When valuing a privately-held entity, there are typically three commonly-accepted methodologies employed by valuation professionals: the Income Approach (which consists of the application of either a capitalized or discounted cash flow method), the Market Approach (which includes both the guideline public company and guideline transaction methods), and the Asset Approach (although this approach is not typically used in the valuation of profitable operating companies). Many valuators rely heavily on an income-based approach as a preferred valuation method, as it relies on management’s estimation of future performance to determine value (and nobody is better positioned to be in-tune with a company’s future prospects than management).
However, projecting future performance can be difficult depending on several factors, including the nature of the subject company’s industry (i.e., highly cyclical), and prevailing market conditions. Additionally, projections by management are susceptible to various cognitive biases that can potentially limit their accuracy. In these cases, valuators often rely on the use of market-based approaches to provide additional indications of value. Similar to income-based approaches, however, market-based approaches have inherent benefits and weaknesses, as discussed below:
Guideline Public Company Method
The guideline public company method (“GPCM”) uses current pricing multiples of publicly-traded companies in the subject company’s industry.
- Pro: Utilizes up-do-date market pricing, which best reflects current investor sentiment, industry outlook and performance expectations, and prevailing economic/market conditions.
- Pro: Publicly-traded prices represent actual, real world prices that investors are willing to pay for companies that could be considered an alternative investment to the subject company.
- Pro: Public company data is easily accessible and verifiable.
- Con: Public companies may lack direct comparability to the subject company in several respects (e.g., public companies are often larger, have greater access to capital, and can be more diversified in terms of markets served and products/services offered).
- Other Considerations: Value indicators based on the GPCM reflect non-controlling values, which may or may not be consistent with the subject interest being valued. If valuing a controlling interest, some adjustment to the applicable multiples or resulting indicators of value may be appropriate.
Guideline Transaction Method
The guideline transaction method (“GTM”) uses pricing multiples based on actual transactions involving companies (private or public) in the subject company’s industry.
- Pro: The GTM analyzes actual transaction prices from companies in the subject’s industry.
- Pro: Compared to the GPCM, it can be easier to find more directly comparable companies using the GTM, particularly in terms of size (although direct comparability based on business description may be difficult).
- Con: Some of the transactions may have occurred during periods with substantially different market/industry conditions, which may not represent the prevailing merger and acquisition environment.
- Con: Data is not as easily accessible as public company data and may require access to costly proprietary transaction databases.
- Other Considerations: Transaction prices typically include a premium to reflect the benefits of control and/or anticipated synergies. As such, a valuator should be careful to consider and adjust for these factors depending on the purpose of the valuation and the interest being valued.
Given the pros and cons of the various valuation methodologies outlined above, a comprehensive valuation analysis should include some combination of income and market-based approaches. Similar conclusions reached based on the application of multiple methods using different valuation approaches serves to bolster valuation conclusions and should give the user a greater degree of confidence in the accuracy of the concluded value.