Market-Based Valuation

The market approach uses direct comparisons to public companies to estimate the fair value of an equity interest in a private company. The three major variations of this are:

1. The guideline public company method (GPMC).
2. The guideline transactions method (GTM).
3. The prior transaction method (PTM).

The market approach is preferred over the income approach and asset approach because it uses actual market transactions.

Private and public companies use similar factors to identify guideline companies. Key factors include the industry in which the company operates, operational form, trends, and current operating status.

Public and private company analyses may differ in the financial metrics used in the valuation process. Price-to-earnings ratios are frequently used in the valuation of public companies while EBITDA/EBIT multiples are used in the valuation of larger, more mature private companies. EBITDA is best compared to the market value of invested capital (MVIC), which is the market value of debt and equity. For smaller private companies, net income multiples are commonly used. Revenue multiples are used for very small private companies.

Guideline Public Company Method

The value of a private company is based on the observed multiples from the trading activity of comparable public companies’ shares. These multiples are adjusted for differences in risk and growth of the private company.

The primary advantage is the large pool of guideline companies and the amount of information available. Disadvantages include possible issues regarding comparability and subjectivity in the risk and growth adjustments to the pricing multiple.

Control premiums are used in the valuation of controlling interests. A control premium is an amount or a percentage by which the pro-rata value of a controlling interest exceeds the pro-rata value of a noncontrolling interest in a company. A control premium is added to the controlling interest value computed using GPCM.

Factors to Consider in Assessing Pricing Multiples

Type of Transaction

Transactions could either be financial or strategic. A strategic transaction involves an acquirer who would benefit from synergies by acquiring the target company. A financial transaction involves an acquirer who expects no synergies from acquiring the target. Control premiums are higher for strategic transactions compared to financial transactions.

Industry Factors

It is assumed that industries that are experiencing acquisition are already reflecting a control premium in their prices because of the probability of acquisition.

Form of Consideration

A transaction involving the exchange of stock might not be appropriate when measuring control premiums because management typically prefers to use stock in acquisitions when they believe their shares are overvalued.

Example: Value of the Private Company using Pricing Multiples

The following information has been gathered regarding comparable public companies to a private company that is being valued:

• MVIC/EBITDA of comparable public companies is 5.
• A downward adjustment of 15% to the average public company MVIC/EBITDA is required to reflect the risk and growth of the private company.
• The private company’s normalized EBITDA is $12million, the market value of debt is $7million.

The value of the private company and its equity can be calculated as:

Solution

$$\begin{align*}\text{Adjusted MVIC/ EBITDA}&=5\times(1-0.15)\\&=4.25\\ \\ \text{Value of firm}&=4.25\times\text{12m}\\&=\text{51m}\\ \\ \text{Value of equity}&=\text{51m}-\text{7m}\\&=\text{44m}\end{align*}$$

Guideline Transactions Method (GTM)

The value is based on pricing multiples derived from the acquisition of comparable public or private companies. GTM uses a multiple related to the sale of entire companies. Transaction data is compiled from public filings. Transaction multiples are most appropriate for valuing a controlling interest in a private company.

Factors to Consider when using transaction-based pricing multiples include:

• Synergies: The price of comparable strategic acquisitions may include adjustments for anticipated synergies.
• Contingent considerations: These are potential future payments to the seller that are contingent on meeting certain milestones like achieving a target EBITDA. The inclusion of contingent considerations in acquisition agreements reflects uncertainty about future financial performance.
• Noncash consideration: Acquisitions may include stock in the consideration. The cash equivalent value of a large block of stock may create uncertainty regarding the transaction price.
• Availability of transactions: Meaningful transactions for a specific private company may be limited.
• Changes between the transaction date and valuation date: The period between the transaction date of the comparable transaction and the valuation date should also be considered as numerous changes may have occurred during the two dates.

Example: Guideline Transactions Method

The following information has been gathered regarding transactions involving comparable public companies to a private company that is being valued:

• The MVIC/EBITDA multiples from recent private company acquisitions in the industry are 7.
• The overall risk and growth opportunities of the acquired companies are similar to those of private company.

If the private company’s EBITDA is $13 million and the market value of its debt is $13 million, the value of the firm and its equity can be calculated as:

Solution

$$\begin{align*}\text{Value of the firm}&=7\times13\\&=\text{91m}\\\text{Value of equity}&=\text{91m}-\text{13m}\\&=\text{78m}\end{align*}$$

Prior Transaction Method

This is based on actual transactions in the stock of the subject private company. It is most relevant when determining the value of a minority interest in a company.

The advantage of this approach is that it provides the most meaningful value as it is based on actual transactions in the company’s stock. On the other hand, it is a less reliable approach for infrequent transactions.

Question

The value of equity for a company with the following information is closest to:

• MVIC/EBITDA of comparable public companies is 7.
• A downward adjustment of 14% to the average public company MVIC/EBITDA is required to reflect the risk and growth of the private company.
• The private company’s normalized EBITDA is $8 million, the market value of debt is $9 million.

1. 38.16
2. 39.16
3. 36.98

Solution

The correct answer is B.

$$\begin{align*}\text{Adjusted MVIC/ EBITDA}&=7\times(1-0.14)\\&=6.02\\ \\ \text{Value of firm}&=6.02\times\text{8m}\\&=\text{48.16m}\\ \\ \text{Value of equity}&=\text{48.16m}-\text{9m}\\&=\text{39.16m}\end{align*}$$

Reading 27: Private Company Valuation

LOS 27 (h) Calculate the value of a private company based on market approach methods and describe the advantages and disadvantages of each method.