Thursday, 7 February 2013

Valuation 201: Comparable Company Analysis

Ever since I wrote “TheBasic Math of Valuations”, which explains the valuation differential between different asset classes, I have been meaning to write a follow-up on specific valuation techniques. There are market based approaches such as public company trading multiples and comparable transaction analyses and cashflow and earnings based methodologies such as the Discounted Cashflow (DCF) analysis.
In this post I’d like to look at market based approaches.  Let’s start with the easier one to explain; comparable company transaction analysis.  This is just like when your real estate agent shows you what houses sold for in your neighbourhood.  You compare your neighbour’s house in terms of number of bed and bathrooms, lot size, etc. and then you figure, well, if that one sold for $500K then, since mine is better, mine must be worth about $600K.  If you have a $200K mortgage you end up with net $400K after the sale.  The logic is the same for companies however it is very rare that you find: (i) a truly comparable company transaction, (ii) completed very recently (or else different economic conditions will have to be considered), and (iii) there is full information available on consideration components (i.e. cash, earn-out, amount of debt assumed, working capital adjustments, deal exceptions, etc.).  Public company trading analysis can provide trending and current day valuation comparisons but the challenge of assembling a good representative sample remains.
Both market approaches need subjective adjustments in order to derive at an attributable value range. Comparable transaction data and public company shares are typically available from larger public companies which means that, in order to attribute this data to a smaller private company, two types of discounts need to be applied, a small company discount and a private company marketability discount and, in addition, public company shares trade at a minority discount which raises the question of how much of a control premium to apply.
How are these discounts and premiums determined? Large public companies benefit from easier access to capital, lower cost of capital, in many cases a strong brand and generally scale, diversification of suppliers and customers and many more risk reducing attributes.  Small companies typically have higher customer concentration, a less established brand, less access to funding sources (be it banks or equity investors) and, private companies are illiquid; it takes a lot of time and effort to find the right buyer.  As such, small private companies are riskier than large public companies.  Every comparison is unique but generally speaking, more risk means a higher required rate of return.
Minority Discounts and Control Premiums are two sides of the same coin.  Public company shares trade at a minority discount because any individual shareholder does not have enough influence (i.e. votes) to change the direction of the company.  However as soon as a control block is in play, the minority discount disappears.  Control premiums are tracked by Mergerstat and were on average 50% in the first quarter of 2012.  So how do the various discounts and premiums stack up?  Generally speaking, small private companies are valued below the trading values of public companies – even without the control premium applied. In other words, public minority share valuations are still higher than small private company control share valuations.
Both market approaches need subjective adjustments in order to derive at an attributable value range.  The question of whether a comparison of a $1 billion public company to a $50 million private company deserves a 30% or a 50% discount requires consideration of many factors and is best answered by an experienced, accredited professional valuator.
Derek van der Plaat, CFA has worked in private market M&A for more than 20 years and is a Managing Director with Veracap M&A International in Toronto.


1 comment:

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    Mergers and Acquisitions