Considerations When Preparing Guideline Public Company Multiples for a Private Business
Among the approaches or methodologies employed by business valuators to determine the value of a business or equity interest is the market approach. The market approach determines the value of a business or equity interest using one or more methodologies that compare the subject business to similar assets, businesses, business ownership interests, and securities that have been sold or publicly traded. The advantages of using the market approach eliminates some subjective estimates and uses data that is readily available and verifiable. Two commonly applied methods under the market approach are the guideline public company method and the precedent transaction method. In this article, we will focus on the guideline public company method.
The guideline public company methodology is a useful tool in determining the value of a business or equity interest by comparing the subject company to similar companies that are publicly traded. This allows a private business to better understand the price it might receive if it was to trade publicly, based on public companies within a similar industry and similarly sized operations.
There are three steps to prepare a guideline public company comparison:
- Identifying a list of comparable publicly traded companies and calculating applicable valuation multiples. A valuation multiple is applied to a financial measure such as normalized earnings before interest, taxes, depreciation, and amortization (EBITDA) to develop the value of a business;
- Adjusting the guideline public company multiples based on the relative size and risk of the comparable public companies in relation to the subject company; and
- Applying the selected multiples, after any adjustments, to the subject company/interest in order to determine its value.
Identifying comparable public companies and calculating valuation multiples
When identifying comparable public companies, it is important to consider the industry, operation size, location, risk, and diversity of revenue streams of the subject company. For each variable, consider the impact of relevant differences between the selected public comparable companies and the subject company. For example, classifying a restaurant into a full-service restaurant industry versus the fast-food limited service industry could result in different market multiples. Similarly, diversified companies are expected to have different market multiples compared to companies that engage in a specific line of business.
A common misconception is selecting more public companies, will result in a better analysis when the public companies may not be truly comparable to the subject company. Ideally, an average of a number or group of comparable public companies should be used for an accurate analysis.
Once a set of public comparable companies have been identified, valuation multiples are calculated using either the Enterprise Value or Equity Value. Both can be applied to earnings before interest and taxes (EBIT), EBITDA, revenue, or even nonfinancial measures. When calculating the valuation multiples, review the public company’s financial reports for one-time adjustments that may affect EBITDA or the selected measure. The most common valuation multiples use the Enterprise Value, being the “debtfree” approach. The Equity Value may be more relevant and reliable for equity valuations. See our Spring/ Summer 2022 issue of the FSAT News for an in-depth discussion on the differences between Enterprise Value and Equity Value.
Adjusting guideline public company multiples for comparability to private companies
Professional judgment is required to determine the potential discounts that is applicable to the subject company. For example, an inherent minority discount applicable to public traded companies may offset a liquidity discount that is applicable to smaller private companies. The following are common discounts to public company valuation multiples when valuing smaller private companies:
Liquidity discount: The amount by which the en bloc value of a business or ratable value of an interest therein is reduced in recognition of the expectation that the business or equity interest cannot be readily converted to cash.
Minority discount: The reduction from the pro rata portion of the en bloc value of the assets or ownership interests of a business as a whole to reflect the disadvantages of owning a minority shareholding.
Size discount: Large, diversified, and attractive businesses may have little or no discount, whereas smaller companies may have considerable discounts.
Applying selected valuation multiples
Finally, prior to applying the selected Enterprise or Equity Value multiples to the subject company, ensure the earnings of the subject company are “normalized” so they are representative of future maintainable earnings and are similar to the earning measure of the comparable public companies.
The market approach is often used as a secondary methodology or to assess the reasonability of a valuation conclusion. However, it can also be an informative first step if you are considering selling your business or adding a shareholder. To ensure you consider accurate guideline public comparable companies multiples for your business, one of our valuation specialists may be able to assist.