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Introduction to Valuation Techniques

Part II
Theory of the Market Approach
The Basic Idea
Observe prices paid by willing buyers to willing sellers for similar assets
Invoke the Law of One Price: identical assets must have identical prices

Market Approach Two Methods


Guideline Publicly Traded Company Method (aka Market Comparable
Method)
Develop value measures based on what similar companies are trading
at in a public market and apply those measures to the subject
companys financials
Guideline Merged and Acquired Company Method (aka Market
Transaction Method)
Develop value measures based on prices at which entire companies or
operating units of companies have been sold or the prices at which
controlling interest in companies have changed hands
Market Comparable Method Introduction

Overview
Highly liquid public capital markets constantly re-price stocks through buyers
and sellers who are well informed and have no special motivations or
compulsions to buy or sell (think of definition of Fair Value or Fair Market
Value)
This constant re-pricing gives up-to-the minute evidence of prices that buyers
and sellers agree on relative to certain metrics perceived to drive their values
(revenue, margins, cash flow, etc.)

In Practice
Estimate the value of the subject company by analyzing the prices paid for
similar companies relative to some benchmark (e.g. price relative to
earnings)
Example: If comparable companies trade in the stock market at 12 times
earnings, and your company has earnings of $1 per share, then you might
conclude that investors would pay $12 per share for your stock if it were
publicly traded
Market Comparable Method Overview

Using the Market Comparable Method involves three main phases and
numerous steps.

Search & Select Adjust & Compute Apply & Conclude


1. Understand your 4. Adjust data on 7. Apply concluded
subject company guideline companies multiples to subject
as necessary company
2. Search for and select
comparable companies 5. Compute selected 8. Adjust implied value
multiples of subject for
3. Select appropriate
appropriate premiums
value measures 6. Conclude on point
(revenue, EBITDA, estimates and/or 9. Conclude on value
etc.) ranges for multiples

If above conclusion results in Total Enterprise Value, subtracting Net Debt will result in the Equity Value
Market Comparable Method Selecting Guideline Companies

As the Market Comparable Method is only as accurate as inputs, selecting


the correct guideline companies is paramount to the concluded value
Do the underlying economic forces driving this guideline company match
those that drive our subject company

Possible factors to consider when determining comparability:

Business lines Types of customers


Markets served Size of business
Earnings Sales volume
Capital structure Product mix / diversification
Credit status Opportunity set
Management Territory of operations
Nature of competition Financial ratios
Maturity of business Book value
Industry position Investment risk (rate of return)

Which factors to look at very much depends on the industry that the
subject company operates within
Selecting Comparable Companies

Study the target


Public companies:
10-K, 10-Q, 8-K, other SEC filings
consensus research estimates
equity and fixed income research reports,
Financial databases (CapitalIQ, IBES, Bloomberg, etc.)
press releases
earnings call transcripts
investor presentations
Private:
corporate websites
sector research reports
news
trade journals
public competitors SEC filings, research reports, investor presentations
Selecting Comparable Companies
Identify Key Characteristics of the Target for Comparison
Purposes
Simple Framework example:

Business Profile Financial Profile


Sector Size
Products and Services Profitability
Customer and End Markets Growth Profile
Distribution Channels Return on Investment
Geography Credit Profile
Calculate Key Statistics, Ratios and Trading Multiples

Key Statistics
Size indications (Sales, Gross Profit, EBITDA, etc.)
Historical and Forward
Profitability (margins)
Growth profile
Return on investment
Credit profile (leverage, debt-to-EBITDA)

Last Twelve Months LTM

Adjustments for Non-Recurring


E.g. restructuring, losses on sales, write-offs, impairments
Calculate Key Statistics, Ratios and Trading Multiples

Once guideline companies statistics are collected and analyzed, and guideline companies
selected, value measures are calculated
Value measures are typically multiples computed by dividing the enterprise value or equity
value as of the date in question by some relevant economic metric
Some variables such as forecasted cash flow, earnings or revenues for the company
may be projected by security analysts and used as a value measure

A Stylized Balance Sheet Common Multiples of


MVIC (Market Value of
Invested Capital):

MVIC / Sales
Market Value
Business MVIC / EBITDA
of Debt
Enterprise MVIC / EBIT
Value (MVIC)
Common Multiples of MVE:

Market Value MVE / Net Income (P/E)


of Equity MVE / Cash Flow after
(MVE) interest
MVE / Book Value of
Equity (Price-Book)
Special Considerations in Applying Market Multiples

Depending on the industry, non financial benchmarks may be a better


indicator of value, some examples include:

Cable: MVIC/ # of subscribers

Health insurance providers: MVIC/ # of covered members

Soft drink bottlers: MVIC/# cases bottled

Technology: MVIC/number of engineers

Its important to know which metrics are commonly used in the subject
companys industry, which often change over the business cycle
Challenges in Selecting Market Multiple

Which are the appropriate multiples?


Using a revenue multiple for a less profitable company in a profitable
industry may not be appropriate
Using a current multiple for a company expected to diverge from current
performance will lead to an inaccurate value
Stock Price/Revenue multiples does not control for leverage
Price to book values are not appropriate for industries with considerable
internally developed intangible assets i.e. brand name

Selection Criteria
Mean, Median, Mode
Comparability based on growth rate, profitability, etc.

Existence of outlier multiples at either end of the spectrum can skew results

Ignoring non-operating assets and liabilities


Valuing a Company (BP) based on financial performance without taking into
account potential future liabilities
Potential Issues in Selecting Comparable Companies

Recent poor performance may result in higher multiples (if


problems are expected to be temporary)

Companies operating in cyclical industries may affect multiples


(i.e. insurance companies, oil and gas, etc.)

Some market prices may be unreliable (thin trading,


regulations, short interest, etc.)

One time costs such as restructuring fees and asset impairment


charges may convolute true earning potential
Caution Low Earnings Can Cause High Valuation Multiples

Need to be Cognizant of low or negative denominators as they can render the comparable
multiple meaningless

Progressive Corp's TEV/EBITDA Multiple v. EBITDA (in USD Millions)


2,500 300.0x

2,153.4 264.8x
250.0x
2,000

1,726.0

TEV/EBITDA MULTIPLE
200.0x
1,551.3
1,500
EBITDA

150.0x

1,000

97.9x 100.0x

500
50.0x

125.8
49.2
6.9x 9.1x 8.6x
0 0.0x
11/30/2007 5/31/2008 11/30/2008 5/31/2009 11/30/2009

Source:
Capital IQ EBITDA TEV/EBITDA
Market Transaction Method - Introduction

Overview

One can derive indications of value from prices at which


entire companies or operating units of companies have been
sold or the prices at which significant interests in companies
have changed hands

Main difference between the two Market Approach


Methodologies is that the Market Transaction Method relies
on the price a controlling interest in an entity sells for
whereas the Market Comparable Method relies on the day-
to-day trading prices of securities (minority interests in an
entity)
Market Transaction Method

General comments
Its common to consider transactions over a fairly long time horizon for the following reasons:
There are fewer transactions where data regarding the transaction and target company is
readily available
Acquisition pricing multiples seem to fluctuate somewhat less over time than public stock
market pricing multiples

Criteria for selecting market transactions are similar to those for selecting publicly traded
guideline companies
In situations where limited transaction data are available, the criteria may have to be
broadened somewhat
Calculation of multiples is performed in the same manner as the Market Comparable
Method
Process for selecting and weighting the multiples calculated to apply to the value
measures of the subject company is similar to that applied in the Market Comparable
Method
Application of multiples to subject company is the same as in the Market Comparable
Method

Need to understand the nature of transaction and the motivations of the parties involved in
the transaction
Market Transaction Method Overview

Using the Market Comparable Method involves three main phases and
numerous steps.

Search & Select Adjust & Compute Apply & Conclude


1. Understand your 4. Adjust data on 7. Apply concluded
subject company guideline transactions multiples to subject
as necessary company
2. Search for and select
comparable 5. Compute selected 8. Adjust implied value
transactions multiples of subject for
appropriate premiums
3. Select appropriate 6. Conclude on point
value measures estimates and/or 9. Conclude on value
(revenue, EBITDA, ranges for multiples
etc.)

If above conclusion results in Total Enterprise Value, subtracting Net Debt will result in the Equity Value
Selecting Guideline Transactions

Study the target


Public companies:
10-K, 10-Q, other SEC filings
consensus research estimates
equity and fixed income research reports,
press releases
earnings call transcripts
investor presentations
Private:
corporate websites
sector research reports
news
trade journals
public competitors SEC filings, research reports, investor
presentations
Selecting Guideline Transactions
Identify Key Characteristics of the Target for Comparison
Purposes
Simple Framework example:

Business Profile Financial Profile


Sector Size
Products and Services Profitability
Customer and End Markets Growth Profile
Distribution Channels Return on Investment
Geography Credit Profile
Selecting Guideline Transactions

Search Transaction databases


CapitalIQ
MergerStat
Thomson Reuters SDC Platinum

Considerations
Time Period
Guideline Company transactions
Market conditions
Deal Dynamics
Public/Private
Percent acquired
Locate the Necessary Financial Information

Historical financials
10-K, 10-Q, 8-K, other SEC filings
Financial databases (e.g., CapitalIQ)
Projected financial information
Equity research reports
First Call or IBES
Financial databases (e.g., CapitalIQ)
Market Data
Rating agencies websites
Bloomberg
CapitalIQ
FactSet)
Calculate Key Statistics, Ratios and Multiples

Key Statistics
Size indications (Sales, Gross Profit, EBITDA, etc.)
Profitability (margins)
Growth profile
Return on investment
Credit profile (leverage, debt-to-EBITDA)

Last Twelve Months LTM

Adjustments for Non-Recurring


E.g. restructuring, losses on sales, write-offs, impairments
Calculate Key Statistics, Ratios and Multiples

Trading Multiples
Enterprise Value Multiples
EBITDA
EBIT
Sales
Equity Multiples
Earnings
Sales
Sector Specific
E.g., Alarm monitoring company - multiple of monthly
recurring income
Adjustments for Synergies
Guideline Transaction Method
Pros
Market-based
Relativity
Simplicity
Objectivity
Current
Cons
Market-based
Time lag
Absence of comparable acquisitions
Availability of information
Acquirers basis for valuation
Special Considerations in Applying Market Transaction Method

In extreme markets, transactions occurring in the distant


past may not have as much relevance as recent transactions
(if at all)

Discounts or premiums may need to be applied for


marketability and control depending on the desired standard
of value
Market multiples derived from market transactions give
you a controlling interest indication of value (transactions
involving controlling interests or entire companies)
Market multiples derived from publicly traded guideline
companies give you a minority interest indication of
value (share price trades of minority interests)
Market Approach Applying Multiple

Estimating the MVIC of the Subject Company


based on multiples
Guideline
Companies Subject
Company

LTM Revenues MVIC/Revenue Multiple = 2x $40mm


($40MM)

LTM EBITDA MVIC/EBITDA Multiple = 6x $10mm


($10mm)

MVIC Based on Revenue Multiple: $40mm * 2x = $80mm


MVIC Based on EBITDA Multiple: $10mm * 6x = $60mm

Range of Values for Subject Company: $60mm - $80mm


Levels of Value in terms of Characteristics of Ownership

$12.00 per Synergistic


share (Strategic)
20% strategic
Value
acquisition
premium
$10.00 per Value of
share controlling
interest
Control Minorit
20% minority
Premiu y
interest
m Discoun Publicly
discount; 25%
t traded
control $8.00 per
premium equivalent
share value or
Stock Market
value of
25% discount for lack of Discount for
minority shares
marketability for restricted restricted stock of
if freely traded.
stock public company

Value of
restricted
$6.00 per stock of public
share company
Additional 20% discount
for private company stock Additional discount
(taken from publicly for public company
traded equivalent value stock Value of non-
$8 per share) marketable
$4.40 per minority (lack of
share control) shares

Shannon Pratts Business Valuation Update

26
Valuation Ranges

NPV

Precedent Transactions

Market Comparables

Enterprise Value

0 Valuation in $M

Developing the Purchase Price is the Art of Blending


Financial Valuation with Qualitative Decision Making
Other Analyses

Contribution Analysis (synergies) How much does each


company contribute to a combination? Must be adjusted for
leverage
Premium Paid Analysis Calculates purchase price based on the
premium demanded by shareholders to approve a deal.
Commonly used as a sanity check by calculating implied
premium and comparing to prior transactions
Break-up Analysis (Sum of the Parts) Used in the case of
conglomerates. A typical valuation analysis is performed on
each segment of the business to determine whether it is worth
more apart than together. Must contemplate tax implications of
any sale of the pieces
Keep Value Valuation performed when assuming a business is
maintained under a parent structure. Often used to compare
against a divestiture, or break up, analysis for decision making