Caveats for a market approach By Richard M. Wise Illustration: Gary Taxali When valuing a business, the right questions need to be asked if value measures are to be of any use If you are valuing a business, business ownership interest or security, there are three basic generally accepted approaches you can take: the asset-based approach, the income approach and the market approach. In certain cases, a combination may be appropriate. Whatever the approach, it will be based on a going-concern or on a liquidation premise, depending on the circumstances. The focus here is on the market approach, which compares the subject to businesses, business-ownership interests and securities that have been sold on the open market and are largely similar. In this approach, there must be meaningful and relevant data available for analysis. It is essential that the business valuator ask the right questions if the data and the value measures derived are to be of practical use. Among the methods for the market approach are the guideline public company method, the merger-and-acquisition method, and analyses of prior transactions of ownership interests in the company being valued. The first two involve the development by the valuator of relevant valuation ratios (market multiples) derived from transactional pricing information and underlying financial data of the "guideline companies" selected, and then the application of these ratios to the corresponding data of the subject company to arrive at value. Guideline companies (public and private) are those that provide a reasonable basis for comparison to the investment characteristics of the company being valued. Ideal guideline companies are in the same industry as the subject company. However, if there is insufficient transactional evidence in that sector, the valuator might select firms in other industries having a similarity to the subject company in investment characteristics such as markets, products, growth and cyclical variability. While guideline-company empirical data can typically be found in transactions involving controlling or minority interests in publicly held or private companies, the concern here is with the use and interpretation of data that the valuation analyst gleans from a transactional database. Using the guideline public company method, market multiples are derived from trading prices of shares of companies engaged in similar lines of business and that are actively traded in a free and open market. The guideline-company data are gathered to develop value measures that can be applied to the subject company's fundamental financial and other data and correlated in order to reach an indication of value for the subject firm's issued shares. It is critical that the valuation analysis distinguish between invested capital and equity. The value measure, or valuation ratio, is determined by dividing the price of the guideline company shares by a financial variable (such as earnings, cash flow, EBITDA or revenue), calculated from the financial data of the guideline company. The valuation ratios are then applied to the subject, after making the appropriate adjustments to ensure consistency in accounting conventions, the timing of the price data used in the valuation ratios, the selection of the underlying data used to compute the valuation ratios, and so on. Similarly, consideration is also given to adjustments in respect of minority or controlling interests as well as marketability. In summary, the computation and application of the valuation ratios are intended to provide meaningful insight concerning the pricing of the subject, considering all relevant factors with an estimate being made, using public data, of the price that would be paid for the common stock of a closely held firm, assuming it was traded in an active market or on an exchange. In the merger-and-acquisition method, valuation ratios are derived from open-market transactions of significant interests in companies engaged in the same or similar lines of business as the subject. The factors considered in judging a reasonable basis for comparing the subject to similar businesses, business ownership interests, or securities that have been sold in the open market include: sufficient similarity of qualitative and quantitative investment characteristics; extent and verifiability of data known about the similar investment; whether or not the price of the similar investment was obtained in an arm's length transaction as a result of a forced or distressed sale or other fact situation that may not provide evidence of fair market value; and the relevance of market conditions at the transaction date and those at or proximate to the valuation date for purposes of the subject valuation. The analysis involves comparing the respective qualitative and quantitative factors relating to the company being valued to those of the guideline companies, including, if appropriate, dissimilarities with respect to minority, control and market-ability. The calculation and use of these valuation ratios (pricing multiples) are intended to provide meaningful insight as to the value of the business being appraised, considering all relevant factors. In brief, the valuation analyst must be extremely careful in the following areas: selecting meaningful (i.e., comparable) guideline companies; selecting the underlying data used to compute the valuation ratios; selecting the time periods and/or the averaging methods used for the underlying data; computing the valuation ratios; and determining the appropriate price data to be used as the numerator in the ratio. It will be critical how the valuation ratios are selected and applied to the subject's underlying data. Therefore, as market transaction values — and ratios developed from them — can provide meaningful insight in valuing a business interest, there must be sufficient similarity of qualitative and quantitative investment characteristics; and even if such similarity does exist, adjustments may still be required to place the subject's relevant financial data on a basis consistent with those of the transacted business. If, however, there is insufficient information as to the specifics of the selected market transactions and the reasons behind the price paid by the purchaser, the use of publicly available transactional data in valuing a business can lead to a meaningless exercise. In an ideal situation, background transactional details can be obtained from first-hand knowledge of financial and other data specific to the transaction (perhaps the business valuator had worked on a particular guideline-company transaction and therefore had intrinsic knowledge of the underlying background specifics concerning, among other things, the acquiree, the purchaser, the value of the consideration paid and the other substantive terms of the deal. With respect to the value of the consideration paid, there may have been an analysis and quantification of the post-acquisition synergies and/or strategic advantages perceived by the buyer when pricing the target). In most cases, the valuation analyst will not have benefited from hands-on experience (either as a valuator, analyst, adviser or negotiator) and would seek pricing, financial and other data from guideline-company information. While there may be many data points available, unless otherwise evident from the information obtained, it would be naive for the analyst to rely on such data in developing valuation multiples (such as price/revenue, price/cash flow, price/ earnings, invested capital/sales, market capitalization/EBITDA) without first seeking answers to the following types of critical questions (as appropriate in the circumstances) vis-à-vis each of the guideline-company transactions, to the extent such information has not been obtained: • Do the data derived from the guideline companies relate to a transaction involving the shares of the businesses or the underlying operating assets? Do the data relate to total invested capital or to equity? • Were there redundant or excess assets? If so, were they included in the deal? • How similar are the respective characteristics of each guideline company and the subject in terms of, for example: size; diversification of markets and products/services; geographic location; demographics; political environment; market share; customer base; employee, customer, supplier and bank relationships; technological development; intellectual property protection; growth trends in revenue and profits; capital structure, leverage and liquidity; tangible asset backing; regulatory compliance; profit margins; return on tangible capital employed; maturity of the business; off-balance sheet assets and liabilities; depth and continuity of management? • To what extent would the Notes —which are an integral part of the respective financial statements of the guideline companies — affect the interpretation of the respective balance sheets and income statements? • Does the valuator know the contents and impact of the Notes? Were there contingent assets or liabilities? How were they dealt with? As an integral part of the financials, they can have a material impact on the valuator's analysis. • How long had each guideline company been in business? • Were any respective acquirees compelled to transact? Was there compulsion on the part of any respective purchasers? Were any transactions negotiated under distress? • Did any of the transactions include payment in respect of a consulting or a non-competition agreement with the vendor? • Were there any earn-out provisions? If so, what were their terms? • Were any acquirees heavily dependent on only a few customers and/or suppliers? • Were any of the guideline companies operated by a key person on whose services the business was highly dependent? • What was the timing of the data for developing the respective valuation ratios with respect to the selected transactions? • How long had each acquiree been exposed for sale in the marketplace? • Were any of the transacted businesses acquired by a special purchaser who, for reasons such as perceived post-acquisition synergies or strategic advantages, was willing to pay a higher price for the acquiree than others? If so, what portion of the purchase price represented a premium for anticipated or strategic advantages? • Were any material customers, suppliers, labour or other contracts under negotiation by a guideline company that could have impacted the transaction price? • Were there new products ready to be launched by any of the guideline-company acquirees, which might otherwise render some of the financial data "irrelevant"? • For high-tech, pharmaceutical and other firms owning intellectual property, how much had the respective acquirees been spending, and planning to spend, on research and development? • Was the guideline-company share transaction in respect of 100% of the shares, 66.66% of the shares, 50% plus one or some other de jure control position? • Was the transaction internally or externally financed? Was it at arm's length? • How much of the price is related to the buyer's ability to lever the acquired assets? • Was the price paid for the acquiree effectively adjusted with respect to the interest rate on the acquiree's debt? • Was the price effectively adjusted in respect of the terms of the deal? • Was the guideline company unionized? • Was any portion of the transaction price not reflected in publicly disclosed data? • Would any of the guideline-companies' accounting policies possibly have a material effect on the comparative financial data? • Have certain patents been applied for in which commercial exploitation has not yet begun and therefore their potential is not reflected in the accounts? • Did any guideline-company aquirees receive government loans, grants, subsidies? Valuation ratios can provide insight into pricing/valuing the subject business, or may be used for corroborative purposes, provided the answers to the foregoing questions are obtained by the valuator. Taking figures from a transactional database and calculating a valuation ratio or multiple without considering such factors could lead to an erroneous conclusion. The list might help in due diligence and may be useful in court for cross-examining an expert who relied on guideline-company data in developing a valuation. The key is meaningful comparisons. Richard M. Wise, FCBV, FCA, CA•IFA, is founding partner of Wise Blackman in Montreal and past president of the CICBV Technical Editor: Stephen Cole, FCBV, FCA, partner at Cole & Partners