Financial valuation Applications and Models phần 3 pdf

184 MARKET APPROACH
Market Approach
OVERVIEW
The idea behind the market approach is that the value of a business (often a small,
privately held firm) can be determined by reference to “reasonably comparable
guideline companies” (sometimes called “comparables” or “comps”), for which val-
ues are known. The values may be known because these companies are publicly
traded or because they were recently sold and the terms of the transaction were dis-
closed. While data sources that provide financial and other information about
guideline companies in a particular industry are useful for understanding industry
norms, they are useful for valuing businesses only if the underlying values of the
businesses are known.
The market approach is the most common approach employed by real estate
appraisers. Real estate appraisers, particularly those who specialize in residential
real estate, are fortunate in that they generally have tens or even hundreds of comps
from which to choose. For a business valuation professional, a large set of comps
may be half a dozen.
Questions to Consider
What does “comparable” mean? Does it imply being in the same industry as the
subject? How important is size, and what measurement of size is relevant: sales,
profits, assets, market capitalization? Is location a significant factor? How much
weight should be given to financial ratios (i.e., profit margins, current ratios, etc.) in
the selection of guideline companies? What about business and financial risks?
What are the key value indicators? What do buyers of these kinds of businesses
look at when determining what they will pay? On what types of factors do investors
in publicly traded companies focus: revenues, income, cash flow, number of clicks,
or assets?
What are the differences between the subject and the comps, and how does one
incorporate them into the analysis? If all of the guideline companies were identical
to one another and the subject company was identical to the guideline companies,
then its value would be equal to the values of the guideline companies (all of which

would have values identical to one another). Since this is never the case, the analyst
has to identify the important differences and determine what adjustments need to be
made to arrive at a reasonable estimate of value for the subject.
184
CHAPTER
6
How much weight should be placed on the market approach in the overall valu-
ation? The market approach is often one of several approaches used in a valuation
analysis. The valuation analyst must decide how much importance the value derived
from the market approach will have in the overall assessment of value. This judgment
normally is based on the number of guideline companies and the quantity and quality
of the data. Sometimes the value from the market approach might be used simply as a
sanity check on the other values, and is not explicitly included in the final assessment.
Quantitative and Qualitative Factors
As with other valuation approaches, the market approach does not exempt the val-
uation analyst from having to exercise professional judgment. The use of guideline
companies is a starting point in that they provide analysts with some objective,
quantitative guidance; these value indications must, however, be tempered with con-
sideration of qualitative factors, such as product quality, depth and breadth of man-
agement, and employee turnover—factors that can be ascertained only from a solid
understanding of the subject company and the experience of the business appraiser.
Market Approach Is Forward Looking
Some people contend that the market approach, unlike other valuation approaches,
is not forward looking (e.g., forecasts). This is absolutely incorrect. The value of a
business is not a function of how it performed last year or the year before; rather it
is a function of its perceived future prospects. Historical balance sheet and income
statements, from which many of the ratios used to value companies have been devel-
oped, can help tell where a business has been. More important from a valuation per-
spective, they provide the necessary foundations from which forecasts can be
developed. Yet these are only some of the many pieces of information investors con-

sider when establishing a price. For example, biotechnology start-ups, which may
have no sales and negative earnings, can have positive market values simply because
investors believe that firms will show positive earnings and cash flows in the future.
TYPE OF VALUE OBTAINED
The value obtained using the market approach is a function of the type of guideline
company information used. When sales transactions are the basis of the value, this
value generally represents a controlling, nonmarketable value. It is controlling
because it is based on acquisitions of entire companies, and it is relatively nonmar-
ketable because the transactions represent sales of private entities, for which no
Type of Value Obtained 185
The prices paid for businesses and business interests reflect investor
expectations. Consequently, any valuation methods that use stock or
sales prices of businesses, including the market approach, must neces-
sarily be prospective in nature.
ValTip
immediate and ready market exists (as compared to the liquidity of public stocks).
However, it is marketable relative to how long it takes to sell the company as com-
pared to a peer group of transactions. The value obtained using publicly traded
companies often is considered a noncontrolling marketable value. It is noncontrol-
ling because most of the trades are of small, minority blocks of stock,
1
and it is
marketable because the stocks of publicly traded companies can be bought and sold
quickly without significant transaction costs (relative to what is involved in the sale
of a private company).
The value indications, however, may be different from those given above if, for
example, there has been some modification to the subject company’s financial infor-
mation. These issues will be discussed in more detail later.
ADVANTAGES AND DISADVANTAGES OF THE
MARKET APPROACH

As with any valuation approach, the market approach has its advantages and dis-
advantages, whether perceived or actual.
Advantages
• It is fairly simple to understand. Companies with similar product, geographic,
and/or business risk and/or financial characteristics should have similar pricing
characteristics. People outside of business can understand this logic.
• It uses actual data. The estimates of value are based on actual stock prices or
transaction prices, not estimates based on a number of assumptions or judgments.
• It is relatively simple to apply. The income approach requires the creation of a
mathematical model. The market approach derives estimates of value from rela-
tively simple financial ratios, drawn from a group of similar companies. The
most complicated mathematics involved is multiplication.
• It includes the value of all of a business’s operating assets. The income approach
also has this advantage. Using the asset approach, all of a business’s assets and lia-
bilities must be identified and valued separately—both tangible and intangible
assets and liabilities. Many of the intangible assets may not appear on the balance
sheet (e.g., customer lists, trade names, and goodwill). This is one of the reasons the
asset approach is often not used to value ongoing businesses, but rather businesses
on a liquidation basis, where the value of these intangible assets is small or zero.
186 MARKET APPROACH
The values derived from both the market and income approaches
implicitly include all operating assets, both tangible and intangible.
ValTip
1
Analysts are not in agreement on this point. Some contend that when public guideline mul-
tiples are applied to closely held companies, the resulting value does not only represent a
minority position, since many public companies are run very efficiently and a control buyer
would not pay any more for the business unless he or she could realize synergies; thus minor-
ity and control values are equal.
• It does not rely on explicit forecasts. Sometimes an Achilles’ heel of the income

approach is the set of assumptions used in developing the forecasted cash flows.
The market approach does not require as many assumptions.
Disadvantages
• No good guideline companies exist. This may be the biggest reason the approach
is not used in a valuation; the analyst may not be able to find guideline compa-
nies that are sufficiently similar to the subject. Some companies are so unusual
or so diversified that there are no other similar companies.
• Most of the important assumptions are hidden. Among the most important
assumptions in a guideline price multiple is the company’s expected growth in
sales or earnings.
Unlike in the income approach, where the short-term and perpetual growth rates
are listed as assumptions, there is no explicit assumption (in the multiple) about
the subject company’s growth. Consequently, the implicit subject company
growth will be a function of the growth rates built into the prices of the guide-
line companies, on which the value of the subject is based. Other important
assumptions such as risk and margins, are not explicitly given.
• It is not as flexible or adaptable as other approaches. Unlike the income
approach, in the market approach it is sometimes difficult to include unique
operating characteristics of the firm in the value it produces. For example, a shift-
ing product mix, resulting in higher future margins, may not be easily incorpo-
rated into a market approach analysis because there may be no other guideline
company whose product mix is expected to change in a similar fashion.
Likewise, synergies cannot be easily factored directly into the analysis. To esti-
mate the value of these two types of situations, either a combination of the mar-
ket and income approaches is necessary, or the analyst will have to use
professional judgment to adjust the value outside of the parameters suggested by
the guideline companies. Furthermore, the market approach typically cannot be
used to value a number of unusual or intangible assets (e.g., customer lists, mort-
gage servicing rights, and noncompete agreements).
BASIC IMPLEMENTATION

As discussed earlier, one of the advantages to the market approach is the apparent
simplicity in implementing it. At its simplest, it requires only multiplication and per-
haps some subtraction, depending on the multiple selected. The basic format is:
Basic Implementation 187
Implicit in the prices of publicly traded companies and transactions is
some assumption about growth. Generally, the higher the expected
growth, the higher the value, all else being equal.
ValTip
Price
Value
Subject
ϭ
[(
_____________
)
ϫ Parameter
Subject
]
Ϫ Debt
Subject
*
Parameter
comps
*Invested Capital Multiples
“Parameter” might be sales, net income, book value, and the like. The
Price/Parameter multiple is the appropriate pricing multiple based on that parame-
ter (e.g., price/sales, price/net income, price/book value) and taken from the guide-
line companies. In some cases (invested capital multiples) the debt of the subject
company may have to be subtracted.
SOURCES AND CHARACTERISTICS OF GUIDELINE

COMPANY DATA
Guideline Company Transactions
Guideline company transactions refers to acquisitions and sales of entire companies,
divisions or large blocks of stock of either private or publicly traded firms.
INFORMATION SOURCES
A number of publications collect and disseminate information on transactions.
Most publications make their databases accessible on the Internet for a fee. Among
the most widely used are:
• BIZCOMPS
®
• Done Deals
• Institute of Business Appraisers (IBA) database
• Mergerstat
• Pratt’s Stats
™
The IBA and BIZCOMPS
®
databases cover transactions of relatively small
companies. The IBA database has considerably more transactions than BIZ-
COMPS
®
. As of August 2001, the BIZCOMPS
®
database had almost 5,000 trans-
188 MARKET APPROACH
Guideline company information can be drawn from two distinct pools.
1. Guideline company transactions
2. Guideline publicly traded companies
Understanding the value implications of using these different types of
data is crucial in properly applying the market approach.

ValTip
actions, with a median selling price of $115,000. The median revenue of the com-
panies included was $325,000.
2
In 2001, Pratt’s Stats™ included over 3,400 transactions. The companies cov-
ered tend to be considerably larger, with a median revenue of $5 million and a
median selling price of $6.4 million. There were 391 transactions that had a sale
date within the last 12 months. These companies had median revenue of $1.4 mil-
lion and net income of $18,000. The median equity/net income multiple was 8.8,
but the range was very large. The information provided for each transaction is much
more detailed than it is for either the BIZCOMPS
®
or IBA databases.
The Done Deals and Mergerstat data sets generally include transactions where
one of the companies is/was publicly traded. (Pratt’s Stats™ also include some pub-
licly traded transactions.) As a consequence, readily available financial statements
(8-Ks or 10-Ks) may be used to find additional information about these transac-
tions, if needed.
Done Deals had approximately 5,000 transactions as of October 2001. The
median sales price for the latest 12 months’ transactions was about $14.5 million,
implying a median price to earnings multiple of 18.3. As with the other databases
covering actual transactions, the range of observations is very large.
ADVANTAGES AND DISADVANTAGES OF THE GUIDELINE
COMPANY TRANSACTION METHOD
Guideline company transaction information can be useful in the case of a contem-
plated sale or purchase, or where the ownership characteristics of the subject
matches those of these transactions—typically controlling and nonmarketable (the
latter characteristic would not necessarily be true for the publicly traded company
transactions, where a publicly traded company was acquired).
The application of these data to the subject company is complex because of the

difficulty determining whether a transaction is truly comparable given the limited
information available in the database. This is one of the major disadvantages of
using guideline company transaction information.
Advantages and Disadvantages of the Guideline Company Transaction Method 189
2
Shannon Pratt’s Business Valuation Update, Vol. 7, No. 8 (August 2001), p. 8.
When using the market approach to value a very small business, the
guideline company transaction method is usually a better method than
guideline publicly traded company analysis. Comparable transaction
information is often available for very small businesses, but even the
smallest guideline publicly traded company may be vastly larger than
the subject.
ValTip
Some examples of information difficultes are as follows: Were there any
expected synergies in the price paid for a particular business, or was the buyer a
financial buyer? Was there a noncompete agreement, employment contract, prom-
ises of perquisites, terms, or other aspects to the transaction that would affect the
actual price paid for the business? While some databases contain this type of
information, it may not be sufficiently detailed to compute a “true” purchase
price.
PUBLICLY TRADED COMPANIES
Publicly traded companies are companies whose securities are traded on any of the
major exchanges: New York Stock Exchange (NYSE), American Stock Exchange
(AMEX), or National Association of Securities Dealers Automated Quotation
System (NASDAQ). As currently more than 10,000 such companies exist, they pro-
vide a rich source of information for valuations.
Information Sources for Financial Statement Data of
Publicly Traded Companies
Publicly traded companies are required to file their financial statements electroni-
cally with the Security and Exchange Commission (SEC). These filings, made under

the Electronic Data Gathering, Analysis, and Retrieval (EDGAR) program are pub-
lic information and are available on the SEC website at www.sec.gov.
Edgar documents can also be obtained from a number of commercial vendors,
who add value by allowing the user to extract selected items (i.e., the balance sheet,
income statement, etc.) or to search all filings for those meeting certain criteria. In
addition, vendors put the data for most or all publicly traded companies in a stan-
dardized format. A partial list of those vendors who reformat the data into stan-
dardized formats is:
190 MARKET APPROACH
The lack of detailed information on comparable transactions is the
major disadvantage of this approach. It is difficult to know the struc-
ture of the transactions or the motivation of the buyer or seller.
ValTip
Detailed financial statements of the acquired company are usually not
available, so it is impossible to make certain adjustments to the data
underlying the pricing multiples, assuming such adjustments are
necessary.
ValTip
• Alacra
• Compustat
• Disclosure
• Market Guide
• Mergent Company Data Direct
• OneSource
Each database contains currently operating U.S. companies. In addition to stan-
dardizing data across companies, these vendors also allow the user to screen for
companies using both descriptive and financial variables. Descriptive data include
business descriptions, Standard Industrial Classification (SIC) and/or North
American Industry Classification System (NAICS) codes, and/or industry descrip-
tions. Standardized financial data are provided both quarterly and annually, for

periods ranging from five to 20 or more years.
Standardization of Data
Standardization of the data in the publicly traded company’s financial statements is
beneficial for the analyst because most financial concepts are uniform across all
companies. One of the trade-offs of data standardization across companies is the
loss of detail. For example, operating profit for IBM is composed of the same sub-
accounts as it is for Dell; however, the detail of what is in these subaccounts is usu-
ally not available in these databases.
In some cases, the data vendor must make judgments about how to compute
the numbers to present certain concepts. These may not be the same judgments the
analyst would make if presented with the same information. Last, because parame-
ter definitions differ across databases, one data set is often used for all portions of
the analysis to lessen the likelihood of glaring inconsistencies.
Restatement of Data
Another issue to consider when using a standardized, publicly traded company finan-
cial statement database is how the restatements are treated. The financial statements
provided by Compustat, OneSource, and Market Guide are restated; restated financial
statements replace the originally issued ones. Mergent and Disclosure provide the state-
ments as they were originally issued, without any restatements. Restated financials are
Publicly Traded Companies 191
The valuation analyst may have to consult with the publicly traded
companies’ filings with the SEC for the underlying detail. The amounts
in these electronic databases are good starting points, but the data may
have to be adjusted to consistently reflect the financial position and per-
formance across the companies analyzed.
ValTip
important when the valuation date is current and comparisons are being made across
time for each of the guideline companies. They can be problematic, however, if the val-
uation date is in the past and financials known as of that date are required.
Periodicity of Data

Finally, the dates in these financial statement databases are a function of the com-
panies’ reporting periods and how quickly they release their financial results after
the financial reporting period. The latest quarter, the latest 12 months, or the latest
fiscal year may represent different time periods for any two companies. For exam-
ple, Company A’s latest available quarter might end on February 28, 2002, while
Company B’s might be as of November 20, 2001. If the analyst were to compare
results for the latest available quarters, in this case, he or she would actually be com-
paring data three months apart. Finally, there is a lag time between when the finan-
cial statements are released (in 10-K or 10-Q SEC filings) and when they are
updated in these data sets.
INFORMATION SOURCES FOR INDUSTRY “COMPS”
Other vendors provide information that can be useful in identifying publicly traded
companies in the same industry as the subject. A partial list of such vendors includes:
• Hoover’s Online
• Ibbotson Associates’ Cost of Capital Yearbook
• PricewaterhouseCooper’s EdgarScan™
Hoover’s provides a list of companies that it considers to be similar to one
another. The Cost of Capital Yearbook has a list of pure-play companies by SIC
code in its appendix.
3
EdgarScan™ lists companies within SIC codes.
STOCK PRICES AND NUMBERS OF SHARES OUTSTANDING
Sources for stock prices are generally different from those for financial state-
ment data. The main reason for this is that the analyst usually relies on the stock
prices for the guideline companies on or close to the valuation date, whereas the
financial information used might be months prior to the valuation date.
4
The number of shares used to compute the market value of equity for guideline
companies (and for the subject company) should be the number of common shares
outstanding net of any Treasury shares on a date nearest the valuation date.

Therefore, information on number of shares outstanding should almost always be
taken directly from one of the publicly traded company’s filings, since the reporting
date for the number of shares outstanding may be closer to the valuation date than
it is to the company’s quarter or year end.
5
192 MARKET APPROACH
3
Ibbotson Associates considers a pure-play company to be one for which 75 percent of its
sales fall within a particular one-, two-, three- or four-digit SIC code.
4
This difference in dates is not a problem from a valuation perspective. The market only has
this “old” financial data when it prices companies; therefore, the prices do reflect the infor-
mation available at the time.
5
The first page of the 10-K or 10-Q has the number of outstanding shares outstanding (usu-
ally net of Treasury shares) as of a later date than the quarter or year end. This later date may
be closer to the valuation date.
ADVANTAGES/DISADVANTAGES OF PUBLIC COMPANY DATA
Because of disclosure laws, the universe of publicly traded companies provides a
wealth of information on a very large scale (approximately 10,000 public compa-
nies from which to draw information). This means:
• the availability of larger potential samples than those from transaction data
• readily available, detailed financial statement and pricing data
• fairly consistent data across companies (i.e., in accordance with GAAP)
• accurate depictions of the financial condition of the firms
CHARACTERISTICS OF PUBLICLY TRADED COMPANIES
Exhibit 6.1 provides various summary measures for publicly traded companies,
demonstrating the wide variety of companies from which to draw data.
6
Note the small size of most publicly traded companies. In particular, the median

(the halfway point) is $90 million in sales; this means that one-half of publicly
traded companies have sales of less than $90 million. However, many of these are
not actively traded.
Exhibit 6.2 shows the distribution of public companies by size and broad
industry classifications.
With the exception of those divisions where there are few companies in total (A
and C) and division H, there are reasonably large groups of companies of all sizes,
including the “$10 million and under” category.
Characteristics of Publicly Traded Companies 193
6
This data was obtained from OneSource and represent over 7,000 U.S. companies, with
sales and market capitalization of at least $100,000 for the latest 12 months. Mutual funds
and certain holding companies are excluded from this group. The data are the most recent
available at the beginning of the fourth quarter of 2001.
16 percent of all publicly held companies had sales of $10 million or
less in the period studied.
ValTip
Some analysts believe that publicly traded companies are much too
large to be used as comps in many situations. While this may be true
for the smallest of subject companies, such as mom-and-pop opera-
tions, small professional practices, or sole proprietorships, there is usu-
ally enough size variation among publicly traded companies that they
should be considered for most other valuations.
ValTip
194 MARKET APPROACH
Exhibit 6.1 Summary Measures for Publicly Traded Companies’ Sales
Range (in Millions) Sales Assets Market Cap.
_________________ ______ ______ ___________
Under $1 2.2% 1.4% 5.6%
$1 to $10 13.8% 11.2% 18.9%

$10 to $25 12.3% 9.4% 11.8%
$25 to $50 12.0% 8.7% 10.9%
$50 to $100 11.5% 10.6% 10.3%
$100 to $250 14.6% 16.0% 11.5%
$250 to $500 9.6% 11.7% 8.9%
$500 to $1,000 8.0% 10.4% 7.6%
$1,000 to $10,000 13.3% 16.2% 11.8%
$10,000 to $100,000 2.7% 4.0% 2.5%
Over $100,000 0.1% 0.5% 0.3%
Summary Statistics (in Millions)
10th Percentile $ 5 $ 8 $ 2
25th Percentile $ 20 $ 32 $ 11
Median $ 90 $ 161 $ 62
75th Percentile $ 467 $ 724 $ 395
90th Percentile $2,020 $2,969 $1,858
Exhibit 6.2 Distribution of Public Companies by Size and Broad Industry Classifications
Sales Range
SIC Divisions:
(in Millions) A B C D E F G H I Totals
__________ ____ ____ ____ ____ ____ ____ ____ ____ ____ ______
Under $1 — 7 1 62 15 9 4 — 51 149
$1 to $10 4 48 3 392 53 21 27 4 288 840
$10 to $25 3 24 8 306 50 25 24 139 216 795
$25 to $50 4 27 3 287 36 24 26 214 219 840
$50 to $100 4 17 9 262 46 32 29 221 213 833
$100 to $250 2 34 8 376 86 34 74 198 251 1,063
$250 to $500 4 28 11 233 78 34 70 167 146 771
$500 to $1,000 — 16 9 211 51 34 60 75 109 565
$1,000 to
$10,000 2 35 26 377 132 47 91 72 119 901

$10,000 to
$100,000 — 11 — 64 38 12 25 109 12 271
Over $100,000 — 1 — 4 1 — 1 30 — 37
_____ _____ _____ _____ _____ _____ _____ _____ _____ _____
Totals 23 248 78 2,574 586 272 431 1,229 1,624 7,065
These divisions, as taken from the 1987 Standard Industrial Classification Manual, are:
A. Agriculture, forestry, and fishing
B. Mining
C. Construction
D. Manufacturing
E. Transportation, communications, electric, gas, and sanitary services
F. Wholesale trade
G. Retail trade
H. Finance, insurance, and real estate
I. Services
The four-digit SIC codes with the largest total market capitalizations are shown
in Exhibit 6.3.
7
These are slightly different from the top 10 SIC codes shown in Exhibit 6.4 in
terms of number of companies.
Most recent Price/Earnings (P/E; based on net income) multiples (positive P/E
only) for public companies are between 5 and 20, with a median of 14.5. Two per-
cent of all companies have P/E multiples of over 100. See Exhibits 6.6 and 6.7.
As shown in Exhibit 6.7, median P/E ratios appear to be highest for service
companies, at 20, with the remaining industries, except for mining, hovering in
the mid-teens. The number of companies included in A and C may be too small
to have high confidence in their medians. Of course, the ranges of P/E multiples,
which are not shown here, is very large for each industry group. Furthermore, the
relationships shown here will almost certainly change as economic conditions
change.

Characteristics of Publicly Traded Companies 195
The median asset size is also surprisingly small at $161 million, with
13 percent of all publicly traded companies having assets of $10 mil-
lion or less.
ValTip
Median equity market capitalization (the total market value of all com-
mon equity) is only $62 million. One-quarter of all publicly traded
companies have market capitalizations of $11 million or less.
ValTip
Almost half of all publicly traded companies lost money for the
last 12 months on a net income (after-tax) basis. Only about 18 percent
of all U.S. companies had net income profit margins of more than 10
percent (see Exhibit 6.5).
ValTip
7
From Market Guide, data as of October 16, 2001, for U.S. companies with sales and mar-
ket capitalization greater than 0.
196 MARKET APPROACH
Exhibit 6.4 Top 10 SIC Codes with Market Capitalization
SIC Number of Market Capitalization ($ Millions)
Code Description Companies Total Minimum Maximum
____ __________ _________ _____ ________ ________
6712 Offices of Bank Holding Companies 680 596,054.3 0.9 68,807.7
7372 Prepackaged Software 370 543,331.6 0.0 315,257.5
6798 Real Estate Investment Trusts 193 147,896.0 0.2 12,497.0
2834 Pharmaceutical Preparations 168 1,220,404.6 0.0 259,452.4
7373 Computer Integrated Systems Design 161 37,661.6 0.0 4,445.9
1311 Crude Petroleum and Natural Gas 159 514,582.8 0.0 286,867.6
7375 Information Retrieval Services 153 172,728.8 0.0 148,839.6
3674 Semiconductors and Related Devices 147 438,129.9 0.6 167,930.9

5812 Eating Places 122 80,879.9 0.0 38,228.5
4813 Telephone Communications,
except Radiotelephone 121 545,352.9 0.0 145,873.5
Exhibit 6.5 Net Income Margins
Net Income Percentage
Margin of Companies
___________ ___________
Losses 47.7%
0% to 5% 20.3%
5% to 10% 13.5%
10% to 15% 8.2%
15% to 20% 4.9%
20% to 50% 4.6%
Over 50% 0.7%
0.6% (Median)
Exhibit 6.3 Four Digit SIC Codes with Market Capitalization
SIC Number of Market Capitalization ($ Millions)
Code Description Companies Total Minimum Maximum
____ __________ _________ _____ ________ ________
2834 Pharmaceutical Preparations 168 1,220,404.6 0.0 259,452.4
6712 Offices of Bank Holding Companies 680 596,054.3 0.9 68,807.7
4813 Telephone Communications,
except Radiotelephone 121 545,352.9 0.0 145,873.5
7372 Prepackaged Software 370 543,331.6 0.0 315,257.5
1311 Crude Petroleum and Natural Gas 159 514,582.8 0.0 286,867.6
6331 Fire, Marine, and Casualty Insurance 66 456,375.3 0.6 225,736.1
3674 Semiconductors and Related Devices 147 438,129.9 0.6 167,930.9
3511 Steam, Gas, and Hydraulic Turbines, etc. 5 383,038.8 4.9 382,193.7
3571 Electronic Computers 46 340,360.3 0.1 176,878.8
5311 Department Stores 14 294,186.5 13.6 237,374.3

CHOOSING GUIDELINE COMPANIES
Understanding the Subject Company
The first step in performing any valuation analysis is to understand the business of
the subject company. This includes its main products, clients, markets served, modes
of distribution, and so forth. Of equal importance is an understanding of its plans,
expected growth, and other factors pertaining to the future. Analysts also look at
lines of business, and how important each of the business segments is to the overall
company in terms of assets, sales, or profits.
A common difficulty in analyzing larger companies is the presence of more
than one distinct line of business. If the subject has one major line of business and
a number of other relatively small ones, the value of the overall company will be
driven by the major business segment. If, however, the subject comprises numer-
ous business segments that are relatively close in size, then its value is really that
of a composite company. Finding comparable companies with similar business
lines can be tricky. The valuation professional can try to find companies engaged
Choosing Guideline Companies 197
Exhibit 6.6 P/E Multiples
Price/ Percentage
Net Income of Companies
__________ ____________
Under 5 6.6%
5 to 10 17.5%
10 to 15 28.1%
15 to 20 16.9%
20 to 25 8.3%
25 to 30 6.0%
30 to 50 9.9%
50 to 100 4.5%
Over 100 2.1%
14.5 (Median)

Exhibit 6.7 Median P/E Multiples by SIC
SIC Median # of
Division P/E Companies
_______ _____ __________
A 11.7 9
B 8.4 170
C 6.2 55
D 16.1 1,198
E 13.8 266
F 14.7 135
G 14.6 241
H 13.7 1,009
I 20.0 488
All 14.5 3,571
primarily in the main business of the subject—sometimes referred to as pure-play
companies. In the case where companies have multiple lines of business, it is
unlikely that other companies could be found with the same business as the sub-
ject. Therefore, pure-play companies in all of the subject’s lines of business may
have to be considered.
8
Sources of Information about Potential Guideline Companies
Finding a good set of potential guideline companies is one of the most important yet
most time-consuming aspects of implementing the market approach. There are sev-
eral ways to identify such companies, but no single way that is best for all
valuations.
Industry Classifications
Since there are so many publicly traded companies from which to choose, the ana-
lyst must develop some way of quickly reducing the set of potential comparable
companies. One of the most common ways is to choose companies in the same
line(s) of business (or industry) as the subject. Presumably these companies will be

affected by many of the same economic and business factors as the subject, and their
prices will reflect these influences. This line-of-business criterion is just one way of
incorporating the subject company’s outlook as well as its business and financial
risks into its price. Of course, other characteristics influence price. However, similar
business lines is the characteristic that typically is used in the initial screening for
potential comparable companies.
A number of data providers categorize the companies on which they carry
information by industry. Some have developed their own industry categories; almost
all, however, categorize potential companies or transactions by SIC or NAICS
codes.
9
The advantage of categorizing potential companies or transactions by these
codes is that they are widely used and more uniform than industry assignments
made by the vendors.
There are several problems to be aware of when relying on a particular data
vendor’s industry classification of potential guideline companies:
• Some companies (even relatively small ones) are diversified such that the sales
or profits in their listed industry are only a fraction of their overall business.
These companies are not pure plays and, unless their mix of business is largely
identical to the subject’s, they may not be appropriate for the guideline com-
pany set.
• While a potential guideline company may have most of its business in one
industry, it may have been classified incorrectly. This could be due to simple
198 MARKET APPROACH
8
Valuing a subject in this way may be more complicated than simply adding the values of the
individual business segments. To the extent that there is some diversification benefit from hav-
ing the particular business mix of the subject, the overall value may be greater than the sum
of its parts. This benefit is realized primarily in the reduction of overall business risk, some-
times referred to as a “portfolio effect.”

9
As of this writing, the North American Industry Classification System (NAICS) is not in as
wide use as the older Standard Industrial Classification system.
misclassification by the data provider. One common situation involves con-
fusing distribution with manufacturing. For example, some companies that
are actually distributors are classified as manufacturers because the data
provider has focused on the product being distributed rather than the com-
pany’s activity.
• Different data providers may place the same company into different industry
classifications.
Subject Company Management
The management of the subject company can be a good starting point to identify
potential guideline companies. Often management knows its competition intimately
and may be willing and able to supply “insider” financial and pricing information
on them. It also may be useful to present the list of publicly traded companies in the
industry to the subject company’s management to obtain their input on which of
these companies might be comparable.
Other Sources
Professionals who work with the subject company (i.e., accountants and attorneys)
and industry experts (who can be contacted through trade associations, commercial
Choosing Guideline Companies 199
Examining detailed business descriptions of the possible guideline com-
panies is an essential step in the analysis. Some data vendors provide
good descriptions of a company’s business(es); however, they are never
more detailed than the data found in a company’s 10-K filing.
ValTip
One challenge involved with showing such a list to management is that
often managers believe their company is “truly unique,” and thus, they
view none of the publicly traded companies as comparable. It is
unlikely that the market niche into which the subject company fits

really appreciates some of the nuances that make the subject “truly
unique.” Unless these nuances result in prospects for the subject that
are substantially different from those of the potential guideline compa-
nies, those companies usually can be used. On the other end of the
spectrum, management may insist that a particular publicly traded
company is comparable because they are a competitor. But the division
which offers a product or service similar to the subject company may
be just one of many larger lines of business.
ValTip
banks, or brokerage firms) also can be good sources of information about the sub-
ject company and its competitors. Industry publications or web sites can be good
sources of information about potential guideline companies.
FINANCIAL AND OTHER INDICATORS
Much of the time spent in identifying comparable companies revolves around find-
ing firms engaged in the same or similar line of business as the subject. Other fac-
tors, however, also should be considered in the initial identification process, which
are also intended to help identify potential guideline companies with similar future
prospects and business and financial risk characteristics.
Size
While there have been no detailed studies to specifically identify size-related
risk factors, some of the more important ones might be:
• Lack of diversifications in products, customers or geographic areas
• Lack of depth in the management team.
There are many issues to be considered if size will be used to establish compa-
rability. In particular, the size measure to use is often a function of the industry in
which the company operates. For service businesses, total revenue is probably the
best measure of size. For manufacturing concerns, size might best be captured in the
level of total assets.
How close must guideline or subject sizes be to be comparable? This will be
a matter of judgment and, again, a function of the environment in which the

company operates. A $10 million company might not be a good guideline com-
pany to use for a $500,000 business; however, it may work well for a $2 million
company.
200 MARKET APPROACH
One of the most important indicators of comparability is size. Size can
be expressed in terms of sales, total assets, or market capitalization.
Numerous studies have indicated that, on average, smaller companies
have lower pricing multiples than larger companies. The main reason
for this is that smaller companies typically have more business and
financial risk than large companies.
10
ValTip
10
More risk means investors will require a higher rate of return on their investment; and the
way to get this is by lowering the price.
Growth
Growth is another very important factor in comparability. It is inextricably con-
nected to value, since expected growth is imputed in the price of a stock. While this
relationship is difficult to observe since it is hard to find an “accurate” measure of
expected long-term growth for any company (at least as the market perceives it at
one point in time), the graph in Exhibit 6.8 shows an observation of this relation-
ship for a date in October 2001.
11
Exhibit 6.8 Relationship Between Expected Growth and P/E
This graph demonstrates a positive relationship between P/E multiple and
expected growth.
12
The fact that this relationship is positive is illuminating given
that this data represents companies from a variety of industries, of different sizes,
and with other disparate characteristics.

The relationship between historical growth shown in Exhibit 6.9, is not as
strong.
13
Another observation that can be made from these graphs is how much more
important expected growth is in the determination of value than is historical
growth. Fortunately, this is consistent with valuation theory.
Expected Growth
Price/Earnings
50
45
40
35
30
25
20
15
10
5
10 20 30 40 50
60
Financial and Other Indicators 201
11
All data are taken from Market Guide. P/E is as computed by its authors and the
expected growth rate is based on a consensus of sell-side analysts for the next three to five
years.
12
The slope of the line shown is statistically different from zero, with a T-statistic of more
than 12, an R
2
of 13 percent and almost 2,000 degrees of freedom.

13
The T-statistic is about 5 on the slope and the R
2
is only 1 percent.
Other Factors
Profitability of the publicly traded companies also should be considered when
selecting guideline companies. For example potential guideline companies with
high gross margins may not be as comparable to a subject company with a low
gross margin.
Another factor that can affect value is the length of time the business has been
operating. Generally, businesses with longer histories tend to have higher pricing
multiples than younger companies, because younger companies are generally more
risky than more established ones since their prospects are more uncertain.
202 MARKET APPROACH
Exhibit 6.9 Relationship Between Historical Growth and P/E
Actual 5-Year Sales Growth
Price/Earnings
10 20 30 40 50 60 70 80
100
90
80
70
60
50
40
30
20
10
90
100

Also at issue is whether trading in a guideline company’s stock is suffi-
ciently active to give meaningful and realistic values for that company.
While companies with low trading volumes may be very similar to the
subject in terms of business and financial characteristics, infrequent
trades may not reflect the actual value of the stock so there is no point
in using valuation ratios based on these prices.
ValTip
SAMPLE SIZE MATTERS
A larger group of comparables will reduce the importance of any single guideline
company. Since at least one company in any group may be anomalous, having a
larger group reduces the effect of this potential anomaly. Furthermore, companies
are complex. No one- or two-guideline company(ies) can approximate all of the
characteristics of a complex subject. Having a larger group of comparables increases
the likelihood that more of the subject’s characteristics can be captured.
Even within groups of companies whose business descriptions are nearly iden-
tical to the subject’s there can be large variations in pricing measures. In certain
cases it may be better to choose guideline companies that are close to the subject in
size, growth, and profitability but less related in terms of business description than
companies that have very similar business descriptions but may differ substantially
in terms of size, longevity, etc.
COMPARABLE COMPANIES INFORMATION DATES
After identifying companies in similar lines of business, the analyst also must per-
form a financial analysis of these companies to determine whether they are good
comparables from a financial point of view. To do this properly for valuation pur-
poses, all information used must be as of the valuation date. For example, if the val-
uation date is June 30, 2002, all of the financial statement data, stock prices, and
the like is usually for a period ended no later than this date. Gathering these data
can be tricky for older valuation dates, since many data vendors have only the most
current data.
BASIC FINANCIAL INDICATORS

Some financial measures that should be included in an analysis for both guideline
and subject companies include:
• Size Measures. These include the magnitude of sales, profits, total assets, market
capitalization, and total invested capital. Given how size may affect value, at
least one, if not all, of these should be included.
• Historical Growth Rates. Consider growth in sales, profits, assets, or equity. The
time period over which to measure this growth is important and is discussed
later.
Basic Financial Indicators 203
Valuation analysts may have to choose between a very small group of
companies whose business descriptions are quite similar to that of the
subject or a larger group of companies, some of whose business
descriptions are not as good a match.
ValTip
• Activity Ratios. Examples are the total assets and inventory turnover ratios.
Depending on the type of business being analyzed, other ratios also may be
important.
• Measures of Profitability and Cash Flow. Consider the four most common
measures:
1. Earnings before interest, taxes, depreciation and amortization (EBITDA)
2. Earnings before interest and taxes (EBIT)
3. Net income
4. Cash flow
Using concepts such as EBIT and EBITDA can be useful because they can reflect
the economics of the business better than net income and cash flow, which are very
much influenced by both the company’s tax planning and its choice of capital
structure.
• Profit Margins. The level of profits is probably less important than the ratio of
profits relative to some base item—usually sales, assets, or equity.
• Capital Structure. It is essential to use some measures derived from the current

capital structure. The most common measures are the values of outstanding total
debt, preferred stock (if it exists), and the market value of common equity, since
book equity generally has very little to do with how stock investors view their
relative position with a company. The ratio of debt to market value of equity
should be included since this represents the true leverage of the company.
• Other Measures. These will be a function of what is important in the industry in
which the subject company operates. For example, value drivers for retailers are
inventory turnover; for banks, loan/deposit ratios; and for hospitals, revenue per
bed and length of stay.
DISPLAYING THE INFORMATION
Once the key items have been chosen, the next step is to put the information into a
usable format. The goal should be to display these data in a way that makes com-
parisons easy. So that comparisons are meaningful, the concepts must be consistent
across companies. Furthermore, the financial information for the subject company
should be shown in a consistent format. One of the advantages of getting the data
from electronic providers is that they try to standardize concepts across companies.
Exhibit 6.10 is an example of what such a presentation of standard financial
indicators might look like for public companies.
204 MARKET APPROACH
The debt number used should be its market value; however, on a prac-
tical basis, most analysts simply use the book value of the debt as a
proxy for market value.
ValTip
205
Exhibit 6.10
Presentation of Standard Financial Indicators
$ Millions
Amounts in $ Millions
___________________
Guideline

Tangible Total
Gross
Pretax Net
Company
Assets Assets Employees Sales Profit
EBITDA EBIT Income Income
________
_________________ __________ ______ ______
_______ ______ _______ _______
Company 1
72.4 74.0 315.0 64.8 33.5 4.5 3.8 4.0 2.5
Company 2
40.2 51.5 353.0 62.0 42.4 9.5 7.0 5.8 3.3
Company 3
35.2 47.4 246.0 55.5 27.3 4.5 3.8 0.8 0.5
Company 4
44.4 52.0 361.0 54.3 26.5 6.0 4.5 4.7 3.1
Company 5
33.4 36.8 121.0 36.7 22.9 12.1 10.7
4.9 2.9
Company 6
25.5 36.3 206.0 31.0 10.7 1.4 0.9 0.1
(0.1)
Company 7
20.7 20.7 134.0 27.5 17.3 1.3 0.8 1.0 1.1
Company 8
26.5 29.8 100.0 21.3 8.0 4.2 1.9 2.3 1.2
Company 9
12.3 13.3 117.0 17.1 7.3 1.7 1.2 0.9 0.5
25th Percentile

25.5 29.8 121.0 27.5 10.7 1.7 1.2 0.9 0.5
Median
33.4 36.8 206.0 36.7 22.9 4.5 3.8 2.3 1.2
75th Percentile
40.2 51.5 315.0 55.5 27.3 6.0 4.5 4.7 2.9
Subject Company
3.6 4.1 29.0 5.2 2.5 0.5 0.4 0.4 0
.3
Long-Term Growth
Gross
Pretax Net
Shrhld.
Company
Sales Profit EBITDA EBIT Income Income
Assets Equity
__________
______ ______ _______ _____ _______
______ ______ ______
Company 1
17.9% 21.3% 36.0% 40.6% 51.6%
58.4% 32.2% 46.6%
Company 2
18.6% 18.7% 34.4% 36.9% 58.5%
33.7% 18.3% 8.2%
Company 3
17.0% 14.2% -0.9% 4.9% -0.4%
-36.6% 15.8% 11.2%
Company 4
10.5% 10.8% 22.8% 23.6% 28.4% 28.6%
17.3% 25.4%

Company 5
49.1% 55.1% 66.4% 67.2% 76.2%
75.2% 42.7% 47.0%
Company 6
40.3% 35.2% 31.0% 32.9% 25.8%
23.0% 28.1% 21.5%
(continues)
206
Long-Term Growth
Gross
Pretax Net
Shrhld.
Company
Sales Profit EBITDA EBIT Income Income
Assets Equity
__________
______ ______ _______ _____ _______
______ ______ ______
Company 7
13.3% 12.6% -4.9% -7.8% -4.1%
5.3% 9.3% 8.5%
Company 8
5.2% -2.7% -5.5% -12.1% 16.0%
13.1% 4.0% 5.0%
Company 9
18.7% 18.1% 14.9% 14.6% 26.8%
13.9% 11.1% 11.4%
25th Percentile
13.3% 12.6% -0.9% 4.9% 16.0%
13.1% 11.1% 8.5%

Median
17.9% 18.1% 22.8% 23.6% 26.8%
23.0% 17.3% 11.4%
75th Percentile
18.7% 21.3% 34.4% 36.9% 51.6%
33.7% 28.1% 25.4%
Subject Company
4.4% 2.2% 19.2% 20.0% 25.0% 16.7%
-2.2% -2.6%
Latest 12 Months Margins (% of Sales)
Long-Term Margins (% of Sales)
__________________________________________________________
____________________________________________________
Gross
Pretax Net Gross
Pretax Net
Company
Profit EBITDA EBIT Income Income Profit
EBITDA EBIT Income Income
__________
______ _______ _____ ______ _______
______ _______ _____ _______ ______
Company 1
51.7% 6.9% 5.9% 6.2% 3.9%
52.4% 12.5% 11.2% 10.5% 7.5%
Company 2
68.4% 15.3% 11.3% 9.4% 5.3%
69.0% 12.9% 9.7% 5.9% 4.0%
Company 3
49.2% 8.1% 6.8% 1.4% 0.9%

55.5% 12.2% 10.1% 6.5% 6.6%
Company 4
48.8% 11.0% 8.3% 8.7%
5.7% 48.9% 11.2% 9.0% 9.2% 6.2%
Company 5
62.4% 33.0% 29.2% 13.4% 7.9%
55.6% 0.0% 0.0% 10.8% 6.4%
Company 6
34.5% 4.5% 2.9% 0.3% -0.3%
40.5% 9.6% 7.6% 8.0% 4.6%
Company 7
62.9% 4.7% 2.9% 3.6% 4.0%
66.8% 7.1% 5.1% 6.1% 4.7%
Company 8
37.6% 19.7% 8.9% 10.8% 5.6%
50.4% 33.9% 25.6% 19.7% 11.8%
Company 9
42.7% 9.9% 7.0% 5.3%
2.9% 42.5% 9.4% 6.8% 4.6% 3.0%
Exhibit 6.10
continued
207
25th Percentile
42.7% 6.9% 5.9% 3.6% 2.9%
48.9% 9.6% 7.4% 6.1% 4.6%
Median
49.2% 9.9% 7.0% 6.2% 4.0%
52.4% 11.7% 9.4% 8.0% 6.2%
75th Percentile
62.4% 15.3% 8.9% 9.4% 5.6%

55.6% 12.6% 10.4% 10.5% 6.6%
Subject Company
48.1% 9.6% 7.7% 7.7% 5.8%
46.9% 9.0% 7.3% 7.1% 5.5%
Total Comm.
Sales/ Curr. Quick W/C / Inv.
Debt Equity Debt/
Company
Assets Ratio Ratio Sales Turn.
($ Mil.) ($ Mil.)
Equity
__________
______ _____ _______ _______ _____
______ ______ ______
Company 1
0.9 2.9 2.4
0.7 3.4 3.1 47.0 0.1
Company 2
1.2 2.8 1.6 0.4 2.5
12.8 28.5 0.4
Company 3
1.2 2.4 1.4 0.3 2.4 8.6
32.2 0.3
Company 4
1.0 5.9 3.9 0.6 2.8 1.8
43.7 0.0
Company 5
1.0 2.9 2.2 0.3 3.8 3.7
19.9 0.2
Company 6

0.9 1.7 0.8 0.2 2.2 7.3
21.1 0.3
Company 7
1.3 4.0 2.6 0.5 2.9 0.1
16.1 0.0
Company 8
0.7 7.6 4.4 0.7 2.2
— 26.2 —
Company 9
1.3 2.2 1.0 0.3 2.5 4.2 7.1 0.6
25th Percentile
0.9 2.4 1.4 0.3 2.4 1.8
19.9 0.0
Median
1.0 2.9 2.2 0.4 2.5 3.7
26.2 0.2
75th Percentile
1.2 4.0 2.6 0.6 2.9 7.3
32.2 0.3
Subject Company
1.3 3.9 3.1 0.6 2.0
— 3.8 —
Several things of note in this example of a guideline company analysis make
establishing comparability easier.
• The income data are for the latest 12 months (LTM) (prior to the valuation data)
and the balance sheet data are for the most recent quarter (prior to the valuation
date).
• A number of size measures are shown; however, only one or two are really nec-
essary to help establish comparability. The others are used to develop valuation
ratios.

• The remaining measures are independent of size, making them meaningful to
compare across companies.
• There are summary statistics for each data series. In this case the 25th, Median,
and 75th percentiles are shown.
14
Other summary measures that could be used
include different percentiles (such as the 10th and the 90th) as well as a simple
average of the companies and a composite of the companies.
• Outliers could indicate an anomalous situation for an industry or company.
These apparent anomalies should usually be analyzed because they may contain
important information about trends in an industry.
• Profitability ratios are computed using both the most recent data and informa-
tion over the last five years.
• The last part of the table gives other operating ratios and indications of the cap-
ital structure.
Typical periods for which short-term and long-term ratios are computed
include:
• Latest 12 months (LTM) prior to the valuation date
• Latest fiscal year prior to the valuation date
• Latest three to five years prior to the valuation date
• A complete business cycle
One of the problems with using either the latest 12 months’ or latest fiscal
year’s data is that results can be significantly affected by a one-time, nonrecurring
208 MARKET APPROACH
Using percentiles rather than simple averages or composites provides a
range of values and protects the information from the effects of outliers.
ValTip
14
The 25th percentile is the value below which are 25 percent of the values in the group. For
example, using the above information, 25 percent, or two, of the companies have latest

returns on EBIT as a percent of sales of less than or equal to 5.9 percent. The median is sim-
ply the 50th percentile; half of the values for that concept are above the median and half are
below.