Making Sense of Business Comps in the Middle Market
Investment bankers use relative valuation techniques, often referred to as “comps and transactions” or “business comps”, to support and inform business valuations. More specifically, investment bankers utilize 1) comparable companies analyses and 2) precedent transactions analyses when constructing a formal valuation. Within the middle market, assembling useful comps can be a challenge, especially when navigating imperfect and partial information. Moreover, business comps are often misused and misinterpreted when supporting a valuation.
A comparable companies analysis examines basic operating metrics and valuation multiples across a subset of public companies. Predictably so, a portion of this data may not be directly applicable to the target business in a middle-market transaction, but certain trends can be deduced to form a stronger valuation underpinning.
The single most important step is identifying a true comparable universe of companies. Intuitively, this starts with a complete understanding of the “target” business (“target” being the ultimate subject of the analysis). In a perfect world, the advisor will be able to find comparable companies that share defining characteristics of the target business and have obvious overlap in terms of industry, operations, products, etc. (almost never a group of perfect fits). Businesses are unique and don’t always fit in with the rest of their public peers, forcing the advisor to leverage experience and improvise.
After selecting the peer group, the investment banker will record the most updated information and conduct some basic analysis. The advisor will cross analyze select metrics such as EV/EBITDA, EV/SALES, and EV/EBIT (among others). Undoubtedly, this will yield a range of valuation indicators and certain companies will be clear outliers. It is the investment banker’s job to examine each comp and understand its relative position and reasoning. In other words, ascertain how past performance, margin profile, one-time expenses, risk, and market position affect the business’s valuation compared to its peers. This exercise will reveal important trends and anchor subsequent assumptions.
Comparable Companies – Shortcomings
Public comps are not created equal. Just because you looked up five metal fabricators on Yahoo Finance and their mean valuation was 7.5x EBITDA, does NOT mean your metal fabrication business is worth 7.5x. Public companies will likely command higher valuations than your privately held business based strictly on their larger size and greater liquidity. Also, be weary of “unscrubbed” financial metrics. Publicly traded corporations skillfully manipulate financial metrics across reporting cycles to best present earnings, requiring the investment banker to normalize any skewed information and work through recent public filings. Lastly, public companies are complex and likely have additional branches, services, and operations that vary considerably from your business. Each section of a public company can be valued differently, which may require adjustments in the analysis.
Precedent transactions analysis is based on the premise that the value of a company can be estimated through analyzing prices paid by buyers of similar targets, under similar conditions. Therefore, this analysis requires the investment banker to assemble a list of recent transactions that apply to the target company, using industry databases and internet searches. This analysis is useful in identifying valuation data and transaction premiums/discounts paid for companies in certain industries, with differentiated characteristics.
Similar to choosing a peer group of comparable companies, it is important to find transactions that are a strong fit with the target. Fit determinants include:
Industry and Market Position – Proximity of core products and services within the industry.
Financial Characteristics – Transaction size, sales, and profitability levels are important considerations.
Transaction-Specific Circumstances – It is important to know the background and conditions surrounding the transaction (e.g. strategic vs. financial buyer, full auction vs. negotiated deal, majority/minority sale, bankruptcy or liquidity situation, and fundamental market conditions)
Timing – All transactions should have occurred within the last three years (at the most). More recent transactions are a better benchmark of current market conditions.
The investment banker will compile transaction data into an analysis and record relevant metrics, similar to those included in public comps. Interpretation of transaction data requires high expertise in the industry and familiarity with the assets involved. The banker will apply more weight to higher fit transactions. Likewise, it is up to the investment banker to understand drivers of value/discounted value across the transaction list.
Precedent Transactions – Shortcomings
Imperfect information can impede the usefulness and merit of middle-market transaction data. Oftentimes, financial information and deal terms are not available for the most applicable transactions. It is important to note that when transaction information is published, often one of the parties involved was motivated to do so. For example, this could be driven by one of the owners or advisors, boasting high value and favorable terms. Also, transaction metrics in the private sector are subject to substantial financial adjustments (EBITDA addbacks or normalizations), which can materially alter the data in a transaction set. Therefore, precedent information can be misleading and partial, unless thoroughly reviewed by the advisor.
Putting it Together
Relative valuation techniques are as much art as they are science. Simply identifying public comps and precedent transactions is only a fraction of the overall task. It is far more important to read between the lines, identify gaps in the information, understand patterns in the data, and be able to thoughtfully apply context to the target company. Most importantly, an experienced investment banker will recognize value drivers across the analysis and understand how to substantiate a more favorable valuation for the client.
With this in mind, relative valuation data should be viewed with a grain of salt and should not be relied upon to anchor value expectations. Comps and transactions, with the help of a professional eye, are a suitable starting point in estimating a middle-market company’s value. It is common practice to supplement relative valuations with intrinsic techniques and basic return analyses. However, the best way to determine any business’s true market value is through a well-run sale process.