Should the Market Approach be Excluded

When Guideline Companies are Not Very Good?

When given a choice, do you prefer to minimize errors of commission or omission? The answer will likely influence your view as to whether the market approach should be used when valuing a company with guideline companies that are not very good. Someone who seeks to minimize errors of commission will likely exclude the market approach due to the difficulties in executing the analysis. Conversely, someone who seeks to minimize errors of omission will likely include the market approach due to the insight it can provide as a ‘sanity check’ to the other valuation approach(es) used. In this article, the author sets forth his views on whether to include or exclude those guideline companies that are imperfect.

When given a choice, do you prefer to minimize errors of commission or omission? The answer will likely influence your view as to whether the market approach should be used when valuing a company with guideline companies that are not very good. Someone who seeks to minimize errors of commission will likely exclude the market approach due to the difficulties in executing the analysis. Conversely, someone who seeks to minimize errors of omission will likely include the market approach due to the insight it can provide as a ‘sanity check’ to the other valuation approach(es) used. It seems logical to conclude that total errors (of commission and omission) will often be reduced when the market approach is included along with an acknowledgment of the inherent problems due to less-than-ideal comparability.

It is often best practice to use more than one valuation approach when valuing a company. Different approaches that yield consistent values generally reinforce the validity of each approach and the resulting valuation.[1] Conversely, different approaches that yield widely divergent values typically suggest at least one of the approaches generated a nonsensical valuation.[2]

But what should you do when it is difficult to apply more than one valuation approach? For example, a company may not have any projections that can be used to execute an income approach-based valuation. Alternatively, a valuation practitioner may conclude there are no publicly traded companies (or change in control sale of companies) that are reasonably comparable to the subject company. This situation results in a ‘lesser of two evils’ choice: either (1) incorporate an approach that is difficult to reliably apply or (2) eliminate a second approach that could be a ‘sanity check.’

Interrelationship between Market and Income Approaches

There is frequently a lot of overlap between the market and income approaches. This interrelationship makes it harder to argue that one approach is applicable while the other is not.

Elements of the income approach factor into application of the market approach. Companies that trade at relatively high multiples tend to have higher than average projected ‘valuable’ growth[3] and/or lower systematic risk. Conversely, companies that trade at relatively low multiples tend to have lower than average projected ‘valuable’ growth and/or higher systematic risk. Thus, core attributes of the income approach are typically used when identifying which multiple to apply in the market approach.

Elements of the market approach also factor into our application of the income approach. The most extreme example is a terminal value based on exit multiples, which effectively turns an income approach into a market approach when the terminal value comprises most of the total value. Less extreme examples include a discount rate based on betas derived from guideline companies and using guideline companies to benchmark the reasonableness of the subject company’s projections.

Can Guideline Companies Simultaneously be Reasonably Comparable and Not Reasonably Comparable?

Sometimes valuation practitioners attempt to thread the needle. For example, they may believe guideline companies can be reasonably comparable for discount rate purposes (e.g., a reliable source for beta) but not for valuation purposes (i.e., apply a multiple in the market approach).

The inconsistent characterization of comparability is an interesting issue. On the one hand, guideline companies are used for different purposes (risk vs. valuation) so it is possible that they could be reasonably comparable for one purpose but not the other. On the other hand, both analyses are based on trading of the guideline companies’ stocks: it may seem disingenuous to argue the same trades are relevant for one purpose but not the other.

Perceived biases can play a role in assessing this situation. Consider a company where all the guideline companies used for their betas trade at multiples that would indicate a ‘high’ (or ‘low’) value for the subject company. The decision to exclude the market approach due to lack of comparability while arriving at a ‘low’ (or ‘high’) value via the income approach may be characterized as result driven.

This is not just a theoretical issue. One of the more interesting valuation disputes I witnessed involved a report that had two sections written by different authors. The first section took the position that there were no good guideline companies, which is why the market approach was not applicable. The second section—which did not reference the first section—argued there were very good guideline companies for purposes of identifying beta and buttressed the argument by showing various ways in which the companies were comparable. Their client presumably wanted (based on the nature of the dispute) a ‘low’ value, which the report arrived at via the income approach. Notably, the multiples for the guideline companies would suggest a ‘high’ value was warranted. The perceived result-driven internal inconsistency was a major focus of cross-examination and rebuttal.  

What is the Lesser of Two Evils?

When confronted with two choices: (1) use guideline companies that may not be as comparable as we would like or (2) exclude the market approach, something is probably better than nothing most of the time. The choice boils down to a preference: Is it better to minimize errors of (a) omission or (b) commission? There may be errors of commission when applying the market approach with guideline companies that are not reasonably comparable. However, a transparent analysis should highlight where those errors may arise and identify areas where adjustments are necessary. The lack of transparency when there is no market approach to analyze sets the stage for errors of omission (e.g., the over- optimism or pessimism used to arrive at a value via the income approach) that may be difficult to assess.

Comparison to Company Specific Risk Premium

A company specific premium (CSRP) is an adjustment to the cost of equity (and by extension, the weighted average cost of capital) based on a determination that the discount rate is too low if it is not included.

The use of a CSRP is controversial. On the one hand, the income approach value without the company specific risk premium baked into the WACC may be too low. On the other hand, the amount used for the company specific risk premium may appear to be a ‘fudge factor’ with no real basis. The apparent need for an adjustment combined with difficulty in supporting a specific adjustment can result in a difficult debate to moderate.

A good way to address the perceived need to lower the value of the business without resorting to a ‘fudge factor’ is to explicitly address why the value appears too high. Perhaps the projected revenue growth or profit margins are too high or the projected capital investment requirements are too low. It is better to explicitly make and defend these adjustments than to implicitly make them through the back door via a CSRP that is harder to quantify and defend.

The same concept applies to the market approach when the guideline companies are not as comparable as we would like. Consider a company that is valued via the income approach at 5x EBITDA when the guideline companies trade at 10x EBITDA. There may be valid reasons for why the subject company is worth only 5x EBITDA. But one may not be able to truly assess whether the income approach valuation is reasonable without understanding why the subject company is valued at half the relative value of the guideline companies. A proper ‘sanity check’ would explain why the subject company is worth much less than the guideline companies that are not as comparable as we would like.

Conclusion

Less is not always more. When valuing a business, it is often better to have both an income approach and market approach than to just have one of these approaches. As a practical matter, virtually every decision in life reflects the consideration of trade-offs, and business valuation is no different. The marketplace offers businesses in all shapes and sizes that offer all sorts of trade-offs. It is often better to include a market approach—even when the guideline companies are not as comparable as we would like—to properly assess how the concluded valuation reconciles with the relative value of other companies in the marketplace.

[1] Of course, the approaches do not reinforce each other when the similar outcomes are due to result-driven choices.

[2] However, there may be logical reasons for such a wide range in values. For example, an income approach will likely result in a lower value than a market approach if the valuation practitioner believes the trading multiples are inflated due to a ‘frothy’ market. The difficulty is in proving up the argument that the market is ‘frothy’ and rebutting the counterargument that the valuation practitioner is unduly pessimistic.

[3] ‘Valuable’ growth refers to growth that creates value as opposed to growth just for growth’s sake. Some businesses will convert growth to value more efficiently than others (e.g., companies that need relatively low incremental capital to finance growth).

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Michael Vitti, CFA, joined Duff & Phelps, a Kroll Business in 2005. Mr. Vitti is a Managing Director in the Morristown, NJ office and is a member of the Expert Services practice. He focuses on issues related to valuation and credit analyses across a variety of contested matters and industries. This article represents the views of the author and is not the official position of Kroll, LLC (fka Duff & Phelps, LLC).

Mr. Vitti can be contacted at (973) 775-8250 or by e-mail to michael.vitti@kroll.com.