening forpotential comparable companies

ana-A number of data providers categorize the companies on which they carryinformation by industry Some have developed their own industry categories; almostall, however, categorize potential companies or transactions by SIC or NAICScodes.9The advantage of categorizing potential companies or transactions by thesecodes is that they are widely used and more uniform than industry assignmentsmade by the vendors

There are several problems to be aware of when relying on a particular datavendor’s industry classification of potential guideline companies:

• Some companies (even relatively small ones) are diversified such that the sales

or profits in their listed industry are only a fraction of their overall business.These companies are not pure plays and, unless their mix of business is largelyidentical to the subject’s, they may not be appropriate for the guideline com-pany set

• While a potential guideline company may have most of its business in oneindustry, it may have been classified incorrectly This could be due to simple

8 Valuing a subject in this way may be more complicated than simply adding the values of the individual business segments To the extent that there is some diversification benefit from hav- ing the particular business mix of the subject, the overall value may be greater than the sum

of its parts This benefit is realized primarily in the reduction of overall business risk, times referred to as a “portfolio effect.”

some-9 As of this writing, the North American Industry Classification System (NAICS) is not in as wide use as the older Standard Industrial Classification system.

misclassification by the data provider One common situation involves fusing distribution with manufacturing For example, some companies thatare actually distributors are classified as manufacturers because the dataprovider has focused on the product being distributed rather than the com-pany’s activity.

con-• Different data providers may place the same company into different industryclassifications

Subject Company Management

The management of the subject company can be a good starting point to identifypotential guideline companies Often management knows its competition intimatelyand may be willing and able to supply “insider” financial and pricing information

on them It also may be useful to present the list of publicly traded companies in theindustry to the subject company’s management to obtain their input on which ofthese companies might be comparable

Other Sources

Professionals who work with the subject company (i.e., accountants and attorneys)and industry experts (who can be contacted through trade associations, commercial

Examining detailed business descriptions of the possible guideline panies is an essential step in the analysis Some data vendors providegood descriptions of a company’s business(es); however, they are nevermore detailed than the data found in a company’s 10-K filing

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One challenge involved with showing such a list to management is thatoften managers believe their company is “truly unique,” and thus, theyview none of the publicly traded companies as comparable It isunlikely that the market niche into which the subject company fitsreally appreciates some of the nuances that make the subject “trulyunique.” Unless these nuances result in prospects for the subject thatare substantially different from those of the potential guideline compa-nies, those companies usually can be used On the other end of thespectrum, management may insist that a particular publicly tradedcompany is comparable because they are a competitor But the divisionwhich offers a product or service similar to the subject company may

be just one of many larger lines of business

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banks, or brokerage firms) also can be good sources of information about the ject company and its competitors Industry publications or web sites can be goodsources of information about potential guideline companies.

sub-FINANCIAL AND OTHER INDICATORS

Much of the time spent in identifying comparable companies revolves around ing firms engaged in the same or similar line of business as the subject Other fac-tors, however, also should be considered in the initial identification process, whichare also intended to help identify potential guideline companies with similar futureprospects and business and financial risk characteristics

find-Size

While there have been no detailed studies to specifically identify size-relatedrisk factors, some of the more important ones might be:

• Lack of diversifications in products, customers or geographic areas

• Lack of depth in the management team

There are many issues to be considered if size will be used to establish rability In particular, the size measure to use is often a function of the industry inwhich the company operates For service businesses, total revenue is probably thebest measure of size For manufacturing concerns, size might best be captured in thelevel of total assets

compa-How close must guideline or subject sizes be to be comparable? This will be

a matter of judgment and, again, a function of the environment in which thecompany operates A $10 million company might not be a good guideline com-pany to use for a $500,000 business; however, it may work well for a $2 millioncompany

One of the most important indicators of comparability is size Size can

be expressed in terms of sales, total assets, or market capitalization.Numerous studies have indicated that, on average, smaller companieshave lower pricing multiples than larger companies The main reasonfor this is that smaller companies typically have more business andfinancial risk than large companies.10

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10 More risk means investors will require a higher rate of return on their investment; and the way to get this is by lowering the price.

Growth is another very important factor in comparability It is inextricably nected to value, since expected growth is imputed in the price of a stock While thisrelationship is difficult to observe since it is hard to find an “accurate” measure ofexpected long-term growth for any company (at least as the market perceives it atone point in time), the graph in Exhibit 6.8 shows an observation of this relation-ship for a date in October 2001.11

con-Exhibit 6.8 Relationship Between Expected Growth and P/E

This graph demonstrates a positive relationship between P/E multiple andexpected growth.12 The fact that this relationship is positive is illuminating giventhat this data represents companies from a variety of industries, of different sizes,and with other disparate characteristics

The relationship between historical growth shown in Exhibit 6.9, is not asstrong.13

Another observation that can be made from these graphs is how much more

important expected growth is in the determination of value than is historical

growth Fortunately, this is consistent with valuation theory

11All data are taken from Market Guide P/E is as computed by its authors and the

expected growth rate is based on a consensus of sell-side analysts for the next three to five years.

12 The slope of the line shown is statistically different from zero, with a T-statistic of more than 12, an R 2 of 13 percent and almost 2,000 degrees of freedom.

13 The T-statistic is about 5 on the slope and the R 2 is only 1 percent.

Other Factors

Profitability of the publicly traded companies also should be considered whenselecting guideline companies For example potential guideline companies withhigh gross margins may not be as comparable to a subject company with a lowgross margin

Another factor that can affect value is the length of time the business has beenoperating Generally, businesses with longer histories tend to have higher pricingmultiples than younger companies, because younger companies are generally morerisky than more established ones since their prospects are more uncertain

Actual 5-Year Sales Growth

suffi-in ussuffi-ing valuation ratios based on these prices

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SAMPLE SIZE MATTERS

A larger group of comparables will reduce the importance of any single guidelinecompany Since at least one company in any group may be anomalous, having alarger group reduces the effect of this potential anomaly Furthermore, companiesare complex No one- or two-guideline company(ies) can approximate all of thecharacteristics of a complex subject Having a larger group of comparables increasesthe likelihood that more of the subject’s characteristics can be captured

Even within groups of companies whose business descriptions are nearly tical to the subject’s there can be large variations in pricing measures In certaincases it may be better to choose guideline companies that are close to the subject insize, growth, and profitability but less related in terms of business description thancompanies that have very similar business descriptions but may differ substantially

iden-in terms of size, longevity, etc

COMPARABLE COMPANIES INFORMATION DATES

After identifying companies in similar lines of business, the analyst also must form a financial analysis of these companies to determine whether they are goodcomparables from a financial point of view To do this properly for valuation pur-poses, all information used must be as of the valuation date For example, if the val-uation date is June 30, 2002, all of the financial statement data, stock prices, andthe like is usually for a period ended no later than this date Gathering these datacan be tricky for older valuation dates, since many data vendors have only the mostcurrent data

per-BASIC FINANCIAL INDICATORS

Some financial measures that should be included in an analysis for both guidelineand subject companies include:

• Size Measures These include the magnitude of sales, profits, total assets, market

capitalization, and total invested capital Given how size may affect value, atleast one, if not all, of these should be included

• Historical Growth Rates Consider growth in sales, profits, assets, or equity The

time period over which to measure this growth is important and is discussedlater

Valuation analysts may have to choose between a very small group ofcompanies whose business descriptions are quite similar to that of thesubject or a larger group of companies, some of whose businessdescriptions are not as good a match

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• Activity Ratios Examples are the total assets and inventory turnover ratios.

Depending on the type of business being analyzed, other ratios also may beimportant

• Measures of Profitability and Cash Flow Consider the four most common

measures:

1 Earnings before interest, taxes, depreciation and amortization (EBITDA)

2 Earnings before interest and taxes (EBIT)

3 Net income

4 Cash flow

Using concepts such as EBIT and EBITDA can be useful because they can reflectthe economics of the business better than net income and cash flow, which are verymuch influenced by both the company’s tax planning and its choice of capitalstructure

• Profit Margins The level of profits is probably less important than the ratio of

profits relative to some base item—usually sales, assets, or equity

• Capital Structure It is essential to use some measures derived from the current

capital structure The most common measures are the values of outstanding totaldebt, preferred stock (if it exists), and the market value of common equity, sincebook equity generally has very little to do with how stock investors view theirrelative position with a company The ratio of debt to market value of equityshould be included since this represents the true leverage of the company

• Other Measures These will be a function of what is important in the industry in

which the subject company operates For example, value drivers for retailers areinventory turnover; for banks, loan/deposit ratios; and for hospitals, revenue perbed and length of stay

DISPLAYING THE INFORMATION

Once the key items have been chosen, the next step is to put the information into ausable format The goal should be to display these data in a way that makes com-parisons easy So that comparisons are meaningful, the concepts must be consistentacross companies Furthermore, the financial information for the subject companyshould be shown in a consistent format One of the advantages of getting the datafrom electronic providers is that they try to standardize concepts across companies.Exhibit 6.10 is an example of what such a presentation of standard financialindicators might look like for public companies

The debt number used should be its market value; however, on a tical basis, most analysts simply use the book value of the debt as aproxy for market value

prac-ValTip

Several things of note in this example of a guideline company analysis makeestablishing comparability easier.

• The income data are for the latest 12 months (LTM) (prior to the valuation data)and the balance sheet data are for the most recent quarter (prior to the valuationdate)

• A number of size measures are shown; however, only one or two are really essary to help establish comparability The others are used to develop valuationratios

nec-• The remaining measures are independent of size, making them meaningful tocompare across companies

• There are summary statistics for each data series In this case the 25th, Median,and 75th percentiles are shown.14Other summary measures that could be usedinclude different percentiles (such as the 10th and the 90th) as well as a simpleaverage of the companies and a composite of the companies

• Outliers could indicate an anomalous situation for an industry or company.These apparent anomalies should usually be analyzed because they may containimportant information about trends in an industry

• Profitability ratios are computed using both the most recent data and tion over the last five years

informa-• The last part of the table gives other operating ratios and indications of the ital structure

cap-Typical periods for which short-term and long-term ratios are computedinclude:

• Latest 12 months (LTM) prior to the valuation date

• Latest fiscal year prior to the valuation date

• Latest three to five years prior to the valuation date

• A complete business cycle

One of the problems with using either the latest 12 months’ or latest fiscalyear’s data is that results can be significantly affected by a one-time, nonrecurring

Using percentiles rather than simple averages or composites provides arange of values and protects the information from the effects of outliers.ValTip

14 The 25th percentile is the value below which are 25 percent of the values in the group For example, using the above information, 25 percent, or two, of the companies have latest returns on EBIT as a percent of sales of less than or equal to 5.9 percent The median is sim- ply the 50th percentile; half of the values for that concept are above the median and half are below.

Income Adjustments 209

event (e.g., a large but temporary increase in the price of raw materials that cannot

be passed on to customers) Computing ratios over a longer period of time, such asthree to five years, reduces the importance of these types of events However, sincethe focus of the valuation analysis is prospective, they should not be overemphasized

if they are not expected to recur To the extent that the company’s business is cal, a three- to five-year period may pick up only the upward or downward portion

cycli-of that cycle and give an incorrect indication cycli-of what is likely to happen in thefuture

Rarely are any of these measures given exclusively Usually data for multipleperiods are shown alongside one another In establishing comparability, longer-termmeasures are often as important as shorter-term measures, although long-termratios (e.g., pricing multiples based on average earnings over a three- or five-yearperiod) are sometimes given less weight

ADJUSTMENTS TO THE GUIDELINE AND

SUBJECT COMPANIES

Before actually comparing the companies, some adjustments to the data may have

to be made Publicly-traded companies tend to need fewer of these adjustments thanprivately held firms To the extent that there are certain accounting changes or non-recurring events reflected in the companies’ numbers, or the companies use differentaccounting methods, the financial data will need to be adjusted so all companyfinancial data is analyzed on a similar basis

INCOME ADJUSTMENTS

A number of adjustments may have to be made to the subject company’s incomestatement While not exhaustive, the following discussion introduces some of themore common adjustments

Nonoperating Income/Expense

Nonoperating income or expense items should be removed from the financial ments of the subject company because publicly traded guideline companies typicallywill not have a large number of nonoperating items, and their prices will not reflectthe risk related to them

state-When preparing an analysis of controlling guideline company tions, there is usually much less data available In particular, usuallythere are no data on which to compute growth rates or long-term mar-gins This lack of information might limit the confidence in the resultsobtained from this method

transac-ValTip

Nonoperating income or expenses can arise in several ways including ments in unrelated businesses and assets, and income on excess working capital.Probably the most accurate way to handle this is to subtract the income or expensefrom the overall income of the subject company, apply the appropriate ratios, andadd the value of the asset or liability that is giving rise to the nonoperating income

invest-or expense If the nonoperating income comes from marketable securities, this is avery simple process If it comes from real estate or another operating entity, a sepa-rate appraisal may have to be performed

Example: A privately held company manufactures electronic medical

instru-ments It has a significant amount of excess cash that it has invested in high-gradecorporate bonds The risk characteristics of the company’s main business are muchdifferent from those of the corporate bonds To apply pricing ratios derived fromguideline companies holding small amounts of excess cash to the overall income ofthe subject would misstate its value

Assumptions:

Nonoperating portfolio of high-grade corporate bonds = $10,000,000 (par andmarket)

Coupon rate of bonds = 5 percent

Company’s pretax income (excluding the interest payments on the bonds)

= $1,000,000

Guideline companies’ average pretax price-to-earnings ratio = 12

Value of Subject Including Bond Income of $500,000

Total pretax income $ 1,500,000

Price/Pretax Earnings _ 12

Value of Subject Excluding Nonoperating Bond Income

Total pretax income $ 1,000,000

 Price/Pretax Earnings _ 12

Value of Subject $22,000,000

These calculations show the substantial difference in values There should be

no doubt that the first of these is incorrect The required rate of return implied bythe valuation multiple is too high for the operating business and the nonoperatingassets (the low risk corporate bond); therefore, the first of these two calculationsunderstates the overall value of this company

Owners’ Compensation

It is not uncommon in small, privately held companies that owners receive pensation in excess of what their duties would command in larger, publicly tradedfirms or if they were employees This “excess” compensation is really not compen-sation; rather, it can be viewed as a return of or on capital In publicly traded com-

com-Balance Sheet Adjustments 211

panies, this return of or on capital comes in the form of a dividend or an increase inthe value of the stock, and the income-based stock multiples of publicly traded com-panies reflect this For the closely held company to be reported and analyzed on thesame basis as the publicly traded guideline companies, this “excess” compensationcan be removed from its costs and treated the same way it is in publicly traded com-panies The same theory holds if an owner’s compensation is less than what his orher duties would command in a publicly traded company; the additional compen-sation (needed to bring the owner’s pay up to a “market level”) could be added tothe subject company’s costs This concept applies to a controlling interest Manyvaluation professionals, when valuing a minority interest, do not make these com-pensation adjustments since the minority shareholder cannot change the compensa-tion policy in the company However, it is possible a minority shareholder could sue

to force a reduction of the controlling shareholders’ compensation

Of course, determining what is “excess” compensation can be difficult Salarysurveys can be used; yet many owners perform multiple duties, making direct com-parisons with managers of publicly traded companies difficult In addition, some of

an owner’s compensation may come in the form of perquisites whose values might

be difficult to quantify

Taxes

Another common difference between publicly traded companies and closely heldfirms is that many times the latter do not pay taxes at the corporate level becausethey are partnerships or S corporations This tax difference is reflected in net incomeand cash flow that appears higher than that of their tax-paying, publicly tradedcounterparts

There are two main schools of thought on how to adjust for this matter Oneschool holds that flow-through entities are worth more than taxpaying organiza-tions simply because there is more cash available to distribute to shareholders Theother school asserts that partnerships and Subchapter S corporations are not worthmore than otherwise similar C corporations because there is no market evidence toprove they have higher values Higher levels of distributable cash can be offset bythe tax burden on minority shareholders from income that may never be distributed

to them Valuation analysts in the latter group decrease the flow-through entity’sincome and cash flows for taxes before applying any value ratios See Chapters 23and 24 for a more detailed discussion of this issue

Nonrecurring Items

The issues associated with nonrecurring items are similar to those of nonoperatingitems, and they will need to be similarly eliminated from consideration This area islikely to affect publicly traded companies as well as privately held ones

BALANCE SHEET ADJUSTMENTS

Unlike the income statement, the balance sheet usually requires fewer adjustments.Since most valuation ratios are based on income or cash flows, these adjustmentsusually are less crucial to the overall value

Debt and Working Capital

Adjustments for debt and working capital are perhaps the most difficult and tant adjustments the analyst must make to the balance sheet Two issues must beaddressed here:

impor-1 Actual level of “long-term” debt

2 Whether the company has sufficient or excess working capital

Long-Term versus Short-Term Debt

The term “long-term” debt refers to debt that is part of the capital structure, that

is, the permanent long-term funding of the company What is listed as “long-termdebt” on the balance sheet may be only a small portion of this permanent funding.For a number of reasons, a business may choose short-term or floating rate debtrather than long-term, fixed-rate debt This may be a choice based on the company’sbelief that rates will remain stable or fall in the future Since short-term funding can

be cheaper than longer-term debt, it can save a company substantial money Or itmay be based on the company’s inability to obtain long-term funding Either way,this type of short-term debt is often treated as part of the capital structure

An indication that short-term debt is really part of the capital structure can beobtained from company management or by reviewing changes in short- and long-term debt over time For example, if long-term debt is being replaced by short-termdebt and the overall level of debt is not falling, then this new debt is probably long-term debt disguised as short-term funding If long-term assets (e.g., property, plant,and equipment) are increasing and this increase is being matched by an increase inshort-term debt, then this new debt probably is going to be permanent and should

be treated as such If working capital is negative or low relative to that of the line companies, this fact may indicate that some of the short-term debt is not beingused to support working capital needs and should be considered permanent funding.Excess versus Sufficient Working Capital

guide-The level of working capital can require adjustment as well Normally one assumesthat the publicly traded guideline companies do not have excessive levels of work-ing capital, since investors tend to frown on this However, it is not uncommon forprivately held companies to have high levels of cash, marketable securities, or othershort-term liquid investments

Concluding Remarks on Choosing Comparables 213

Income related to this excess can be eliminated from the subject company’sfinancial statements, and the market value of the assets can be added to the indica-tion of value obtained from applying the guideline company valuation multiples.For example, in the case of cash, there is very little income from it, but the excessamount must be added to the value of the subject company simply because theguideline company multiples may not anticipate that level of cash

In addition, the issue of working capital is intimately involved with that of term debt Because of this interdependence, it is often a difficult adjustment to make.While it would be better if there were true working capital “norms” to which the sub-ject company could be compared, this is often not the case As shown earlier, theranges of financial ratios for similar publicly traded companies are often wide Because

long-of this, the analyst will have to exercise judgment in making these adjustments.EFFECTS OF ADJUSTMENTS ON VALUE

Numerous analysts believe that adjusting excessive owners’ compensationdownward and then applying publicly traded company multiples to the resultingincome amounts gives a controlling, marketable value The obverse of this also jus-

tifies such an assertion That is, not making this type of adjustment, when there is

an issue of excess compensation, implies a minority position, since a minority holder cannot force a change in owner’s compensation The appraiser must usejudgment when making these types of adjustments and applying either transaction-based or public company–based multiples In some cases a discount or premiummay still be required

share-CONCLUDING REMARKS ON CHOOSING COMPARABLES

The process for choosing guideline companies can be summarized as:

• Using a variety of data sources, compile a list of companies in the same or lar industry as the subject company

simi-The analyst should be aware that making certain changes can changethe character of the resulting value—many times from a noncontrol to

a control value

ValTip

Excess working capital can be identified by comparing the workingcapital ratio of the subject to those of the guideline companies or bycomparisons to industry norms

ValTip

• Review the detailed business descriptions of these companies and eliminate thosethat are dissimilar to the business of the subject company.

• Eliminate companies whose financial characteristics are not similar to the ject Two of the most important characteristics are absolute size and growthpotential

sub-• Collect detailed financial information (both historical and prospective, if able) about each of the potential guideline companies, placing the data in a for-mat that is consistent across all companies, and include the same information forthe subject company

avail-• Make any necessary adjustments to the guideline companies and the subjectcompany

CALCULATING STANDARD PRICING MULTIPLES

A pricing multiple (also known as pricing ratio, valuation multiple, or valuationratio, among other terms) relates the value of a company to some balance sheet or,more often, income statement item It is a way of scaling values, allowing the valu-ation professional to use pricing information from companies of different sizes Forexample, as of October 2001, both Utek Corp (ticker: UTOB) and Exxon MobilCorporation (ticker: XON) had price/earnings ratios of around 15, but Exxon was40,000 times the size of Utek in terms of sales

Pricing multiples provide some insight into what investors are willing to pay for

a certain level of sales, income, and assets For example, a price/earnings multiple of

18 implies that investors are willing to pay 18 times earnings for the stock of thecompany Of course, this number incorporates some expectations about future earn-ings growth, along with a reasonable return on investment

While all pricing multiples have “price” in their numerators, “price” is notalways defined in the same way The price definition used depends on whether themarket value of shareholders’ equity (MVEq) or the market value of invested capi-tal (sometimes abbreviated MVIC) is used

EQUITY VERSUS INVESTED CAPITAL

Equity and invested capital are two different facets of the ownership of a company.The latter is sometimes called the business enterprise value, meaning that it repre-sents all claims on the cash or earnings of the business

The market value of equity is simply the number of all outstanding commonstock multiplied by its market price If there is more than one class of commonstock, equity is the sum of the values of all of the classes Preferred stock may be

The quality and quantity of the publicly traded company informationwill affect the confidence one places in the results from the guidelinepublic company method of the market approach

ValTip

Equity versus Invested Capital 215

added here as well.15MVIC is equal to the market value of equity plus the marketvalue of all interest-bearing debt that is part of the capital structure (however that

is determined)

One way to incorporate the market value of debt into MVIC is simply to useits book value This is usually accurate for short-term debt items; it may, however,result in some misstatements on longer-term items The market value of longer-termdebt may be of concern if it represents a significant portion of the capital structureand if current market interest rates on comparable debt (comparable in credit qual-ity, payment characteristics, and maturity) are significantly higher or lower than therate on the subject debt Where prices on the traded debt of publicly traded compa-nies cannot be easily obtained, they can be estimated using the information avail-able in the companies’ 10-Ks Nontraded debt also can be estimated using thisinformation

The value of preferred stock may or may not be included here, depending uponwhether it is included in equity Usually preferred stock is such a small part of a pub-lic company’s capital structure that its treatment is immaterial

If the purpose of the valuation is to determine a controlling interest value, thenMVIC may be the better measure of price since a controlling buyer is interested inthe entire business, irrespective of its capital structure For minority positions, themarket value of equity can be the price concept Of course, the choice between priceterms based on the purpose of the valuation is often a presentation issue; it is a sim-ple matter to convert MVIC to the MVEq and vice versa The more important rea-son an analyst has to choose between them is to reconcile the capital structures ofthe guideline companies and the subject

The choice of whether to use MVEq or MVIC is a function of both thepurpose of the valuation and the capital structures of the subject andguideline companies, and the analyst’s preference

Two common ways to express the capital structure are by using either debtdivided by MVEq or debt divided by MVIC If the capital structures of the guide-line companies and that of the subject are similar, then either measure of price can

be used If the capital structures are considerably different, using the valuation ratiobased on MVIC might be better

FINANCIAL STATEMENT MEASURES

The second part of the pricing multiple is the denominator, the financial statementparameter that scales the value of the company The four general groupings of val-uation ratios, include those based on:

1 Revenues

2 Profitability or cash flows

3 Book values

4 Some other measure

Some specific common measures include:

• Revenues

• Gross profit

• EBITDA

• EBIT

• Debt-free net income (net income plus after-tax interest expense)

• Debt-free cash flows (debt-free net income plus depreciation/amortization)

• Book value of equity

• Book value of invested capital (book value of equity plus debt)

• Tangible book value of invested capital (book value of equity, less intangibleassets, plus book value of debt)

is a prospective concept, containing the market’s best assessment of theprospects for the future

ValTip

Financial Statement Measures 217

ment–based multiples and the most recent observation prior to the valuation datefor the balance sheet–based multiples Often the presumption in using these recentvalues is that the near future will be similar to the current period If, however, thecompany’s performance has been volatile and this latest period is either especiallyhigh or low relative to what is expected, then a longer-term (three-, four-, or five-year) average might be appropriate It also may be appropriate to use a multiple ofnext year’s parameters, which are obtained from analyst forecasts

The analyst must choose those ratios that are appropriate for that type of ness being valued The advantage of using net income is that it is a very popularmeasure Most quoted price/earnings multiples are based on net income Equity ana-lysts, however, look beyond this widely available statistic A more useful version ofnet income is net income before extraordinary items; most investors recognize thatextraordinary income or expenses will not recur and price the stock accordingly.The advantages of using EBIT or EBITDA are that they more closely reflect theoperations of the business, and they exclude the nonoperating, financing (capitalstructure), and tax planning (and depreciation policies for EBITDA) aspects that arepart of net income If the capital structures, tax situations, and non-operating char-acteristics of the guideline companies and subject company were similar, then itwould probably make little difference whether EBIT, EBITDA, or net income wereused in the valuation multiple But because these things can vary widely amongcompanies, it is certainly important to consider these measures along with, or inmany situations, as a replacement for net income

busi-While it is often tempting to use the same set of multiples to value all nies, doing so is not consistent with the way investors make decisions There are anumber of sources of information on what appropriate multiples might be

compa-• Industry Investors within an industry tend to look at the same multiples when

making investment decisions and can give the analyst the best indication ofwhich value measures are most important Articles in trade journals and thefinancial press that discuss recent acquisitions often mention the types of multi-ples that investors rely upon For example, many acquisitions of manufacturersare discussed in terms of P/Es or price to some form of cash flows In bank acqui-sitions, price/book equity (sometimes referred to as market/book) is very impor-tant In service businesses, prices/sales may be important Hospitals sometimesare priced on a revenue-per-bed basis It is not unusual for an industry to havemore than one key valuation multiple

• Subject Company The appropriate multiples to use in the valuation analysis may

be dictated by the particular situation of the subject company For example, if thekey valuation multiple for the industry appears to be price to earnings (where

Overall, EBITDA and EBIT multiples tend to be frequently used acrossmany industries

ValTip

earnings are net income) and the subject company has not had and is notexpected to have positive earnings for the next year or two, valuing it using thestandard P/E multiple would result in a nonsensical (negative) value A betterchoice might be to use a different definition of earnings or a different valuationmeasure altogether Furthermore, if a reading of industry literature does not yieldgood information on how companies are usually valued, then the management

of the subject company may be a good source of guidance

• Rules of Thumb Most rules of thumb have been developed over time as a

result of actual transactions Rules of thumb are usually quoted as a multiple

of some financial measure such as 1.5 times operating cash flow or 2 times enues These measures are too broad to be of much use in valuing a company

rev-as there is no agreed upon definition for the financial merev-asures used, but theycan be helpful in two ways The financial measure used in the pricing defini-tion (e.g., operating cash flow) is an indicator of the measures that investorslook at so the analyst may include it in the calculation of the valuation ratios.Rules of thumb can also serve as a test of the reasonableness of the valuationconclusion If the Rule of Thumb in an industry is 2 times earnings and the val-uation conclusion is 12 times earnings, the analyst should try to reconcile thetwo measures

COMPUTATION OF MULTIPLES

The calculations of the various valuation multiples are relatively simple One takesthe price, which is either the market value of equity or of invested capital as of thevaluation date, and divides it by the appropriate financial statement parameter,computed over the appropriate time period:

PriceMultiple
_

ParameterOne approach is to calculate everything on a per-share basis first and then cal-culate the valuation ratios Alternatively, these ratios can be computed on a “gross”basis, using aggregate market values, since the number of shares is eliminated fromboth the numerator and denominator For example, price/earnings can be calculated

by dividing the price of a share of stock by the most recent earnings per share (theper-share approach) or by dividing the latest market value of equity by the last 12months’ earnings (the gross basis approach)

While rules of thumb seldom should be used as the sole way of valuing

a business, they can offer insight into the way investors view theindustry

ValTip

Dispersion of Pricing Multiples 219

MATCHING PRICE TO PARAMETER

Conventionally, “price” is matched to the appropriate parameter based on whichproviders of capital in the numerator will be paid with the monies given in thedenominator For example, in price/EBIT, price is MVIC, since the earnings beforeinterest payments and taxes will be paid to both the debt and equity holders Inprice/net income, price is the market value of equity only, since net income is afterinterest payments to debt holders and represents amounts potentially available toshareholders Any denominators that exclude interest (e.g., EBIT or EBITDA)should usually be matched with its corresponding numerator (e.g., MVIC)

MVIC is usually the numerator for:

• Revenues

• EBITDA

• EBIT

• Debt-free net income

• Debt-free cash flows

• Assets

• Tangible book value of invested capital

MVEq is usually paired with:

• Pretax income

• Net income

• Cash flow

• Book value of equity

Example: Exhibit 6.11 is the remainder of the example (Exhibit 6.10) shown

ear-lier, giving the market values of equity along with the pricing multiples

DISPERSION OF PRICING MULTIPLES

The coefficient of variation is a useful statistic for analyzing multiples It measuresthe dispersion of the data relative to its average value The higher the coefficient ofvariation, the larger the range of pricing multiples For example, in Exhibit 6.11,price/EBITDA, which ranges from 3.8 to 15.6, has a much lower coefficient of vari-ation than price/net income, with a low of 10.2 and a high of 112.2

The coefficient of variation is computed by dividing the standard deviation ofthe set of data by its average value The coefficient of variation can be used to com-

Negative valuation multiples, which usually arise from losses, are notmeaningful and should be ignored

ValTip

Applying the Valuation Multiples 221

pare the dispersions of a series of numbers, whether or not they are of similar nitudes In the table in Exhibit 6.11, the price/revenue multiples are much lowerthan the price/net income multiples, yet their coefficients of variation can be com-pared directly

mag-If the companies in the guideline group are viewed similarly by the market, thenthe key valuation indicator(s) used by the market to price their stocks also should

be similar The coefficient of variation can help the analyst to find this (these) keyvaluation indicator(s) In the table in Exhibit 6.11, the companies’ price/sales,price/EBIT, and price/EBITDA are fairly close to one another and have a lower coef-ficient of valuation, suggesting that sales, EBIT, and EBITDA might be the mainindicators considered by the market when it sets prices for these types of companies.Groups of companies in different industries will have different pricing multiples thatare important This type of analysis could be used in conjunction with a knowledge

of what professionals in the industry consider to be important drivers of value.APPLYING THE VALUATION MULTIPLES

The final step in guideline company analysis is to apply the valuation multiples tothe subject company At this point, the companies that remain in the guideline com-pany set are usually ones that should be reasonably comparable to the subject.The table in Exhibit 6.12 shows the equity values (for 100 percent of the equity

in the subject) using the pricing multiples given above and applies them to theappropriate financial variables for the subject company (all amounts are in millions

of dollars)

Clearly the range of equity values for the subject is quite large—from $1.2 lion to $33.7 million However, the range of values based on the median pricingmultiples is very small—from 4.2 to 5.4.16

mil-Exhibit 6.12 Equity Values ($Millions)

For equity values based on MVIC pricing multiples, the calculation is (sales isused here as the concept):

MVICEquity ValueSubject
[ 冢 _Sales  SalesSubject冣 DebtSubject]

compUsing the sales multiple from Company 1 (Exhibit 6.11) and applying them tothe sales of the subject gives us:

Equity ValueSubject
0.7  5.2  0.0
3.6 (rounded)

For equity values based on the MVEq pricing multiples, the calculation is (netincome is used here as the concept):

MVEqEquity ValueSubject
 NetIncomeSubject

Net IncomecompUsing the sales multiple from Company 1 (Exhibit 6.11) and applying them tothe net income of the subject:

Equity ValueSubject
16.9  0.3
5.1 (rounded)Analysts use the factors discussed previously to decide which types of pricingmultiple(s) to use

While the creation of the tables, including the calculation of the pricing ples, is a fairly objective process, the final assessment of value is less so As statedearlier, the use of the type of guideline company analysis shown here does notabsolve the analyst from using judgment; it simply provides more targeted informa-tion on which to develop an opinion

multi-The subject in the last example has some attributes that would place it at thehigh end of the group and some that place it at the low end:

High End

Asset turnover (Sale/Assets ratio)

Leverage17

Quick and current ratios

The final determination of which particular pricing multiple(s) to usemust be based on an understanding of how the subject compares to theguideline companies in term of the important factors discussed earlier(i.e., growth, size, longevity, profitability, etc.)

ValTip

17 Lower leverage (in this case, the subject has no debt) implies lower financial risk, all else being equal.

Profit margins

Low End

Size18

Historical growth (which in this case reflects expected growth19)

Because of the size and growth issues, the subject appears to be on the low end

of this group of companies, implying that its pricing multiples should be at the lowend of this group as well Based on industry research and the types of statistics dis-cussed earlier, we conclude in this illustration that the most appropriate ratios to useare the MVIC/EBIT and MVIC/EBITDA, equally weighted Furthermore, the 25thpercentile pricing ratios appear to adequately capture the subject’s position vis-à-visthis group of guideline companies The final value is $3.1 million

CONCLUDING THOUGHTS ON VALUE

The market approach should be considered in virtually all valuations Whether thesubject is a large, diversified company or a small operation, sources of data may beavailable to estimate its value Even if the comparables are not truly like the subject,this approach still may provide a sanity check on the values obtained using otherapproaches

USING THE PRICING MULTIPLES FOR GROWTH

As discussed earlier, one of the most important determinants of price is growth—expected growth, not historical growth Given how important this factor is indetermining value, it is sometimes desirable to make adjustments to guideline com-panies whose growth might differ from the subject’s to use their pricing multiples on

a more objective basis In other words, the purpose of this process is to restate theguideline companies’ pricing multiples so that they reflect the expected growth of

The analysis using guideline company transactions is essentially thesame as what is shown here except there is considerably less data avail-able Furthermore, the application of valuation multiples from each ofthe databases results in a different type of value, e.g., with or withoutinventory or working capital