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The Problem with Transaction Multiples

5/24/16

Business owners, appraisers and their jurors – auditors, judges, other parties affected by the appraisals – tend to have a serious “Goldilocks” problem when considering “comps,” guideline companies that have published valuation multiples. Any measurable differences between a subject company and its comps can be – and typically are – used to exclude transactions that would otherwise provide useful information. Owners say, “They aren’t as profitable as we are,” or “I know the owner and he’s an idiot. I would never run my business that way.”

Business owners often will think that a basket of transactions from their business sector are not relevant (“That comp doesn’t do what my business does”), but they will hang their hat on one or two transactions they’ve heard about businesses that are similar to theirs.

These same owners will, however, listen to their broker’s advice and diversify their own retirement portfolio by buying a handful of mutual funds that invariably track the S&P 500 or other broad index. Their view of their marketable equities portfolios is completely different from their view of their equity investment in their own company.

What are appropriate benchmarks for managing a private company and determining its value? If owners ran their retirement portfolios the same way they view comps, they would have difficulty finding a meaningful benchmark.

Compare, for a moment, a typical brokerage statement. Data on industry sectors and broad market indices are provided, comparing any investment to one or more peer groups. That type of comparison is just as useful and valid for a private company.

Where does data for comps come from?

Two main sources of data for market multiples are trading in shares of public companies (public comps), and acquisitions or mergers of whole businesses (transactions or deal comps).

The market as a whole provides just as much, or more, useful information as does a small selection of comps, whether public comps or deal comps. There is an overwhelming amount of information published on public companies. And there is a much smaller but constantly growing amount of information published on transactions of private businesses.

Private business transaction reporting is, for the most part, voluntary, and the veracity of the data is subject to the degree of verification that database providers undertake in publishing it. That said, commercially available data of deal comps is generally taken to be about as reliable as that for public comps, which means you have to take it with some skepticism – and that is before applying any judgment on how applicable the data is to a subject company.

So why is this important?

Knowing that each company is as unique as each of its owners and employees and all the personal influences they bring, and yet also knowing that value is derived from the assets a company has and how it uses them to create future earnings, we continue to search for the comps that are just right and ignore the power of the data available to us if we step back and consider the bigger picture.

Ignoring the available data is as foolish as an astronomer trying to study the motion of the stars only by looking through a telescope. How can you get a sense of what’s going on if you focus on only one pinpoint at a time? Zoom out a little, and learn a lot more.

Too often, a valuation report will dismiss the market approach for lack of “truly comparable”guideline companies, and often without further explanation of what was considered and excluded. Common excuses include “Public companies are too big and too different,”“No meaningful transactions were identified,” or “All the selected transactions analyzed were too different from the subject to derive an appropriate valuation multiple.”

Users of valuation reports should not accept these excuses, especially without understanding what efforts were made to reach such conclusions. If some public or transaction comps were initially identified and subsequently excluded, ask what information was gleaned from the analysis and judge for yourself how useful that is to you.

The current generally accepted (and taught) valuation practice is to “drill down” from the universe of available data until only a small handful remains. It is not unusual to see a market approach rely on a dozen transactions or a few public companies – or less.

It is typical to see one median multiple from the data set applied, if any. Frequently, no time is devoted to comparing and contrasting the results from the whole universe against the sector and further still against the industry or peer group of companies that have similarities to a subject company.

Consider that, for public comps, there are 15,000 plus public companies listed in the United States or, more narrowly, all 500 companies in the S&P 500 index or 2,000 companies in the Russell 2000 index. For deal comps, several thousand transactions involving U.S. companies are published each year. To say that none of the data can be applied in valuing a subject company is as disingenuous as the statement that a company is so unique that it has no competition.

So what is the better alternative?

If you need to understand the value of a company, look in the valuation report for an explanation of steps taken to identify and analyze market comps data.

You are paying for good information and analysis – ask for it and use it with a critical mindset. Ask, “What are the general market trends”and “What are good companies in the industry or sector trading for, and what is the range of multiples?” No matter how unique you believe your business to be, do not accept that it cannot be analyzed by comparison to other businesses that have been traded or are publicly traded.

If the valuation report determined the value of the company using a capitalization rate or discount rate, you have already accepted the premise that the company is valued using information from capital markets.

The value of your company isn’t determined from just one or two limited data points. Obtain the bigger picture from market comps so you can understand where the conclusion that is applied to your company lies within that broader spectrum.