As the number of businesses for sale increases, so does demand for information about business valuation. This insightful post originally appeared on OneAccordPartners.com; we are posting an updated version here with permission.
In my last valuation post I explained how profitability, either historical or projected, can be used to get a sense for a company’s value. The result is a theoretical value that may benefit from some real-world validation. Valuing a company by comparing it to transactions for which the market value is known is called the market approach. The keys to using this approach lie in knowing where to find comparable data, understanding how to interpret the information and applying the results to each individual situation. I’m going to briefly touch on all three of these issues.
Where to Find Comparable Data
Comps can come from either public or private transactions. The challenge with private transactions is that they’re, well, private. Fortunately, there are a variety of resources to tap into, including databases like Pitchbook, Done Deals and Pratt’s Stats. In fact, there are no less than 20 databases that compile deal details. Additional sources of transaction information can include other business owners, M&A advisors, attorneys, CPAs or other advisors who are involved in deals. In addition, there are some reliable sources, such as CapIQ and GF Data, for deals involving private equity groups for transactions as small as a few million up to hundreds of millions in value.
How to Interpret the Data
Finding information is the easy part; making sense of it is the hard part. Market data is far from perfect, but can be very useful as long as you use it with caution. Keep in mind that transaction data for private deals is self-reported (usually by intermediaries or private equity groups) and the information may or may not include all of the relevant details. For example, does the value of the reported transaction represent an all cash deal? Or is stock, contingency payments or a seller note involved? Are accounts receivable, inventory or other working capital included? Is it a stock or asset sale and how is the deal structured for tax purposes? Could it be a synergistic or fire sale? And so on.
Transaction details from publicly traded companies are readily available since they’re required to report certain information to the SEC. Data from public transactions can be useful, but keep in mind that large, publicly traded companies are generally less risky, more diverse, have deep management teams and are highly liquid. In fact, you can buy and sell shares the same day (or even the same minute!) while racking up less than $20 in fees. Try that with a privately held business. To put this risk difference in perspective, the S&P 500 Enterprise Value to EBITDA ratio (basically a private company’s market value to EBITDA multiple) historically ranges from about 8-12X. Most privately held businesses are going to trade at about half that of the S&P 500, so 4-6X give or take.
Applying the Results
Don’t make the mistake of deriving private company value from publicly traded P/E ratios. P/E is a different animal since P includes cash and debt, among other things, and E is after subtracting interest, depreciation and C-corp taxes. The small coffee roasting company that attempts to get a sense of value from looking at Starbucks’ P/E multiple is going to be way off base. Despite these differences, data from public transactions in the same industry can be useful as long as you make appropriate interpretations and adjustments.
The market-based approach to valuation is a great tool for determining market value, just make sure you understand the source and limitations of the information. Using market data along with the income approach and various accepted rules of thumb allows for different perspectives that should all prove useful in deriving a company’s value.
All businesses will change hands at some point, it’s just a question of when, to whom and for how much. Surveys have shown that the number one reason sales of privately held businesses fall apart is unrealistic expectations of value by one or more parties involved. So understanding value and, just as important, explaining value are critical elements of successful transitions. Develop realistic expectations, worry less about the multiple and focus more on your goals and the business fundamentals—especially if you’re in the early stages of building your business or have quite a few years before a transition. And remember, there is purpose beyond the multiples.
Speak with an expert about transitioning your business.