Now that we understand the difference between Net Income, EBIT, EBITDA and SDCF, let’s take a look at how these metrics can be used to determine the value of a company.
You may already have some familiarity with ways in which residential real estate is valued. For example, your neighbor’s house might be 2,000 sq. ft., have 3 bedrooms, 1 ½ baths and sold just 6 months ago for $300,000. Your house on the other hand may be slightly larger at 2,500 sq. ft., have 3 bedrooms and 2 baths. Does this mean that you house is worth more than your neighbors? What about the age and condition of the premises? Do the properties both have garages? If so, how many cars?
What we are doing in the above example is a form of the market approach to value. We are comparing the property we want to value (our house) with that of a similar property in a comparable location with actual sales data. This same analysis can be done with businesses. If you have actual transaction data to analyze, this is known as the Similar Transactions Method. If you don’t have transaction data to rely upon, you must look to publicly traded companies for guidance; this is known as the Guideline Company Method. With either approach, the ultimate goal is to compare the subject company to what is happening in the market on an “apples to apples” basis.
How then do we compare? What makes businesses comparable? Can a small closely held company really be “apples to apples” to a large multinational corporation?
Unlike real estate, we don’t have bedrooms, square footage or bathrooms to compare. So, we must first look to the industry of operation. We need to locate businesses or transactions in the same or similar industries as the subject company (using SIC or NAICS codes) and we must use current data if we want current value. We know the value of the public “comparable companies” (shares outstanding * share price) and we know the value of the target companies in our similar transactions (the deal value). So, how do we compare these transactions to our subject company? Answer: We use ratios.
Common rations are: Price/Sales, Price/Net Income, Price/EBIT, Price/EBITDA and Price/SDCF. The ratios that give us the best comparison depend upon the business we are valuing, the industry in which the companies operate and our premise of value. If we are looking to value a manufacturing facility where profitability is integral to our analysis, a Price/Sales comparison is not our best choice as it does not take into consideration profitability. However, if we are valuing a service business, such as an insurance company, Price/Sales may be more useful.
BE CAREFUL. This is not the end of your analysis. Don’t stop reading. We’re not apples to apples yet. You should have noticed that we just assumed a buyer or acquiring company would be willing to pay for the cash flow or EBITDA of a small closely held company in the same proportion (or ratio) as the market is willing to pay for cash flow or EBITDA of a publicly traded company like Wal-Mart. This makes no sense. Obviously an investor or acquirer will be willing to pay more for ownership shares in Wal-Mart than in a local family owned-retailer. A large multi-national company has access to capital markets, is better diversified, has buying power, etc., all things our small closely-held subject company may want but does not have. So, how then can we assume a buyer will pay the same proportion for the cash flow of our subject company as they would for shares of a large, publicly traded player? We can’t. We must make adjustments AND LOTS OF THEM to get to the “apples to apples” comparison that we so strongly desire. We will delve into the subject of multiple selection and multiple adjustments in our next post.
For now, let’s stick to the basics and leap ahead to applying the multiple. In order to determine an indication of value for the subject company, we must apply the selected multiple to the corresponding metric of our subject company. For example, if our comparative analysis results in the selection of a Price/EBITDA ratio of 4.0 times EBITDA, we multiply the EBITDA of our subject company by 4.0 to arrive at an indication of value for the subject. Sound simple enough? The math is simple. But the real trick is properly selecting and adjusting the multiples as mentioned above.
This summary is not intended to make you an expert on the Market Approach to value or to oversimplify the process. It is merely meant as an introduction or a starting point to provide you with some basic knowledge about the process. We will continue this discussion and our exploration into acquisition multiples in our next post. Please, stay tuned….