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Not Important in Valuations: Selecting Relevant Comparable Companies.

Well … we don’t believe that, but our observations point to a relative lack of focus on this critical aspect of valuation analysis.  Much of formalized valuation guidance proclaims that a valuer should “use professional judgment” or document the “process used in the selection of the guideline public companies.” Yet, there is little guidance on selecting, let alone fitting peer companies or guideline public company (“GPC”) financial measures to a specific valuation.

GPCs can provide a wealth of useful information to power many elements of valuation analysis.  Conversely, the same valuation analysis may require more than one GPC group to estimate different inputs within the same model. Below we cover some of the ways GPCs are applied.

Market Approach (Market Multiples)

From the watercoolers at high-flying tech companies to the halls of bulge bracket investment banks market multiples rule the day.  It appears that all you need to know is EBITDA or revenue multiplier to appraise a business.  But multiples vary, a lot, while sloppy application of these magic multipliers can lead to thoroughly erroneous estimates. An incomplete analysis is often just as accurate as random number-picking.

The market multiples are observed from comparable GPCs or transactions, but establishing comparability is tricky.  For example, a mobile app developer should not use revenue multiples of Apple Corp., even though both companies target the same users.  Many startups don’t have a single good comparable GPC.

For the purposes of estimating applicable market multiples, it is instructive to look for the companies in the same industry niche and of the similar size, nature of operations, stage of corporate development, profitability, and geography of operations.  They should produce the same type of widget, made from the same type of stuff, with the similar methods of production. 

Pure play peers (e.g. PayPal) are almost always better than conglomerates (e.g. JP Chase).  Finally, ideal GPCs are relatively established businesses exhibiting consistency between market multiples and other financial measures.

Income Approach (WACC)

Income approach values companies, assets and liabilities based on future cash in- or outflows.  Weight Average Cost of Capital (“WACC”) is a discount factor that converts uncertain future cash flow into a certain present value.  GPCs help estimate WACC by correlating their own stock price performance to that of the broad stock market.  Smaller companies are perceived to be riskier and higher discount is expected.

It is common to use the same GPCs for estimating both market multiples and WACC.  However, because WACC relies on a statistical measure such as correlation, matching business model or precise industry niche is not as important.  It may be more critical to have GPCs with long enough trading history or regular trading patterns.  Not all market multiple GPCs will be used in the WACC calculations.

Income Approach (Financial Ratios)

Financial ratios such as profitability, net working capital or CapEx requirements are often needed to build a financial forecast.  They also assist with some key assumptions in the cost approach method of valuing businesses or individual assets (e.g. intellectual property).

Because financial ratios reflect nuts and bolts of a business operation, GPCs must have similar operating models.  An end customer is not concerned with who sells Product X, but a valuation specialist must distinguish between online market place seller vs. inventory holder, distributor vs. manufacturer, balance sheet lender vs. broker.  In selecting GPCs, the nature of Product X is often secondary to the method of operation.  Financial ratios guide GPCs selections under the market approach.

Let’s Get Esoteric (Option Pricing Method and DLOM)

In 409A valuations, stock price volatility helps calculate Discount for Lack of Marketability and enables Option Pricing Method that separates common stock value from that of the preferred in complex capital structures.  Volatility is also used in valuing earnouts and other complex financial instruments.

Estimating volatility is a complex and nuanced process that relies on GPCs.  Accounting Standard Codification Topic 718 mentions that the subject company and GPCs should share industry, stage of life cycle, size, and financial leverage.  The industry is often a defining factor, while the exact product match is far less important than the stage of corporate life cycle or size.

Volatility GPCs can be substantially different from those used in deriving WACC or net working capital requirements.  A pre-revenue biotech company would require similarly situated GPCs to estimate volatility, but it will need established biopharmaceutical peers to build a long-term financial forecast.

In Short…

Do not select GPCs simply because they:

♦  offer a competing product (their complete product portfolio can be entirely different),

♦  compete in the same market (e.g. cardiovascular surgery vs. drugs),

♦  are key industry player (these are often large conglomerates that provide other unrelated products and services),

♦  are a potential acquirer (e.g. integrating vertically), or

♦  work on a similar technology (but a different method of monetizing it).

 

We recommend that valuation service clients:

♦  provide a valuation specialist with what they consider relevant GPCs up-front,

♦  scrutinize GPCs utilized in the valuation with the focus on those included and omitted,

♦  understand how GPCs are being used in the valuation analysis,

♦  consider overlaps between valuation report GPCs and those used for other purposes such as calculating stock-based compensation,

♦  consider the views of the Board, bankers and other strategic stakeholders in relation to the GPC set selected by your valuation specialist.

 

The End

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