David Letterman’s “Is This Anything?” sketch provided viewers with not only a good laugh, but also a memorable maxim when contemplating meaning and relevance. At Dave’s prompt, the curtain would rise to reveal such things as a scantily clad model running a circular saw against an armored breastplate, shooting sparks across the stage. The question posed to the viewers was then, “Is this anything?” . . . does this elaborate and eye-catching show amount to anything?
Users of valuation reports sometimes find themselves asking a similar question. For all of their elaborate and eye-catching presentations, do these analyses actually conclude values (or ranges of values) that reasonably approximate those at which market participants would agree to transact?
There are, of course, many variables and considerations that go into estimating the value of a privately held company, let alone a particular security within that company’s capital stack. However, there is one area of a valuation report on which readers might initially focus, and a corresponding question that they might ask themselves, in order to quickly assess the likelihood that a valuation analysis is on a path to a conclusion that reasonably reflects the perspective of market participants. An affirmative response to this key question tends, in my experience, to suggest an increase in that likelihood.
Key Question: Does the report convey reasonable basis for how market multiples were evaluated and selected?
Establishing reasonable basis is an important part of employing market multiples, but valuation reports that include a market approach periodically fall short of exhibiting such reasonable basis. While the opinions in valuation reports can be as varied as the personalities and backgrounds of the professionals who prepare them, a careful review of stated rationale regarding market multiples can be illuminating as to whether, or to what extent, reasonable basis was sought in the analysis. Absent such reasonable basis, deployment of market multiples can become problematic. Perhaps Dr. Aswath Damodaran of NYU’s Stern School of Business described this best when he said, “The problem with multiples is not in their use but in their abuse.”
Below, I summarize three observations from practical experience that provide some insight into what “abuse,” or lack of reasonable basis, may look like in this context.
A restatement of facts without a clear connection between those facts and the chosen multiple(s).
This sort of “red flag,” if you will, is often followed closely by other “red flags.” For example, I came across this comment in a third-party valuation report, which illustrates this cascading red flag effect:
. . . the selected multiples considered i.) the strong revenue growth observed in the last fiscal year (LFY), ii.) the modest revenue declines experienced in the last twelve months (LTM), and iii.) the accelerating revenue declines and corresponding operating losses reasonably anticipated in the next twelve months (NTM) . . .
While at first blush the statement appears to contain basis, it immediately begs a question of how these factors influenced the selection of multiples. The report provided no answer to this question and, thus, the reader was left unable to discern any connection between these statements and the ultimate selections (red flag #1). Instead, the report provided only a schedule indicating that three BEV/R multiples had been selected (BEV/R(LFY), BEV/R(LTM) and BEV/R(NTM)) at exactly the upper quartile of the data set, with no rationale given for either the magnitude or the statistical similarity of the selections (red flag #2). The analysis then went on to not only calculate and present business enterprise value indications that were significantly different from one another, but also weight these indications equally without a stated rationale for doing so in that circumstance (red flag #3). The tale of these sorts of “red flags” is thus a simple and sobering one: Once freed from an onus to establish and convey reasonable basis, analysts can effectively select any combination of multiples they wish (a theme that will appear again in the next observation).
Inclusion and direct incorporation/weighting of multiples of companies having significantly different business models and risks than the subject company.
A quick scan of the guideline firms used in a valuation report can sometimes reveal striking differences within the sample set. While some functional differences are always to be expected in such sample sets, significant differences in business model and risks can lead to inaccurate results if not properly acknowledged and addressed.
For example, and in similar fashion to the cascading red flags noted in the prior example, I reviewed a third-party valuation report of a sporting goods retailer where the preparers had included two bargain apparel retailers in the sample set (in addition to the seven sporting goods retailers already gathered, which initially seemed both curious and superfluous) (red flag #1). In fact, the analyst’s own industry analysis of sporting goods retailing had specifically noted that “. . . retailers that exclusively sell apparel are not included in this industry” (red flag #2). The bargain apparel retailers traded at multiples that were significantly above the other sporting goods retailers, and the analyst relied on that fact to ultimately quantify multiples that were materially (and seemingly, at first glance, randomly) above the range of the sporting goods firms (red flag #3). No rationale was provided (or was readily apparent) for the chosen magnitude of each specific multiple utilized, nor was any rationale provided for weighting all four value indications equally (red flag #4). Ultimately, the only pattern and purpose for the chosen multiples that could be discerned was that the average value indication derived from them exactly matched the valuation indication prepared under the discounted cash flow method (DCF). Stated differently, it appeared as though the preparers had chosen a slate of multiples with the intent to conveniently “corroborate” this purported market approach indication with that of their DCF and, thus, the credibility of both the market approach and the entire valuation analysis was called into question.
Unsupported use of median(s).
Even in less egregious and more simple cases, where rationale is clearly stated, such basis may fall short of being reasonable. For example, I observed a median BEV/R multiple being selected in another third-party valuation report, and this was the sole rationale provided for the median selection:
. . .We generally believe that the median is the best representative statistic for the guideline company data because it minimizes the distortion from outliers . . .
While minimizing distortion from outliers may be a valid reason for preferring the median over the average, it does not in isolation constitute reasonable basis for the selection in the first place. In other words, there is likely good reason that a sample set of guideline firms do not all trade at the median multiple, and investigating both the contributing factors and the relevance of those factors to the subject company is an important part of evaluating and applying market multiples.
It is understandably difficult for readers of valuation reports on privately held companies to gauge the likelihood that the conclusions contained therein reflect the perspective of market participants. There are many variables and factors to be taken into consideration, and so many different opinions circulating in markets that it should come as no surprise that valuation reports often become the subject of debate or dispute. However, a quick check of whether a valuation report has established and conveyed reasonable basis with regard to evaluating and selecting market multiples may be a useful early indicator for whether that report is on the path to rendering a conclusion that is consistent with the perspective of market participants.
Dr. Aswath Damodaran, It is all relative . . . Multiples, Comparables and Value!, Leonard N. Stern School of Business, New York University, p. 6. ↑
Business enterprise value to revenues. ↑