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The Art and Science of Valuation – Part 2

Market Approaches & Market Methods

The market approach to valuation has several valuation methods that use the pricing metrics derived from the transactions of interests in comparable companies to that of the company to be valued.

GTM and GPTM are two market based valuation methods

1. Guideline Transaction Method – GTM

The GTM or the Guideline Transaction Method is one of the most viable options for valuation. The valuation is based on pricing multiples derived from transactions of similar nature in the industry. This method is usually used to value companies for Mergers and Acquisition transactions. Usually, similar M&A Deals are taken as guideline transactions. This method calculates the comparable multiples based on the enterprise value. Therefore, the value arrived at by the subject company is also the enterprise value when valued using this method.

The steps involved in valuing a company based on the Guideline Transaction Method are as follows:

  1. Scouting the market for transactions involving comparable companies

  2. Selecting those transactions which are most suitable and are resembling the company and belong to the same industry. Economic conditions are one other factor that influences the chosen transactions to a greater extent.

  3. Applying the pricing multiples to the subject transactions.

2. Guideline Public Traded Comparable Method

The guidelines public-traded comparable method considers the different multiples such as EBITDA and revenue multiples of publicly traded companies similar to the one being valued. The companies chosen as comparable should be the ones operating in a similar or identical industry and sector. They must be of the same size, with similar characteristics. In other words, it should be an apples-to-apples comparison.

One example of a set of comparable companies are as follows: TATA Consultancy Services Limited, Infosys Limited, WIPRO Limited, and HCL Technologies Limited.

If there are no similar companies to that of the one being valued, companies with similar characteristics such as growth, risk, markets served, etc., are required. This method calculates the comparable multiples based on the enterprise value. Therefore, the value arrived at by the subject company is also the enterprise value when valued using this method. Therefore, to arrive at the company’s equity value, it is necessary to subtract debt and cash.

This kind of valuation is usually done in three steps

  1. Identifying comparable companies.

  2. Adjusting the multiples derived for differences in various factors between the chosen company and the company to be valued.

  3. Applying the pricing multiples that have been adjusted for in the second step to the company being valued.

This is one of the most widely used valuation methods because of the availability of abundant information and market data regarding the same. One limitation of this method is manipulating data or data being affected due to temporary conditions in the market.

Market Multiples

The following are the two broad types of market multiples

  • Equity Multiples

  • Enterprise Value Multiples

1. Equity Multiples

a. Price-Earnings multiple

The price-earnings ratio, also known as the price multiple or the earnings multiple, is used to identify the amount paid for each rupee of money paid. In other words, the multiple of earnings the investor is ready to pay per share of the company. The ratio is calculated by dividing the market value price per share by the earnings per share. The Price-Earnings multiple is one of the most common valuation measures that use a multiple of accounting earnings. This P/E ratio can either compare a company against its historical financials or compare the aggregate market or similar companies either historically or in the present time. This multiple is usually calculated by dividing the market value per share and the earnings per share.

Price to Earnings Multiple = Market Value Per Share/ Earnings Per Share

b. Price to Revenue multiple

The price-to-revenue multiple, also known as the revenue multiple, sales multiple, or price-to-sales ratio, basically compares the company’s stock price to its revenues. This is mainly used for valuing companies that are making losses. This multiple can be calculated by dividing the market capitalization as a whole of the company by its total sales or revenue of a particular period or dividing the stock price per share by sales per share.

Price to Revenue Multiple = Market capitalization/ Total sales or revenue of a particular period.

Price to Revenue Multiple = Share price/Sales per share.

c. Market Price to Book value multiple

The market price to book value multiple or the P/B ratio helps compare a company’s market capitalization to its book value.

Market Price to Book value multiple = Market Price per share/ Book value per share

Here, the company’s market value refers to its share price multiplied by the number of shares outstanding. In contrast, book value refers to the company’s net asset, which is usually expressed on the balance sheet.

A P/B Ratio of 1 is considered to be a solid investment. A ratio lower than one means the company is undervalued. Sometimes, there might even be something fundamentally wrong. It helps to know if it is overvalued. This ratio is beneficial for companies where assets primarily drive earnings.

2. Enterprise Value multiple

Enterprise value multiple is a multiple which compares the enterprise value and the earnings before interest, taxes, depreciation, and amortization. These are some of the most appropriate and widely used multiples for mergers and acquisitions transactions as they usually eliminate the effect of debt. The enterprise value of a company can be calculated by adding the company’s market capitalization with the total debt minus cash.

Enterprise Value (EV) = Market Capitalization + Total Debt – Cash

A more detailed formula for the same:

EV= Common shares + Preferred Shares + Market Value of Debt + Minority Interest – Cash and Equivalents

These are some of the multiples which can be called Enterprise Value multiples:

  • EV/ Revenue = Enterprise Value/ Sales or Revenue

  • EV/EBIT = Enterprise Value / Earnings before Interest & Taxes.

  • EV/EBITDA = Enterprise Value / Earnings before Interest Taxes Depreciation & Amortization.

  • EV/ Invested Capital = Enterprise Value/ Invested Capital

  • (This multiple is mainly used for capital-intensive industries)

  • EV/EBITDAR = Enterprise Value/Earnings before Interest Taxes Depreciation & Amortization and Rental Costs. (This multiple is primarily used in the hotel and transport sectors)

Guideline Public Traded Comparable Method Multiples and Data of Publicly Traded Comparable Companies

Calculating valuation multiples here.

Average of the Multiples

Average of the multiples calculated above.

These average multiples of the comparable company can be used for the company being valued (Note: The company being valued should be in the same sector, and have the same characteristics, and size as these comparable, if there are slight differences, they should be adjusted accordingly. The situational adjustments are mentioned below. Once this is done, the multiples can be applied to the EV/ Revenue of the company being valued to get the value of that company.

Situational Adjustments in Valuation

To obtain a proper, accurate valuation of a company or a transaction using the market approach, it is vital to adjust for situations. These usually arise due to differences between the asset or company being valued and the guideline transactions or publicly traded companies.

Need to adjust for lack of marketability, lack of control, illiquidity and blockages
4 adjustments exist
Control Premiums and Discounts for Lack of Control (DLOC)

Control Premiums and Discounts for Lack of Control (DLOC) are applied to reflect differences between the comparable and the subject asset regarding the ability to make decisions and the changes that can be made as a result of exercising control. This premium can be added as the buyer has the right to determine the direction of the company.

Control Premium = (Acquisition or Takeover price – Market price)/ Estimated Price.

Control Premium = (Target Invested Capital – ((Shares Outstanding * Unaffected Price) + Total Interest-Bearing Debt and Preferred Stock)) / ((Shares Outstanding * Unaffected Price) + Total Interest-Bearing Debt and Preferred Stock)

Control Premium usually refers to the amount that an investor or a buyer is reasonably expected and willing to pay over and above the fair market value with the view of gaining a controlling interest in ownership in a publicly-traded company.

The Discounts for Lack of Control (DLOC) are also referred to as the minority discount. This is usually used as a method of valuation when an investor might not have a controlling interest. This discount usually adjusts the price obtained due to valuation in which the assumption of control perspective is inherent. This is generally used for valuing private companies and is determined by various factors such as the type of transaction, industry conditions, type of purchase consideration, etc. The DLOC can be obtained from the control premium with the help of the following formula.

DLOC = 1 – (1/ (1+ Control Premium))

This discount is usually used along with a discount for lack of marketability, and the formula for finding the total discount using both is as follows:

Total Discount = 1- [(1- DLOC) (1- DLOM)]

Illiquidity Discounts

Illiquidity is a significant factor that needs to be considered and adjusted for while valuing companies. The need for liquidity may be varied. Publicly traded companies usually offer high amounts of liquidity, and liquidation costs are generally a tiny percentage and are very negligible. However, private companies are pretty illiquid, and the transaction costs for the same could be substantial. Therefore, there is a need for illiquidity discounts.

  • Adjusted Discount Factors

  • Bid-Ask Spread Approach

Blockage Discounts

Blockage discounts refer to the discount that needs to be paid due to dealing or transacting with a large block of shares or securities, usually in publicly traded security. This is done with the assumption that the owner of such large blocks of shares would not be able to sell such large quantities of shares without harming the price. This is based on the principle of demand and supply. An increase in the supply of shares due to the sale of large blocks and less demand leads to a fall in the price of the shares. Thus, this is a critical discount to be considered and adjusted for.

This can be arrived at by either of the following methods:

  1. Price Pressure and the Market Exposure Method

  2. Estimation of the present value of future cash flows Method

  3. Portfolio Insurance Method

Other Similar Valuation Adjustments

Some of the other adjustments to be considered while valuing a company or a transaction are as follows:

  1. Tax Benefits available to the company or availed by the company

  2. The existence of Contingent Liabilities or Assets

  3. The findings of the Due Diligence reviews

  4. The Value of Surplus Assets

  5. The Qualifications of the Auditors

Value indications: The Rule of Thumb

The rule of thumb is also known as the Anecdotal meaning hearsay, which is highly undependable and unreliable. This is considered a value indication for the market approach. Anecdotal or “rule-of-thumb” valuation benchmarks are considered to be a valuation indication for the market approach. This approach is highly unreliable. There is always a massive difference between the subject company and the companies taken as comparable. For every different industry, there is always a rule of thumb valuation innuendo. These give an insight. Values derived from the rule of thumb indications should not be given a high weightage unless relevant aspects prove otherwise. Each business differs from the other. Therefore, using the industry average for a company with significant variations may result in incorrect valuation.

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