It is essential to know the value of your business. While some companies are valued annually, some are valued two to three times annually and five times. A lot of factors govern business value. However, these factors remain flexible and are influenced by many external factors. It usually includes profitability, employee base, service or product line, age in the industry, and many more.
Comparable Transaction Method is one of the popular ways to measure the company’s valuation. Here is a guide to knowing everything about it.
What is a Comparable Transaction?
Comparable transactions are among the most popular conventional methods to determine business value. As the name suggests, this approach considers similar or comparable past transactions. The comparable company is from the same industry and has a similar business model or size. A similar multiple of the company earnings is compared with transaction multiples to determine the business valuation. The comparable transaction method is most considered during merger and acquisition (M&A). Also called comp transaction, this method can assess a fair value for a takeover. Also, this fair value is based on recent earnings.
Companies often wish to acquire other companies to expand their businesses, get more resources, expand their market share, remove competition, etc. However, overpaying can prove to be a financial loss. Hence, the company and its team get the comparable transaction done to derive a fair valuation. The takeover target M&A investment banking company also does the same analysis to ensure they have a lucrative shareholder offer. Even public companies use the comparable company analysis but use company “stock price.” Per the control premium, the comparable transaction method works according to the price paid to acquire the company.
Comparable Transaction Multiples
The comparable company analysis multiples, used to target the company’s information and determine the valuation are:
- Enterprise value to Revenue
- Enterprise value to EBITDA
- Enterprise value to SDI
- Price to earnings
- Price to book
- EBITDA, the earnings before interest, taxes, depreciation, and amortization, plays an important role.
- The comparable transaction valuation is also used with other data parameters like discounted cash flow, price-to-sales ratio, price-to-cash-flow ratio, etc. Additional factors depend on the industry type.
How Does Comparable Transaction Work? The Step-by-Step Guide
To use the comparable transactions method, here is what you need to do:
- Define your parameters and find a comparable business similar to yours. The parameters include industry, size, age, geographic location, etc. It will narrow down your search, and you will be easily able to find comparable businesses.
- Now, research the recent transactions. Aim to find businesses that were sold last year to find relevant data.
- If you find a business similar to yours, there will still be some differences. Find those differences and adjust the sale price.
- Use other valuation methods along with the comparable transaction method to get an accurate valuation for your business.
When valuing the business, consider the following factors about the company:
- Financial performance, including revenue and profit.
- Growth potential
- Competitive edge
- Management team
- Share price.
Comparable Transactions Method: The Benefits
The Precedent Transaction offers a lot of benefits:
- This precedent transaction analysis method helps companies estimate the value of their business and determine the right price when selling or acquiring.
- Banks and other financial institutions use this method while lending money to a business.
- This method helps the company know its potential buyers and their willingness to pay a certain amount.
- This valuation method helps businesses understand their competition in the market.
- It helps businesses mitigate the risk of overpaying for their business. Using the results, the businesses can negotiate a lower price.
- Since the comparable transactions method is based on actual market data, you can expect high precision. This also makes it a reliable valuation method.
- Hence, it would not be wrong to say that this is a valuable tool, and businesses use it to estimate the correct value of their company.
Valuation Multiple Analysis: Quick Review
Valuation Multiple Analysis forms an integral part of Comparable Company Analysis, providing valuable insights into the relative valuation of the target company compared to its peers. By calculating and analyzing various valuation multiples, investment bankers gain a deeper understanding of how the market values the company. Let’s take a closer look at the key valuation multiples commonly used in Comparable Company Analysis:
- Price-to-earnings (P/E) ratio: The P/E ratio is one of the most widely used valuation multiples. It compares a company’s stock price to its earnings per share (EPS). The P/E ratio indicates how much investors are willing to pay for each dollar of earnings generated by the company. A higher P/E ratio suggests that investors have high expectations for the company’s future earnings growth, indicating market optimism. Conversely, a lower P/E ratio may suggest undervaluation or lower growth prospects.
- Price-to-sales (P/S) ratio: The P/S ratio compares a company’s stock price to its revenue per share. This multiple provides insights into how the market values a company based on its sales performance. The P/S ratio is particularly useful for companies with low or negative earnings, such as early-stage startups or companies in highly capital-intensive industries. A higher P/S ratio implies that investors are willing to pay a premium for each dollar of sales generated by the company, indicating market confidence in its growth potential.
- Enterprise value-to-EBITDA (EV/EBITDA) ratio: The EV/EBITDA ratio compares a company’s enterprise value (market capitalization plus debt minus cash) to its earnings before interest, taxes, depreciation, and amortization (EBITDA). This multiple is commonly used when assessing companies with significant debt or varying capital structures. The EV/EBITDA ratio provides a comprehensive view of a company’s valuation, taking into account both its market capitalization and its operating performance. A higher EV/EBITDA ratio may suggest a relatively higher valuation compared to its peers, while a lower ratio may indicate potential undervaluation.
Wrapping up
The main use of the comparable transaction analysis is during an active M&A market. Different industries may use different valuation multiples. Comparable transaction is one of the most accurate methods, however the results depend on the correctness of the choice of comparable companies. The comparable transaction method must be used with other valuation methods to gain holistic assessment and excellent outcomes.
