Valuation — Market Approach

    a. Comparable companies
    b. Comparable transactions
    c. Market price

Comparable Company Method (CoCo) or Guideline Company Method :
Under the comparable company method, valuation multiples are computed based on prices at which stocks of similar companies are traded in a public market. The valuation multiples thus computed will be applied to the subject company’s fundamental data to arrive at an estimate of value for the company.

The value derived from CoCo method often represents a publicly traded equivalent value or freely traded value. In other words, it is a price at which the stock would be expected to trade if it were traded publicly. Thus, the value indication is appropriate for a marketable, minority ownership inter-est, using the premise of value in continued use, as a going-concern business. The method leads to fair market value, as it is a value at which an asset can be exchanged between willing buyer and willing seller with a full market knowledge and on an arm’s-length transaction.

We will use an example of AB Television Limited (‘ABTV’) to demonstrate practical application of market approach. ABTV is a general and business news channel with :

    Revenues of INR 5,000 million;
    EBITDA of Loss. INR 2,000 million; and
    EBIT of Loss. INR 2,500 million.

ABTV has around 6 news channels in its bouquet which includes 1 general English news channel, 1 general Hindi news channel, 1 English business news channel and 1 Hindi business news channel. It also has 2 regional language general news channels. It also has its general news Internet portal named www.abtv.com.

    Identification of comparable companies :

Comparability of companies often becomes a central issue in litigated valuations. Companies can never be absolutely comparable to each other. The economics that drive the comparable companies should match those that drive the target company.

In order to determine the comparability factors such as product-mix, geographies, size, stages of business, market positioning, operating or EBITDA margins, dividend history, trading volumes, management, etc. should be considered.

Table 1 below shows list of broader comparables of ABTV.

The current portfolio of ABTV constitutes only news channels — business and general. It also includes its Internet business. Based on the business of ABTV and the above selection criteria, we selected com-panies like Zee News Limited, IBN 18 Broadcast Limited, TV Today Network, Television 18 Limited. NDTV has recently announced that it has sold off its 3 entertainment channels NDTV Imagine, NDTV Lumiere, NDTV Showbiz to Turner International. The TTM revenues of NDTV include revenues from the general entertainment business and hence, due to major restructuring of the businesses we have excluded NDTV Limited from the list of comparables. Though we have ignored the multiple of NDTV, we have tried to corroborate news channels’ multiples with the multiple of NDTV Limited.

    Normalise the financial statements :

Normalising the financial statements is essential to remove the impacts of non-recurring and non-operating income or expenses, accounting differences, etc. from the financials, to arrive at maintainable or sustainable earnings and margins, operating revenues, etc.

    Calculate multiples based on various financial parameters :

Multiples may take many forms. The numerator may be based on equity or enterprise value and the denominator may be based on a variety of normalised financial performance matrices on pretax or after tax basis.

If the numerator of a multiple is an equity value, then the denominator of the multiple should be an equity measure, such as PAT or net income or book value. Similarly, if it is enterprise value, then it should be operating parameter like operating revenue, EBIT-DA, EBIT, etc.

The time period used to calculate multiples is generally trailing twelve months (‘TTM’) or latest fiscal year. Sometimes the estimates of next year’s expected results also are considered.

Generally, TTM multiples display the latest information and the current state of operations, however they may not be readily available and need to be computed by using interim financial statements. Latest fiscal year multiples are directly available, but would not reflect the current state of operations. Forward multiples give a forward looking valuation, however they may not be accurate as they are estimates.

Valuation multiples computed from comparable company data for some time period (say, TTM), applied to the target company data for a different time period (say, last fiscal year) can result into consider-able distortions, especially if the industry conditions differ significantly between the time periods.

Either avoid comparable companies with recent corporate actions like mergers, acquisitions, etc., or make the adjustments to time period to arrive at real value. This is to make like to like comparisons and avoid speculative effect due to corporate announcements.

To calculate market capitalisation of the comparable companies, calculate 3 months’ or 6 months’ or 12 months’ volume-weighted average market price (‘VWAP’) to avoid daily fluctuations and speculative effect on the market prices.

In case of ABTV we have selected TTM revenue and TTM EBITDA to arrive at the enterprise value of the company. Further, we have considered 6 months’ VWAP for arriving at market capitalisation for the comparable companies.
 

Table 2 shows the range of multiples for ABTV Limited.

Notes : Market Cap. is Market Capitalisation; MI = Minority Interest; EV means Enterprise Value; TTM EBITDA numbers are adjusted for non-operat-ing and non-recurring items; NA is Not Applicable.

    Select the type of multiple to be applied :

Selecting the type of multiple requires significant judgment. Industry practices are good indicators of the type of multiple that can be selected. In case of companies that are mature and generate stable cash flows, one must consider using earnings multiples.

In Table 2, we have not considered EBIT multiple or PAT multiple as most of the companies including ABTV Limited are making losses at EBITDA level. Ideally, EBITDA and EBIT multiple are best parameters to judge the business value. Hence, the key parameters for valuing ABTV Limited would be EV/Revenue. EV/EBITDA should also be ignored as EBITDA multiple is derived based on 2 companies’ parameters which may distort the valuation. To get the robust multiple, larger set of comparable should be adopted. But if the similarity of the businesses of the two companies is very similar, then one can consider even two companies as benchmark. In other words, more the disparity in the businesses of the comparable companies, the larger should be the group.

Further, while valuing ABTV Limited, EBITDA multiple will have to be multiplied with EBITDA number of ABTV which is a negative number. Therefore, for the purpose of this example, we have only considered revenue multiple which is also in range of multiple of NDTV Limited.

    Selected comparable company multiple :

The median multiple is generally selected because the median provides a better measure of central tendency than the mean. Outliers would have a higher distorting effect on the mean than the median. The selected multiple needs to reflect the relative strengths and weaknesses of the subject company relative to comparable companies. If the outlook of the subject company is lower in terms of risk and/or more in terms of growth, then a multiple which is higher than the median may be selected.

In our illustration, the comparable companies are comparable in terms of risk and growth opportunities, as more or less all the companies are in business or general news channel except for IBN 18 broadcast which has various entertainment channels under its bouquet like MTV, Colours, Nick, and Vh1. It is also engaged in other businesses like film production, distribution of branded merchandise which though are in a start-up phase and are immaterial to its channel businesses. Therefore, if we remove it as an outlier, then median EV/Revenue is around 2.4x and average EV/Revenue is around 2.7x.

    Apply adjustments for non-operating as sets and liabilities :

Excess cash and other non-operating assets need to be added and non-operating liabilities and inter-est-bearing debts should be subtracted from the enterprise value arrived at by applying the selected multiple to the financial performance matrices of the target company.

For example, ABTV has cash and cash equivalent of INR 1,200 million and Debt + Minority interest of INR 9,125 million which needs to be adjusted to its enterprise value. Enterprise Value of ABTV = EV/Rev-enue x TTM Revenue.

Types of multiples :

    Price to earnings multiple :

Price to earnings (‘P/E’) multiple is calculated as follows :

Current Market Price

Earnings per Share

Earning power of a company is one of the key drivers of its valuation. P/E ratio is one of the most widely accepted valuation parameters. Net profit after taxes, post adjustments for extraordinary and non-recurring income should be used to calculate the P/E ratio. The ratio cannot be used for companies with negative earnings. The P/E ratio is significantly influenced by the accounting decisions of the company. The guideline companies should have similar financing structures to compare their P/E ratio.

    PEG ratio :

PEG ratio is calculated as follows :

                                                      PE Ratio
PEG ratio    =             _____________________________

                                           Expected Growth Rate

Analysts compare PE ratios of a company with its growth rate to identify undervalued and overvalued stocks. PEG ratio of a firm must be compared with other firms operating within the same industry. A lower PEG ratio indicates undervaluation and a higher PEG ratio indicates overvaluation. The firm’s equity is considered fairly valued if PEG ratio reaches value of one. PEG ratio is useful to predict future growth of companies.

    Price to book value multiple :

Price to book value multiple is calculated as follows :

                                                  Market price per share
Price to book value =_______________________________________

                                               Book value of equity per share

The price to book (‘P/B’) multiple can be used for companies with negative earnings. The multiple is stable as the book value of a company does not change much from year to year. Book value of an asset is driven by the original price paid for the asset and accounting decisions of the company. As common sense would suggest that there is significant degree of correlation between return on equity and price to book value. Hence, while considering multiples of comparable companies also correlate the return on equities of the comparable companies and subject company.

Book value multiple is used in traditional manufacturing companies that derive their value from assets in place and high capital expenditure. The multiple is useful to value finance, investment, insurance and banking firms that hold significant liquid assets. P/B ratio can also be used for firms that are going out of business. The multiple is generally not used for valuation of companies in service industries primarily, because the multiple does not capture the potential of identifiable and unidentifiable intangible assets.

    Revenue multiple :

Revenue multiple is calculated as follows :
Revenue Multiple = Enterprise Value/Revenue

Revenue multiple is another widely accepted valuation ratio because of several factors. Firstly, growth rate is a fundamental driver of valuation, which begins with sales. Secondly, sales information is subject to less manipulation than any other financial parameter. Besides, sales information is easily available for all types of firms including troubled and very young firms. Thirdly, revenue multiple is less volatile than the earnings multiple, therefore it can be used in cases where there are large fluctuations in earnings. A drawback of this ratio is that it does not capture the difference in cost structures and capital struc-tures between different companies. Further, it can be one of the best parameters for the companies in growth phase, or when company has launched new products and has not broke even.

    Enterprise value to EBITDA/EBIT :

EBITDA multiple is calculated as follows :

                                                        Enterprise Value
EV/EBITDA or EBIT    =            _______________________

                                                         EBITDA or EBIT

EBITDA or EBIT multiple is one of the best param-eters to analyse the business value of the company. Since EBITDA or EBIT are operating margins of the business they are best to use for any industry. EBIT-DA or EBIT multiple can be used for comparing firms with different degrees of leverage. For these rea-sons, this multiple is particularly useful for valuation of companies in almost all industry. It may not be useful when the companies are in the growth phas-es or haven’t broke even. Best time to use these multiple is when the industry or subject company are in stable phase or mature phase.

    Other multiples :

Analysts use other valuation multiples such as sec-tor specific ratios, for example price per hit ratio is used to value startup website companies, price per subscriber is used for valuation of cable and telecom companies, price per megawatt is used to value power generation companies, EV per tone can be used for cement or steel industry, etc.

Comparable Transaction Approach (‘Cotrans’) : One can derive indication of value from the price at which a company or an operating unit of a company has been sold or the price at which a significant in-terest in a company has changed hands. Such data is harder to find as compared to daily stock trading data. The steps followed by a valuer/analyst using the comparable transaction approach are similar to those of the comparable companies approach.

The primary difference between CoCos method and CoTrans method is that in CoTrans method the transaction price is the basis of calculating the multiple, whereas in CoCos method basis is the current market price of similar companies. Transactions in the target company’s industry or similar industry are analysed over a period of 3 to 5 years depending upon availability of set of transactions and changes in the industry.

This is because there are fewer transactions, and acquisition price multiples generally do not fluctuate a lot over time as compared to market price multiples. Characteristics of each transaction need to be analysed to decide which adjustments may be necessary in order to use the transaction price multiples. In case of ABTV we have considered the following as comparable transactions :

Valuer/Analysts should take into account the follow-ing aspects while using the CoTrans method :

    Source of data :

Generally, the availability of data for comparable transactions is comparatively scarce v. stock price data for comparable companies. Data on the acqui-sitions of private companies are not subject to any regulations and vary tremendously in scope and format. If the subject company itself has changed control in the last few years, the transaction may be an excellent source of valuation multiples.

Several databases are also available such as Bloomberg, Merger Market, Capital IQ, etc., which provide information on transactions across different sectors and different geographic locations. We have selected comparable transactions for ABTV from Merger Market.

    Non-availability of data :

In case of most transactions, financial data is not available. In case of acquisitions of privately held companies, the data with respect to purchase price, revenue or earnings measures of the target company, percentage stake acquired, etc. are usually not available in the public domain. Therefore, analysts need to use appropriate judgment in case of trans-actions where data is not available.

    Understanding the deal structure :

One must understand the rationale of each comparable transaction. For example, one must understand if the transaction was a strategic investment or financial investment, percentage of stake sold in the transaction, whether the sale was a distress sale, etc. Typically, due to different purposes of investments, transaction rationale and synergy benefits, different control premiums and minority discounts are embedded in the transaction values. Differences between the comparable transactions and the contemplated subject transaction should be noted and adjusted appropriately in developing valuation multiples. Due to lack of information on such parameters it would be difficult to really analyse these aspects of transactions and hence, comes the judgment of the Valuer.

    Announcement versus closing date

The announcement and the closing date of a trans-action can be months apart. There may be a difference between the indicated deal values on the two dates. Generally, the date used does not make a material difference to the valuation. Most multiples are developed based on announcement date. This gives an indication of what the buyer and seller originally intended to pay or receive for the company based on the information available at the time when the deal was originally analysed and negotiated.

    Rule of thumb :

Some industries have rules of thumb about how com-panies are valued for transfer of controlling ownership interests. If such rules of thumb are widely disseminated and referenced in the industry then, they should be used. Generally, there is no credible evidence on how these rules of thumb are developed. They fail to differentiate operating characteristics of one company to another and do not consider differences in the terms of the transactions.

    Control premium :

The value of a majority stake in a company is always more than the value of a minority stake, because the majority shareholder gets control of the financial and operating decisions of the company. Therefore, if a transaction considers the acquisition a majority stake, then the price includes a control premium. The market price considered in calculation of multiples in CoCos method does not take into account any control premium. Therefore analysts should adjust the transaction multiples to remove the effect of the control premium while valuing a minority stake in a company.

Market Price Method :
Under the market price method, an asset is valued based on the price at which it is traded in the open market. This method gives a reliable indication of the value of an asset as the market price reflects the value that a buyer is willing pay to a seller for an asset in the free market. In case of shares of a company that is listed on a stock exchange, one can consider the market price of the company based on the last six-month VWAP on the stock exchange where the company’s shares are most frequently traded. It may happen that the equity market may not reflect the fair value of a stock, as the equity prices on a stock exchange get influenced by the market sentiments. It is important for a valuer/analyst to consider these market sentiments while using the market price method. At times the valuation practitioner may choose to ignore this method of valuation if market price is not a fair reflection of the company’s underlying assets or profitability.