Determining Company Value with Precedent Transactions

Precedent transactions is among the major three types of valuation methods used for companies, in addition to discounted cash flow (DCF) and company comparable analysis (“comps”).

Precedent transactions modeling is predicated on the idea that a company can be valued by analyzing the selling prices of similar companies under similar purchasing conditions in the past.

By looking at precedents that have been set in a particular industry, such as valuation multiples and premiums paid, we have an alternative means of determining valuation outside of company comparables and discounted cash flow.

Precedent transactions information is obtainable in various forms – merger proxies, trade publication data, the Securities Data Corporation (SDC), annual reports and SEC’s 10-K, or databases such as FactSet or CapitalIQ.

To perform the analysis, previous transactions must be screened for the appropriate criteria relative to the analysis of the targeted company. These include:

• Industry
• Business model and types of products sold
• Size of the deal
• Location

Typical data pulled from these deals include the following with respect to the target company:

• Enterprise value (amount paid by acquiring company; abbreviated EV)
• Market capitalization (price per share * number of fully diluted shares)
• Earnings per share (EPS)
• Revenue
• Cash flow
• Earnings before interest, taxes, depreciation, and amortization (EBITDA)

Common company comparable multiples include:

• EV / EBITDA
• EV / Sales
• EBITDA margins
• Price / Earnings (P/E, Stock Price / EPS)
• Growth rates
• Market capitalization / Book value

The actual valuation component involves looking at the financial metrics of the company you wish to value and comparing them to multiples in the transaction universe that’s been accumulated (i.e., similar companies).

How does Precedent Transactions differ from DCF?

Precedent transactions analysis, as mentioned, involves valuation multiples to determine the value of a company and involves a control premium.

A control premium entails the amount the acquirer is willing to pay for a publicly traded company beyond the market price in order to obtain a controlling share of the target firm.

Discounted cash flow focuses on the present value of all future cash flows and future and expect business performance to derive the intrinsic value of a business.

The level of risk associated with the discounted cash flow and capital structure of the company is captured by the discount rates used in the discounted cash flow calculations.

The Model

A precedent transactions model is similar to a standard DCF model.

Since there aren’t many dedicated comps or precedent transactions models online, it’s possible to borrow a discounted cash flow (DCF) template and turn it into a precedent transactions model by using that company as one you also wish to evaluate by precedent transactions rather than just DCF alone.

You can find other companies within the industry that have sold and carve out a place on the spreadsheet to study their revenue, EBIT, EBITDA, enterprise value, and other relevant financial information. This will help you understand where they sold and how that compares to the company you’re looking at.

Inputs

Inputs would be those needed for a DCF analysis (revenue, expenses, assets, liabilities), and many components specific to the capital structure of the company. NYU Stern professor Aswath Damodaran has many examples of such spreadsheets on his website.

You could also use inputs for both the high growth and stable growth periods of a firm, which is appropriate for firms experiencing moderate growth.

Outputs

Example outputs in this model include practically any metric that’s used to value a company:

• Enterprise Value (EV)
• EV/EBIT
• EV/EBITDA
• EV/EBIT(1-t)
• EV/FCF
• EV/Sales (aka EV/Revenue)
• EV/Capital Invested
• P/E

This allows us to answer questions such as:

“If our EBITDA was $20 million, what would our transaction price likely be if other companies in the industry have commonly sold at an EBITDA multiple of 12x?”

Lots of analysts like using EBITDA as a proxy for cash flow because it controls for:

• capital structure (interest expense)
• jurisdiction (taxes)
• asset base (depreciation), and
• takeover history (amortization)

We can easily determine our answer by multiplying the two quantities together – $20 million and the 12x multiple – and obtaining an answer of a $240 million valuation.

Likewise, if the average FCF multiple were 15x in a particular cluster of comparable companies, if one company had an annual FCF of $100 million, that means its valuation based on similar companies would be $1.5 billion.

Banks and financial institutions are unique in that P/E ratios are typically used. Debt works differently for financial firms, so enterprise value-related multiples aren’t used.

So if banks were trading at a P/E ratio of 10x and a bank was earning $3 million per quarter ($12 million per year), its valuation would be estimated at $120 million.

Conclusion

Precedent transactions analysis allows us to find the value of a company based on the sales of similar companies under similar circumstances in the past.

We can screen for the relevant company criteria within the same industry as the company we are looking to value in a database such as FactSet, CapitalIQ, or the public filings that are published on sec.gov.

The multiples (such as EBIT, EBITDA, Sales, P/E) that are used to analyze company valuation are usually decided by managing directors in a company who know the industry and what tends to work well.

The analyst will then “spread” these multiples (lay them out on a spreadsheet and look at them one by one) and use them to calculate the estimated value of the company.