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.
