Over the past month, we have been in no fewer than five meetings discussing the sale, purchase, or transition of an existing company. We first listen in order to gain an understanding of goals and timelines. Then we often suggest that as a next step, a business valuation be prepared by an objective, experienced valuation professional.
The professional valuators rely on careful analysis, company metrics and more importantly, transaction databases, which contain the details of thousands of real-life public and private business/company sales. They are often used by business valuators whilst applying the transaction method to determine a value of a business. This method — also known as the merger and acquisition (M&A) method — is a product of the market approach. The M&A method derives a company’s estimated value from prices paid for by companies engaged in the same (or similar) business.
Selection Criteria
Valuators start this methodology by filtering transaction databases based on specific selection criteria, the most common of these are total annual revenue, number of employees and geographic area. These parameters affect which transactions the valuator analyzes. A minor change in the selection criteria can have a major impact on value. Timing is essential in today’s uncertain marketplace. The use of outdated transactions when applying this method could lead to erroneous value conclusions.
Pricing Multiples
Next, valuators analyze the sample of transactions to develop pricing multiples that relate the sale price in each transaction to the respective company’s underlying financial data. Valuators can compare selling price to many financial metrics. For example, a valuator might apply the average price-to-cash-flow multiples to the subject company’s revenue or cash flow in order to estimate value. Which metrics are relevant depends on a comparable company’s operations and historical performance.
Generally, valuators have the most confidence in the pricing multiple which shows the lowest standard deviation. This means that if the transactions are graphed, the preferred pricing multiple is the one in which the datapoints are the most tightly clustered with the fewest outliers. In some cases, a valuator might use several pricing multiples and assign varying weights to each relevant multiple.
Detailed Approach
It is critical for valuators to research each sale transaction closely to understand what is being transferred and the underlying terms of the deal. The more detail a database provides about the transaction and company, the more confident a valuator can be that the guideline company is comparable to the subject company.
Valuators also make assumptions and adjustments based on informed professional judgement. In turn, these modifications affect valuators’ final conclusions. The outcome of this method is only as reliable as a valuator’s professional judgement and understanding of the transaction data.
Exercise Caution
Courts often perceive transaction databases as one of the most straightforward, objective sources of valuation evidence. And when business owners contemplate buying or selling their company, the information in these databases can also provide insight into industry trends. But it is important to carefully review the details of each transaction and understand how each database reports financial metrics to avoid inaccurate conclusions.
Contact us for more information about the application of this nuanced methodology.
