Market approach

There are three ways to put a value on a business. Work out what its future cash flows are worth today — the income approach. Work out what its assets would cost to replace, or fetch if sold — the cost approach. Or look at what buyers are actually paying for similar companies right now, and apply the same yardstick — the market approach.

The market approach is the one that anchors to observable prices. Its logic is that for a transaction to be properly priced, what matters is the current market value, and multiples are how that value gets carried from one company to another.

Its popularity is partly practical. It is easier to explain and less quantitative than a discounted cash flow, which is why research analysts, transaction bankers, brokers and investors reach for it in both capital markets and the alternative space.

Chapter 11 splits the multiples into two families:

• Earnings based multiples, also called Transaction Comparables or Deal Comps — principally EV/EBITDA and EV/Sales, the latter known as the topline multiple.
• Market based multiples, also called Trading Comps — principally the P/E ratio and the Price to Book Value ratio.

The critical structural point: relative valuation methods determine the Enterprise Value. To reach the equity value you must deduct the book or market value of outstanding debt.

The workbook is candid about the limitations, and all four are examinable:

1. It ignores future capital expenditure and incremental working capital, both of which can move value substantially.
2. It suits companies that have reached maturity and are stable in outlook.
3. The selection of multiples is subjective.
4. Multiples are driven by external factors, so a company's valuation can move with no fundamental shift in intrinsic value between two dates.

And the standing warning: relative valuation requires comparing an apple to an apple. Where business models are unique or comparable data is unavailable, the approach may simply not be appropriate.

EV/EBITDA  = Value of firm ÷ EBITDA
EV/Sales   = Value of firm ÷ Revenue          (topline multiple)
P/E        = Market price ÷ Earnings per share
P/BV       = Market value ÷ Networth

Equity value = Enterprise value − outstanding debt

Networth, as the workbook defines it: net fixed assets + long-term investments + net current assets − long-term liabilities; equivalently, share capital plus accumulated reserves.

The workbook's two illustrations, taken together.

Illustration 11.6 — an EV multiple. The DCF in the same chapter produced an enterprise value of Rs 26,737.79 lakh. Estimated EBITDA for year 1 is Rs 1,875 lakh:

EV/EBITDA = 26,737.79 ÷ 1,875 = 14.26

Illustration 11.8 — a market multiple. Alpha Ltd has after-tax profit of Rs 100 lakh and paid-up capital of Rs 200 lakh in 20 lakh shares of Rs 10 each, trading at a P/E of 32:

EPS = 1,00,00,000 ÷ 20,00,000 = Rs 5
Market price = 32 × 5 = Rs 160 per share

Now use them the other way round. A Category II AIF is pricing an unlisted speciality chemicals company with EBITDA of Rs 210 crore and debt of Rs 340 crore. Three listed peers trade at EV/EBITDA of 11.2x, 13.8x and 12.4x — a median of 12.4x:

The discount is the point. The peers are quoted; this company is not. The IPEV guidance in the same chapter says it is normal to apply a discount to a quoted market ratio to reflect the illiquidity of unlisted stock, reduced where the manager believes an exit is imminent.

Chapter 11 (Valuation), section 11.4 for the three-approach framework and section 11.7 for relative valuation, with Illustrations 11.6, 11.7 and 11.8. Expect a multiple computation, a question on which approach is which of income, market and cost, and a question on the limitations — the "apple to an apple" point is the one the workbook repeats.

• Relative valuation produces enterprise value, not equity value. Deduct outstanding debt. Forgetting this is the commonest arithmetic error in the chapter.
• The market approach is not the income approach. The workbook maps market approach to relative valuation and cost approach to the asset-based method; the income approach is DCF.
• Pair like with like. EV multiples pair whole-firm value with pre-interest earnings; P/E pairs equity with equity. Dividing enterprise value by PAT is meaningless.
• The method suits mature, stable companies. For a pre-revenue start-up there are no comparables and no earnings to multiply.
• Multiples move with external factors — sentiment, rates, sector flows — so a valuation can change between two dates without the business changing at all.
• The selection of multiples is subjective. Choosing which peers count is where most of the answer actually gets decided.