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Types of Comparables
A company may be valued using any number of characteristics about the business. In general, the price of that company’s total equity is compared to some value characteristic of the company, such as the before or after-tax earnings, cash flow, or revenue of the company. This ratio may then be used to value comparable companies by simply multiplying the target company’s value characteristic by the similar company ratio. Of course, this valuation is adjusted to account for differences between the two firms.
Transaction multiples are used to estimate the value of the target company based on purchase prices of companies that were recently involved in similar transactions (sales, merger, funding, etc.). The performance characteristics of the companies are compared against the price at which the company is sold. These ratios are used as a starting point for valuing the present company. The ratios are adjusted to account for differences between the transactions and companies. For example, the acquisition of a given company always includes a premium in valuation to account for the level of control afforded the investor.
Industry comparables are used to estimate the value of the target company based upon a ratio of price to a value characteristic of companies within a given industry. For example, companies in the industry may have a price to revenue value ratio of 5 to 1, or five dollars in company valuation to one dollar of annual revenue. It is important to note that the term industry has a loose definition. An investor may consider any number of characteristics about a company’s operations when classifying it as operating in a given industry.
The comparable company method calculates the market value of the company’s equity by employing a value-characteristic ratio derived from companies with some comparable features that justify the comparison. Companies from any industry may have characteristics about operations, mission, market segment, strategy, etc., that makes it a good source of comparison when valuing a business. As with transaction and industry comparables, a value-characteristic ratio is derived from the comparable company and used to determine a value of the subject business.