Business Valuation: Comparable Transaction Method

Comparable transaction analysis is one of the most conventional methods used in mergers and acquisitions (M&A) to determine a company’s value.

The worth of a business is what the buyer is willing to pay to acquire it.

‘Just as the items offered at a pawn shop are only worth what the buyer is willing to pay, so are businesses.’‘

Brian Hamilton, chairman and co-founder, Sageworks

People who go to a pawn shop usually have unrealistic expectations regarding the worth of their items. Most have no point of reference to base their item valuation, so when they negotiate the price, they cannot justify it.

According to a recent Forbes study, “More than 60% of business owners plan to sell their business in the next ten years.” Considering that, it’s essential to know how to calculate your business’s value before beginning negotiation.

Various factors, such as the operation industry, influence the value calculation. Accounting firms are usually valued at one time their annual revenue, coin laundromats at two or three times their annual profit, and software companies at three to five times their annual revenue.

Heuristics govern business value, so knowing the rule of thumb for your business niche is important. However, those rules are flexible and influenced by other important factors, such as whether or not the business is growing, the overall profitability, profit margins, and intangible items like the employee base and the service/product being offered.

Comparable Transactions Analysis

The Comparable Transactions Method looks for similar or comparable past transactions in which the company targeted for acquisition has either a similar business model and is of similar size. To derive the value of a business, compare a similar multiple of the business’s earnings with transaction multiples.

The same method is used with public companies. The only difference is that comparable company analysis is done based on the company’s “stock price” on the public market. In contrast, comparable transaction analysis is determined by the price paid to acquire the company, including a control premium.

Multiples from the comparable transaction analysis are applied to the target company’s data to decide the implied valuation range. These multiples include:

• Price to earnings (P/E)
• Enterprise value to EBITDA (EV/EBITDA)
• Enterprise value to SDI (EV/SDI)
• Enterprise value to Revenue (EV/Revenue)
• Price to book (P/B).

How to Select and Categorize Comparable Transactions Deals

The accuracy and quality of transaction analysis depend entirely on selecting the most applicable transactions. Criteria include:

• Industry: The target company’s overall industry should be as similar as possible to the industry of comparable companies or transactions.
• Deal size: Select the most relevant transactions as close in size (in terms of revenue) as possible to the target companies.
• Transaction characteristics: Understand the company’s background and other circumstances to derive meaningful insights, such as domestic vs. overseas, negotiated deal vs. complete auction.
• Time: The data’s relevance is determined by time: more recent equals more relevant.

The “Deal Dynamics”

Once you have found a few deals with good potential for use, look at the details. Market conditions significantly impact all deals, so carefully study them, including industry trends, etc. For instance, buyers paid astronomical prices for information company acquisitions at the height of the technology bubble in early 2000.

Other considerations to understand the “deal dynamics” include:

• Buyer type: In the past, strategic buyers have paid more because of their innate ability to understand business collaborations. Find out if the buyer was a strategic buyer or a financial backer.
• Buyer motivation: What were the motivations of both the buyer and the seller for the transaction? For instance, a strategic buyer is willing to pay more than the usual if the target company fits within their strategic growth plan. Similarly, a financial backer will pay more when the target company fits within their existing portfolio of companies. Likewise, companies struggling for liquidity might consent to sell their non-core or subsidiary businesses at a lesser price to speed execution of the deal.
• Sale type: Find whether the target company was sold through a negotiated deal or an auction. Auctions generally yield a higher price than average.
• Terms of payment: Find out the terms of payment. Did the buyer pay for the acquired company in cash or with stock? Stocks purchases generally result in a lower valuation.

Information Sources for Selection of Relevant Transactions

Securities Data Corporation (SDC) is the leading provider of data on M&A, new issues, and basic security. If you conduct an “SDC run,” you will get a spreadsheet of comparable transactions per your search criteria. In a typical case, an SDC run will deliver results dating back three to five years.

This is an excellent source of information on past transactions, but sometimes it’s not as exhaustive as desired. If possible, cross-check the information with research reports from the industry and consult with the industry’s investment bankers.

To conduct an SDC run, you need the following information:

1. SIC codes
2. Time duration
3. Deal size (range)
4. Deal types
5. The nationalities of both the seller and the buyer.

Merger proxy: This document describes the various valuation methodologies used to determine the company’s value and lists the different transactions used for analysis.

Trade and research journals: These are the best sources for significant recent transactions; however, they might only publish and discuss transactions within their coverage area.

Information Sources for Transaction-specific Information

For publicly traded target companies, consult these documents:

• Merger proxy: For transactions that need the shareholder’s approval, filing this document (DEFM14A) with the SEC is a must. These documents are publicly accessible.
• Tender offer document: Whether it is a hostile takeover deal or a friendly acquisition, both Schedules TO and Schedule 14D-9 are filed with the SEC concerning tender offers.

For a privately traded target company and a publicly-traded acquiring company, consult these documents:

• 8-K: This document is filed with the SEC by public companies for all significant events like material acquisition. Whenever a division or a subsidiary of a company is sold, filing an 8-K is a must.
• 10-K & Annual Reports: These documents, also filed with the SEC, often have sections covering all significant transactions for a given year.
• Other sources: News, trade periodicals, and research reports may also provide information to varying degrees.

Positive & Negative Aspects of Comparable Transactions

Positives:

• Public information is the basis of all valuations.
• This information is realistic, and the business appraisal is based on the actual purchase price.
• The analysis also indicates the types of transactions trending, e.g., acquisitions for consolidation, foreign purchases, etc. The research also gives a sneak peek into what buyers are looking for and the most frequent buyers.
• Analysis helps assess market demand for different types of assets; e.g., what is the transaction frequency? What were the paid multiplies?

Negatives

• A scarcity of information or incomplete information may be misleading.
• Market conditions (e.g., business cycle, competitive environment, and shortage of assets) can considerably influence business valuation.
• Transactions are not always directly comparable. The deal dynamics may not be the same and can’t be applied to the current scenario.
• Some aspects such as commercial agreements, issues relating to governance, and Section 338(h)(10) election cannot be expressed in valuation multiples.
• The multiples may vary to such an extent that their use is limited.

Ideal Conditions to Use Comparable Transactions

Comparable transactions best suit valuation purposes when you need to:

1. Determine the value of a private business that does not have a public trading equivalent.
2. Understand and assess market demand for the acquisition of a company based on past recent transactions within an industry and the basis of the total dollar volume of the business.
3. Show data analytics in determining M&A activity and other partnership trends.
4. Identify potential bidders if the target company is looking for a buyer and identify potential sellers if a company seeks to expand.
5. Provide transparency to the board of directors when a company is buying or selling a part or whole of its business or being taken over through sale.

Final Thoughts:

A comparable analysis is the most common approach to determine the value of a company, although it has limitations and is far from perfect. Since the outcome depends on the completeness and accuracy of the data on companies under scrutiny, it should be used along with other valuation methods to determine a complete, holistic assessment of the target company. The biggest obstacle to preparing a meaningful analysis is the limited availability of financial data of past transactions between private companies.

Despite its shortcomings, this valuation method remains a standard valuation technique, primarily used with other valuation methods.