Common Errors in Applying the Guideline Company Method

Past performance should be utilized as errors in applying the Guideline Company Method will result in erroneous estimates of a firm’s fair market value. 

By Lester Barenbaum (Philadelphia)

The value of a closely held firm is based upon what is expected to occur in the future. Revenue Ruling 59-60, promulgated by the IRS to establish a framework for valuing non-traded financial assets, states this fundamental principle in the following manner[2], “Valuation of securities is, in essence, a prophesy as to the future and must be based on facts available at the required date of appraisal.”[3] This concept is one of the most important valuation fundamentals. That is not to say that an analysis of the historical financial performance of a business is unimportant. Rather, past financial performance should be utilized to develop a forecast of expected future benefits. The value of a closely held business is driven by the expected future distributable cash flows the business is expected to generate. When this principle is not applied the Guideline Company Method will result in erroneous estimates of a firm’s fair market value.

Applying Guideline Company Method

The Guideline Company Method begins with the business appraiser selecting public firms that are comparable to the private firm being valued. The next step is to derive trading multiples for the public companies and apply them to the firm being valued. Typical trading multiples are P/E (Share Price to Earnings per Share) and P/B (Share Price to Book Value per Share). The Guideline Company Method is based upon the concept that stock prices and their resulting valuation multiples are based upon the valuation considerations of well-informed investors who have actually spent money to acquire equity positions. It is often viewed as being more objective than other methods that require more judgment of the business appraiser.

A public company’s P/E ratio can be expressed as a function of three financial metrics as shown below.

The numerator represents the portion of expected earnings paid out as future dividends, which are generally referred to as a firm’s payout ratio. The denominator has two terms. An investor’s required rate of return (rrr) captures the risk inherent in receiving future dividends and capital gains. The greater the rrr the lower will be a firm’s P/E ratio. The second term in the denominator is the expected growth rate of dividends. Greater expected growth results in a higher P/E ratio. In the guideline company method, we apply the observed multiples of the guideline companies, such as the P/E ratio (Price to Earnings ratio), by the earnings of the closely-held firm’s earnings to arrive an indication of value.

A challenge for the appraiser is to select publicly traded firms with operating and financial characteristics sufficiently similar to the private firm being valued so that the resulting pricing multiples can be employed to value the private firm. There are no hard and fast rules for the selection process. The valuation concept is that the operating and financial characteristics of the public companies should be similar enough to that of the private company to draw valuation parallels. Investor opinions of the current and likely future operating and financial characteristics of the selected companies ultimately result in the valuation multiples of those companies, which are observed. Severe biases in value can result unless 1) differences in growth expectations between the firm being valued and firms from which the multiples have been derived are recognized and adjusted and 2) transitory earnings of either the public or private company are correctly handled.

Common Errors in Applying the Market Approach: Expected Growth

Public companies often grow through acquisition or external growth. In fact, this is one reason why firms go public, to finance revenue growth through issuing additional equity. Expected growth in profits and distributions has a material impact on trading multiples. Therefore reconciliation between the expected growth of comparables and the firm being valued is necessary.

As shown below we isolated publically traded firms with similar profitability (return on assets (ROA) between 6 percent and 8% for their past fiscal year as of August 19, 2011), but different growth expectations as expressed by investment analysts. We then separated the firms into high expected growth firms, (firms where analysts had forecast sales growth between 20 and 25 percent)

and low expected sales growth, (firms where analysts had forecast sales growth between 5 and 6 percent). The P/E multiples for these two groups are shown above. High expected growth firms had a P/E multiple approximately materially greater than those with lower expected growth. Keep in mind profitability for both groups is the same.

To the extent the valuation expert has controlled for profitability but not expected growth between guideline public companies and the target firm, their choice of an appropriate multiple will probably be flawed and open to criticism. Private companies tend to grow through organic or internal growth financed by reinvesting the profits of the company. As a result, private companies often grow at much lower rates than public companies that grow at higher rates through acquisition and internal growth.

Highly biased results can occur if trading multiples are not adjusted for differing expected growth between the guideline company and the company being valued. A review of public filings of the guideline public companies as well as investment reports will generally provide insight into expected growth. These expected growth rates must then be compared to those of the company being valued.

Common Errors in Applying the Market Approach: Transitory Earnings

As investors price securities based upon expected future earnings, temporary or transitory current earnings can result in highly biased trading multiples as shown below for several companies selected from the same industry sector. A review of the current P/E for these four companies indicates P/E multiples are in the mid-twenties. However, these public companies all have earnings that are temporarily depressed and have higher forecasted earnings. Therefore, if the business appraiser had selected the multiple to value a company based upon current P/E multiples the conclusion of value would be overstated.

The forward P/E of approximately 11x is more indicative of value. When determining what multiple to be applied to normalized earnings of a private company the forward P/E multiple will be more appropriate if the current P/E is biased upward due to a temporary drop in guideline company earnings. This situation may not occur for all the guideline companies selected by the valuation expert. Thus a careful examination of current and expected earnings of the guideline companies and the company being valued must take place.

The Guideline Company Method may seem more objective than other valuation methodologies but this is often not the case. Judgment is required in both selecting appropriate guideline companies and the selection of valuation multiples. Firm value is always based on expectations and to the extent the valuation expert does not build this into their analysis conclusions of value will open be to a well-constructed cross-examination.

Lester Barenbaum, Ph.D. is a Managing Director at Financial Research Associates (‘FRA’) in Philadelphia and a Professor of Finance at LaSalle University. FRA is a litigation support firm dealing with all financial aspects of divorce and other valuation matters such as economic damage, stock option valuation and dissenting shareholder suits.