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Investment bankers use several different types of methodologies while arriving at the valuation of a company. One of the most commonly used analysis is called precedent transaction analysis.
Precedent transaction analysis is a relative valuation methodology, just like comparables analysis. This means that these methodologies do not derive the value of the company from the underlying cash flow but instead derive the valuation based on the valuation of other companies or other transactions that have gone through. The basic idea is to come up with a valuation based on what the valuation of similar companies under similar circumstances have been.
This type of valuation is also used in our everyday life. For instance, when we indulge in real estate transactions, we often try to find out the price points at which houses in similar locations have been sold. This value is used to derive the value of a property in question.
Investment bankers generally undertake precedent transaction analysis in a more structured form. This is where there are multiple steps that are followed while conducting the analysis. The details of the steps have been listed below:
Step #1: Selecting the Comps: Investment bankers begin the process by selecting companies that are very similar to the one in which the transaction is about to take place. The problem here is that companies are not like houses. This means that they are not homogenous. Even if companies sell similar products and operate in similar markets, there could still be many factors that could influence their valuation.
Investment bankers try to find the best comparables using factors such as industry, geography, size, and even the time period when the comparable transaction took place. The time period is very important while looking at comparable transactions. This is because there is a fundamental principle of the time value of money involved. If similar transactions took place five or seven years ago, their value would have to be adjusted to reflect the current valuation.
In the case of big companies, the details of these transactions are generally made public. This is the reason why conducting a precedent transaction analysis for them is fairly easy. On the other hand, when it comes to smaller private companies, information has to be pulled up from certain databases that have been specifically created for this purpose. It is important to note that a single transaction cannot be made a basis for a new valuation. The new valuation has to be derived as an average of six to ten precedent transactions.
Step #2: Creating the Financial Model: After the precedent companies have been analyzed, we need to put their data into a financial model. For instance, we need to look at the income statement, balance sheet, and even the cash flow statement in order to identify the important numbers. The problem is that these numbers are seldom available in the public domain.
A public company acquiring another public company is a rare occurrence. Generally, at least one party to the transaction is a private company. Since private companies have no compulsion to disclose their data to third parties, obtaining this data becomes quite difficult.
Step#3: Calculating the Multiples: The valuation of one company can only be used to derive the valuation of another company once it is expressed in the form of a comparable. For instance, the valuation of companies is often expressed in the form of enterprise value to EBIT or in the form of a price equity ratio. This is because such an expression creates a plug and play valuation model.
For instance, if the P/E ratio is derived at 20, then we can use this to derive the valuation of our firm. For example, if we know that the earnings of a firm are $1 million, then we can use the P/E ratio to derive the price, which would be 20 times $1 million i.e., $20 million.
The multiples which are used in different industries are quite different. For instance, in some industries, price to book value is an important multiple, whereas, in other industries, the ratio may be irrelevant.
It is also common to corroborate the valuation using various multiples. For instance, the value derived from price to book value ratio, as well as the price to earnings ratio, is often compared to see whether the values remain consistent even if different multiples are used. It is important to take into account that a higher multiple is used if the buyer is taking a controlling stake in the company being sold. This is a common practice in the industry and is called a control premium.
Step #4: Aggregating the Values: Since the precedent transaction analysis does not depend upon one value, data has to be aggregated. For instance, there will be a range of price earning ratios or price to EBIT ratios. In order to use them effectively, companies often use statistics such as the mean of all the values or the 75th percentile of all the values. The statistical value derived is the one that is actually used to derive the valuation of the underlying company.
There are many investment banks that have readymade software tools that are used to query databases and return precedent transactions analysis based on the parameters provided. However, an investment banker with specialized knowledge is required to make sense out of the numbers being quoted.
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