CENAK Consulting - News and Views

Valuation - Art and Science

If we needed more evidence that valuation is as much an art as it is a science, we only need to look at the acquisition of Bear Stearns by JP Morgan.  The initial share price was set at USD2 per share.  A few days later, JP had to sweeten the offer to USD10 per share, a fivefold increase!  How can a company be valued five times as much within such a short period of time?  That's where the art factor comes into play.  This particular deal had many underlying forces, including some parties that really should stay out of the M&A business such as the Fed.  Bear Stearns had to agree to the USD2 offer that weekend if it didn't want to file for bankruptcy on Monday morning.  It also would have sent the financial markets into chaos.  So Bear Stearns' management agreed to the low offer because they had no other chance.  When in subsequent days the stock traded well above the USD2 mark, it send a clear signal that investors believed the offer to be too low, forcing JP to increase it significantly.  I am sure that if we had a chance to take a look at the cash flow models, that JP still predicts a very healthy return even at this price.  We do not know where the "make-or-break" value for JP is based on the cash flow models, but what we do know is that in this case, the science part of valuation clearly took a backseat to the art part.

Business Valuation Using Comparable Company Analysis - Part 2

Part 1 of our valuation series was an introduction to the multiple or comparable company analysis.  The first step to a meaningful analysis is to find a basket of publicly listed companies that can serve as comparable companies to the target company.  In this second part of our valuation series we'd like to talk about where the information and data for a comparable company analysis can be found.

In selecting sources for information, it is important to always favor the primary source over the secondary source.  For example, financial statements should always be taken directly from the company's SEC filings and not from secondary sources such as FactSet or Bloomberg.  These secondary sources often try to standardize their reporting system and it may not always be clear how certain financial items are being treated by these information providers.  However, it is always a good idea to double-check data with one or two of these service providers.

The following sources are most commonly used in the investment banking community for a comparable company analysis:

1. 10-K and 10-Q for financial data and footnotes.  These annual and quarterly reports can be found on the Edgar Archives of the SEC.
2. Real-time stock price data from services such as a Bloomberg terminal or FactSet.  These services are expensive, and other free online sources may provide a cheaper alternative.  However, Bloomberg and FactSet are excellent tools to double-check an analysis and should be preferred sources for stock price data.
3. Equity research reports from investment banks for financial forecasts.  These reports can be bought from services such as Thomson Financial's Investext.  They can cost up to USD30 or more per page to download, however they are important as forward-looking multiples are more significant than historic multiples.  Unlimited subscriptions can cost USD12,000 or more annually.  It is important to get recent reports that are not older than 6 months.  Equity research reports  typically get updated shortly after the companies report their quarterly data.

These are the most important sources to find financial information for companies.  International companies that do not report in the US typically publish their financial data on their websites.  Note that not all countries and exchanges require companies to report quarterly.  We will explain at a later time how to deal with inconsistent data and reporting.

Once the above information has been collected for the basket of comparable companies, the analyst can begin the calculation of the multiples.  In our next segment of the valuation series, we will talk about which multiples are typically used.  We will also talk about industry differences and specifics.

If you have any questions regarding the comparable company analysis, please do not hesitate to contact us at any time.

Business Valuation Using Comparable Company Analysis - Part 1

One method to value a business (target) is the comparable company analysis (Compco) or multiple analysis.  We at CENAK use this method as one data point for company valuations in addition to cash flow models and other valuation approaches.  The Compco is typically not used as a stand alone valuation method.  Due to its relatively easy mechanics it is often used as a starting point or "back-of-the-envelope" method to get a general idea of a valuation range.  In this series we will describe this method over the next few days and weeks.

The quality of the results of a Compco depends highly on the quality of the input data.  In fact, the majority of the preparation time goes into making sure that the data used is consistent and applicable. The data needed for a Compco is:

• Target company's historic and projected financials (2 years forward)
• Comparable companies' historic and projected financials (2 years) as well as stock price and capital structure

The first and most important step in preparing a Compco is to identify publicly traded companies whose business model is similar to the company to be valued.  For example, if the target company is a producer of PCs, then companies such as Dell, Acer, Lenovo and HP could serve as comparable companies.  However, it can already be seen that there are differences even in this universe of comparable companies.  For example, Dell markets its products almost exclusively through its website while others market their products through other distribution channels as well such as retail stores.   HP produces other, higher margin products in addition to PCs such as printers.  Lenovo is traded on the Hong Kong stock exchange and Acer in Taiwan.  It is in the discretion of the analyst to adjust the analysis for these differences by taking into account different accounting treatments and general valuation differences between countries (country adjustment).  Further, certain companies may trade at a premium because they are considered "best in class", while others may trade at a discount to the average.  Some companies may have to be taken off the list because their valuation is based mainly on other product lines.  In our example, HP's data would only be of limited use because HP's core business is computer periphery such as printers.  HP's multiples should reflect this and be a blend of multiples of the different business segments.  IF HP were to spin off its PC business tomorrow, it would trade at a different (probably lower) multiple than the combined business today.  All of these factors will ultimately have to be considered in analyzing the final results.

Some industries may not lend themselves to the Compco due to the lack of comparable companies.  The more comparable companies can be identified the better, however as a bare minimum a basket of at least five companies should be evaluated.  If there are less than five or no comparable companies available at all, a close look should be taken at the underlying business model.  For example, if the target company is in the commodity business but there is no other public company in the exact same space, then it might be worth looking at other commodity businesses as a proxy for the target company, even though the underlying commodities between the target company and the comparable companies might be different. 

Compcos are of limited use if the target company is a start-up with no income or even revenues.  Compcos compare certain financial multiples of companies that are applied to revenues and certain earnings measures (more about that in part 2).  If there are no revenues yet it does not make sense to apply any multiples.  The same holds true for companies with negative earnings (losses).  As an example, Internet start-ups in the late 1990s often went public without having ever produced positive margins.  These companies were sometimes valued using revenue multiples only.  In the biotechnology arena, companies went public without having ever sold anything, making the preparation of a Compco meaningless.

Compcos can be prepared for parts of target companies if data is available for the division to be valued.  This is routinely done for companies that consider spinning off a division.  Conversely, divisions of comparable companies cannot be used for the analysis even if broken down financial information is available, because the stock price relates to the entire entity and reflects a blended value over all of the the company's divisions.

Despite these few limitations the Compco can be a very valuable tool for business valuations.  Most  businesses and industries today can be valued using this methodology.    

 

Once a basket of comparable companies has been identified, the next step is to collect financial data about these companies.   In part 2 of our series we will describe in more detail where the data can be found and how it needs to be adjusted for a meaningful analysis.

If you have any questions regarding the multiple analysis please contact us at any time.

Valuation Series - Introduction

With today's blog I'd like to start a series about valuation techniques we employ here are CENAK.  Over the next few weeks, I will try to explain in more detail which analysis tools we use and how they work.  I hope that this will make the valuation process more transparent and highlight the advantages of our approach.

Generally, there are two different valuation approaches.  The first approach is based on using historic financials to estimate what the value of a company is today.  This method is often employed by accountants or lawyers.  The second approach uses projected future financials to determine a company's value.  Here at CENAK, we strongly believe in the second approach as a better way of analyzing a company's financial performance.  Just as in the stock market, the value of a company is based on future earnings and cash flows, not historic.

Typically, we use the following forward-looking valuation methods:

• comparable quoted company analysis (Compco)
• comparable acquisition analysis (Compaq)
• discounted-cash-flow analysis (DCF)
• merger consequences analysis (Merger Model)

Over the next few weeks, I will comment on all of these methods to shed some light on them.   These methods are routinely used by investment banks and serve as a foundation for any value negotiation today.  We will highlight the strengths but also some of the limitations of these methods.  We hope you will enjoy our valuation series and look forward to receiving your feedback.