An Explanation of the Market Approach to Valuation – Guideline Transaction Method
By Sean R. Saari, Partner, Advisory Services
Investors in publicly traded companies have the luxury of knowing the value of their investment at virtually any time. An internet connection and a few clicks of a mouse are all its takes to get an up-to-date stock quote. Of all U.S. companies, however, less than 1% are publicly-traded, meaning that the vast majority of companies are privately-held. Investors in privately-held companies do not have such a readily available value for their ownership interests. How are values of privately-held businesses determined, then?
Each month, this eight blog series will answer that question by examining a key component of how ownership interests in privately-held companies are valued.
In my last blog, I explained the Income Approach to Valuation using the Discounted Cash Flow Method. Today, we’ll discuss the market approaches.
There are two market approaches that are primarily used when valuing a business, the Guideline Transaction Method and the Guideline Public Company Method. These methods are used to value a company based on the pricing multiples observed for similar companies that were sold or are publicly-traded.
More information related to the Guideline Transaction Method is provided below along with example:
Guideline Transaction Method – The Guideline Transaction Method values a business based on pricing multiples derived from the sale of companies that are similar to the subject company. The steps taken in using the Guideline Transaction Method include finding transactions involving the purchase of comparable companies, selecting the transactions that closely mirror the company’s operations and which occurred in similar industry and economic conditions, and finally, applying the indicated pricing multiples from the representative transactions.
Valuation experts typically subscribe to databases that allow them to perform searches for comparable transactions. The companies involved in the guideline transactions typically differ from the subject company in their respective stages of development and size, but they should have comparable operational characteristics and financial risks. The comparable transactions also reflect the economic conditions of the industries in which the subject company operates. Thus, the comparative analysis to the subject company being valued is based on the performance and characteristics of the sample as a whole rather than on any individual transaction selected.
Once a population of guideline transactions is identified, some valuation experts also analyze transaction subsets that focus on specific groups of transactions such as companies of similar size, companies with similar margins, and transactions that have occurred most recently.
It should be noted that the calculated transaction multiples are typically based on the enterprise value of the purchased companies, meaning that we arrive at an enterprise value of the subject company when using the Guideline Transaction Method. Enterprise value incorporates all of a company’s operating assets, except for cash, and includes working capital, fixed assets and intangible assets. Because enterprise value indicates the value of a company’s equity and interest-bearing debt (excluding cash), one must subtract debt and add cash to the calculated enterprise value to arrive at the company’s equity value.
An example of the Guideline Transaction Method is presented below:
To summarize, the Guideline Transaction Method is a market-based approach to valuation that is based on the pricing multiples derived from comparable transactions. If you have any questions regarding the value of your business, the methods of deriving value or concerns about your financial position, please contact Sean R. Saari, Partner, Advisory Services.