Friday, February 1, 2013

Estimating Value: Part 4 Using Comparables in Valuation

Three previous posts have talked about methods of valuation, specifically 
 the use of discounted cash flow in valuation,  the use of multiples in valuation and the advantages and disadvantages of multiples.  We extend this series with a brief discussion of the Method of Comparables.  

Method of Comparables
If  data is available on firms similar to the one we are trying to value, this data can be used as benchmarks.  In fact, this reliance on comparable firms is at the heart of the multiple method discussed previously.  Here we are looking at the price to earnings, price to book, price to EBITDA or other multiples of comparable firms and trying to derive our own inferences.

Comparables are particularly useful in looking at actual completed transactions.  This method is often used in valuing residential property. In that case, the analyst gathers data on the recent sales of similar property (e.g., a four-bedroom split level house in a particular school district) and uses this average as a point of departure for valuing the property of interest. Subjective adjustments to this estimate are made depending upon perceived differences in the property of interest and the comparables. For example, the estimated value would be lowered if the property had less desirable curb appeal; values would be raised if the property had, say, an updated kitchen.

Similarly, a comparables analysis of a business starts by finding several firms whose value is known.  Given the objective information provided by these comparables, the analyst then makes subjective adjustments based on the differing characteristics between the comparable firms and the one to be valued.  

This type of analysis is particularly useful when we have a set of comparable firms that have recently been sold.  The strength of the comparable method with completed deals is that it relies on market transactions to establish a benchmark price.  The disadvantage is the difficulty in getting recent market data on a meaningful set of truly comparable firms.  Differences in industry, size, geographical location, and accounting techniques are among the difficulties in finding comparables. Moreover, accurate data on privately held companies is often difficult or impossible to obtain.

Finally, we again emphasize  the distinction between using transactions and non-transactions data.  Transactions data are ideal as they reflect selling price information on actual deals that have been completed.  However, adding this restraint to the matching criteria listed above usually severely restricts sample size.  Non-transactions data are also quite useful, but, of course don't reflect actual deals.  Thus, we're looking at a stated market price for our comparables, but not necessarily a price at which the firm would be sold.  Setting the latter value involves not a multitude of factors.  To mention just a few we must consider the strategy, motives and characteristics of the acquiring firm, the target, the way the deal is structured, the bargaining power of the parties, the availability of other bidders, and any premia for control or discount for illiquidity.  

In subsequent post, we'll talk more about control premia and liquidity discounts as well as about some sources of data for comparable transactions.


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