The Criticism of the Guideline Private Comparable Transaction Method

Tread Carefully Using this Market-Approach

In valuation theory, the market-based approach, being one of the three main valuation approaches, can rely on the guideline private comparable transactions method, suggesting that the results obtained in that way should be treated equally with other valuation approaches and methods. However, the disadvantages of the guideline private comparable transactions method are so consequential that its reliability should be strongly questioned, and the results based on it should be taken with significant caution. This article justifies this opinion by stating the most important weaknesses of the mentioned method.

In valuation theory, the market-based approach, being one of the three main valuation approaches, can rely on the guideline private comparable transactions method, suggesting that the results obtained in that way should be treated equally with other valuation approaches and methods. However, the disadvantages of the guideline private comparable transactions method are so consequential that its reliability should be strongly questioned, and the results based on it should be taken with significant caution. This article justifies this opinion by stating the most important weaknesses of the mentioned method.

The guideline private comparable transactions method is based on the presumption that the transactions completed in the past regarding other entities which are similar to the valued entity can be used to determine the value of the valued entity. Using the multiples taken from the published transactions, e.g., EV/EBITDA, P/E, or other metrics, we can apply them to determine the fair value. Even this fundamental assumption can be questioned, given that no two identical companies exist in the world. There will always be differences related to the market position, staff competencies and abilities, growth prospects, and particular risks. To overcome this problem and limit its impact on the valuation results, we can restrict the peer group to the most suitable companies. But this will not eliminate the other obstacles.

First, usually, the goal of the valuation is to determine the fair market value of the asset. It is defined as the amount that would be obtained to sell an asset or pay to transfer a liability in an orderly transaction between market participants at the measurement date. How can we be sure that the parties have concluded the reference transaction in an orderly manner? There are situations when the seller is under compulsion to sell due to financial distress, some contractual or legal obligation, or other reasons restricting the time for marketing the asset on the market properly. Consequently, without detailed knowledge about each and every transaction, we can include in our peer group the multiples which are not indicative of a fair value of the comparable asset which would skew the results.

The other important matter is the issue of timing. As the definition of fair value states, the price should represent the amount transferred at the measurement date. At the same time, the guideline private transactions are a collection of deals completed in the past months or can cover even years to enlarge the reference group when the relevant market activity is scarce. It is obvious that the market participants would perceive the value of the company differently at various points in time. External factors, like interest rates, GDP growth, input prices, and currency rates, are changing constantly, impacting the value perception of businesses. No one needs to be convinced that the value of the company is significantly different at the bottom and at the peak of the economic cycle which may be only a few quarters away from each other.

But even if we restrict the transactions to the most recent, which should diminish the effect of changes in the environment, there is one more problem—the representativeness of the sample. Most of the private transactions are confidential, which means that we cannot know the price for which the company was sold. In the main databases, the deals with disclosed value represent only 20–40% of the total number of transactions, depending on the sector, market, and size of the targets. This means that we are getting only a random sample of multiples and we cannot be sure that the sample is representative of the whole population. We can compare it to the situation where we have selected a peer group composed of publicly listed companies, but for the valuation, we can use only a random sample of their multiples.

Except for public companies which are usually obliged to inform about the conditions of the completed acquisitions or disposals, the other parties buying or selling can decide to make the information public only if this is favourable for them. This can mean that the buyers boast only when they paid low, and sellers only when they sold high. I have personally participated in a deal where the public company, acting as a purchaser, has deliberately negotiated a low multiple for the first stage of the transaction acquiring a majority stake, only to convince the public that the deal is a bargain. At the same time, the second stage, covering the buyout of the remaining stake in the future, was set contractually at a significantly higher multiple, making the whole transaction not so attractive anymore. But the buyout conditions and the future multiple were confidential and not disclosed during the announcement. In such a case, taking only a multiple that was published, leads to incorrect conclusions. As a consequence, the disclosed deal values may include a bias depending on the dominant side in the set.

Disregarding the above, we can believe that the sample of transaction multiples which is large enough will be still representative. But then another obstacle comes out—the hidden or deferred considerations included in the sale contracts. Very often the seller can receive additional payments after the transaction, depending on the achievement of some financial goals or predefined milestones. Rarely they are disclosed to the public and incorporated into the total deal value for the purposes of the calculation of a multiple. The contracts may also include some other arrangements, like preferable trade relations with a seller, future use of the assets of a selling entity, or some other forms of remuneration, which can be related more to the sale conditions than to the subsequent business relationships. Only combined conditions represent the full picture of the transaction and benefits obtained by the seller. Without complete knowledge about them, simple multiple calculations are prone to errors.

The incomplete information about the deal arrangements might be further enhanced by the distortion of the financial data of the target company presented in its financial statements. They may include some positive or negative one-off events; however, the providers of the multiples are usually not adjusting the numbers, calculating the multiple on the basis of the original numbers. What is more, the price paid by the company may cover also some non-operating assets owned by the entity, not contributing to the sales or profit including, e.g., real estate or investments. This would elevate the multiple and make it not relevant for the valuation of other companies.

The abovementioned weaknesses of the guideline private comparable transaction method strongly question the reliability of the results obtained that way. As a consequence, basing conclusions about the fair value of the entity on that method, fully or even partially, may skew the results and lead to unfavourable outcomes for recipients. Nevertheless, they do not make the method totally inapplicable, as it can still be used as a cross-check to verify the reasonableness of the value generated by the income approach.

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Tomasz Manowiec, CFA, FCCA, is a director responsible for the Corporate Finance department at Baker Tilly TPA, an audit, consulting, and advisory company. His practice includes valuation of enterprises and financial instruments, financial modelling and analysis, transaction advisory, and business planning. Before his consulting role, he was in the investment industry working as a sell-side analyst, buy-side analyst, and fund manager responsible for the equity markets.

Mr. Manowiec can be contacted at 011-48-606244697 or by e-mail to tomasz.manowiec@bakertilly-tpa.pl.