Valuation using Comparable Transactions Method
This week’s spotlight takes one of the most practical and straightforward alternative valuation methods to the known method of discount free cash flows. It’s called the comparable transactions method. Meanwhile, the discount free cash flow method analyzes and projects future results to determine value, the valuation method based on comparable transactions consist of analyzing the price paid for past transactions for similar deals and companies. This method gives you a comparative price estimation that has been paid in the market for a company like yours.
This method proposes a set of unique advantages. It’s faster, simpler and more practical, although may prove to be far from reality if conducted incorrectly. Because the analysis of this method is based on assumptions, it can potentially lead to future discrepancies between the seller and the buyer. This is due to the sellers often basing their price on future value generation (or what the buyer will do with the company) which can lead to issues occurring during the breakdown of negotiations, as both parties have different expectations. For this reason, the discount cash flow method of valuation can prove to be more accurate. The validity of the discount cash flow method is therefore conditioned by the uncertainty about the projections.
The Comparable Transaction Method
Let’s look at another method that bases the valuation using the present snapshot of a company’s performance. The first step of the comparable transactions method consists of analyzing and selecting similar companies. It is vital to choose the right companies because the analysis will not make sense otherwise. One of the key characteristics to look out for is company size.
It is highly advised not to compare companies based on sales volume, or profits lower than 50% of the target company. It’s also critically important to have a comprehensive database of past mergers and acquisitions and a thorough knowledge of the targeted sector along with all its participants. Always be on the lookout for special cases and outliers.
In practice, most buyers choose the simplified valuation method based on EBITDA multiples. Valuating by multiples is a valid method only if the following criteria are reached:
• If you have a wide range of similar companies
• If the range of companies or transactions is homogeneous
• If the data is relevant and timely
Using the multiples can help you understand how much is being paid for companies like yours and can prove to be essentially useful during negotiations, especially if you have information about the history of transactions of the counterpart. A best practice would assume the application of both methods in complement to each other to ensure a higher precision of the estimated value.
It is needless to say that the chosen valuation method and corresponding key performance indicators (KPIs) will heavily depend on the sector in which the company operates. Here are the most common ones:
• Price to earnings ratio (PER) – an equity valuation measure defined as market price per share over the annual earnings per share.
• EBITDA – earnings before interest, taxes, depreciation, and amortization.
• Book value
• Multiples of revenues
There are also sector-specific quantities, such as the volume of contracted premiums in insurance; net assets in banking; tons sold and/or installed capacity; and dollars per space in car parking.
As mentioned earlier, the most popular method is EBITDA. The main reason for the widespread use of this method is that it allows for better comparison between companies. However, this method also acquires its disadvantages that must be accounted for during the valuation. Some of the limitations include:
• EBITDA multiples ignore possible restructuring costs of the operation.
• The EBITDA doesn’t reflect changes in need of funds (NOF).
• EBITDA doesn’t reflect investment needs. In the case of a capital-intensive company, analysts might prefer to only use the earnings before interest and taxes (EBIT).
• Occasionally, EBITDA requires adjustments to balance one-ff costs such as employee layoffs and non-recurring spending.
Despite these limitations, this method of valuation is known as a good way of making a quick estimation of value. It is also useful as a reference tool to use for a market comparison, to see what the market is paying for similar companies. Once you calculated the EBITDA multiple, you must subtract the debt.
Here at ONEtoONE, we consider every aspect and intricacy of the everchanging market environment in our valuation process and are known for our unique methodology for providing the best value for your business. If you want to learn more about what we do and our methodology, please visit our corporate website or contact us via this form. In case you wish to learn more about the ways you can maximize the value of your company today, read our free e-book! It’s free.