We launched our series of articles by checking out the times you may need to conduct a business valuation, and the methods you can choose to do so. Then we provided a detailed overview of the advantages and disadvantages of the most popular valuation method, the income-based method. In this article we elaborate on the characteristics of the comparables methods and assess their strengths and weaknesses.
What does comparative data reveal?
Using comparables methods, the value of a company is determined based on data from third parties. The comparables methods are based on market data. Simply put, the value of a company is assessed based on the current selling price/prices or the stock exchange price of a similar company or companies.
What are the comparables methods?
Basically, the comparables approach constitutes two groups of methods:
- Comparative analysis supported by indicators
- Use of precedent transactions
The essence of the comparison based on indicators is that a company’s value can be assessed based on the stock exchange price of listed companies and using certain indicators. Valuation based on the P/E ratio, i.e. the price/earnings ratio, is the most common method of indicator-based valuations. The business value is calculated by dividing the stock price of the comparable companies with their taxed earnings per share, and then using the average of the available P/E ratios of the compared companies to multiply with the ordinary profit of the company being valued.
Using precedent transactions is a much simpler method that relies on historical data from databases.
Source of comparative data
This procedure is carried out by querying and evaluating comparative figures from various publicly accessible data sources or stock exchange databases. Databases are generally only accessible by paying considerable subscription fees or query charges.
What correction elements are necessary?
To avoid the pitfall of comparing apples and pears, the different nature of the company being valued from the companies involved in the comparison means that correction elements have to be applied to reach the most realistic business value possible. It is easy to see why the simple comparison of a family business and a listed company operating in the same sector is not advisable, simply because of their differing sizes and market shares. For similar reasons, different exposure to third-party funding can also affect the value of a business. What is also important during a valuation is whether you are buying an entire company or only part of its shares/holdings. All these aspects can be taken into account by modifying the comparable values and applying associated multipliers. However, quantifying these modifying multipliers is the biggest challenge of this method.
What are the strengths of the method?
The undeniable advantage of comparables methods lies in their simplicity. Using the comparative data available, the valuation can be conducted remarkably fast. Given the use of public data or figures from accessible databases, the valuation result is less subjective than with other methods.
What are the disadvantages of the method?
The weaknesses of the method are as follows:
- Accessing comparative data is costly.
- Data in the given sector is not always available in sufficient amounts.
- The less comparative data there is available, the more we have to factor in specific impacts during the valuation.
- This valuation does not take into account the future potential of the company.
- It does not consider the company’s strategies for the future.
- In the case of profitability indicators, the company’s profit/loss figure can be influenced by accounting measurement methods, so it may not always offer an objective benchmark.
- Defining the right extent of correction factors is difficult.
Based on the pro and contra arguments highlighted above, it is clear that the comparables methods are the fastest and simplest ways of determining business value.
If you would like to learn more about business valuations or the valuation of a specific company, please contact our financial consulting experts.
