Transaction databases contain the details of thousands of real-life public and private stock sales. They’re used by business valuators when they apply the guideline transaction method. This method — also known as the merger and acquisition method — is a subset of the market approach. It derives a company’s value from prices paid for companies engaged in the same, or similar, lines of business.

Selection criteria

Valuators start this methodology by filtering transaction databases based on specific selection criteria. These parameters affect which transactions the valuator analyzes. A minor change in the selection criteria can have a major impact on value.

The most obvious selection criterion is the subject company’s Standard Industrial Classification (SIC) or North American Industry Classification System (NAICS) code. But valuators also might set parameters for such factors as size, financial performance, geographic location and time frame. Timing is essential in today’s uncertain marketplace. The use of outdated transactions when applying this method could lead to erroneous value conclusions.

Pricing multiples

Next, valuators analyze the sample of guideline transactions to develop pricing multiples that relate the price paid in each transaction to the respective company’s underlying financial data. Valuators can compare selling price to many financial metrics. For example, a valuator might apply the median price-to-revenue or average price-to-cash-flow multiples to the subject company’s revenue or cash flow to estimate value. Which metrics are relevant depends on the comparables’ operations, historical performance and business structures.

Generally, valuators have the most confidence in the pricing multiple that shows the lowest standard deviation. This means that, if the transactions are graphed, the preferred pricing multiple is the one in which the data points are the most tightly clustered with the fewest outliers. In some cases, a valuator might use several pricing multiples and assign varying weights to each relevant multiple.

Detailed approach

It’s critical for valuators to research each guideline transaction closely to understand what’s being transferred and the underlying terms of the deal. The more detail a database provides about the transaction and company, the more confident a valuator can be that the guideline company is comparable to the subject company.

Valuators also make assumptions and adjustments based on informed professional judgment. In turn, these modifications affect valuators’ final conclusions. The outcome of this method is only as reliable as a valuator’s professional judgment and understanding of the transaction data.

Exercise caution

Courts often perceive transaction databases as one of the most straightforward, objective sources of valuation evidence. And when business owners contemplate buying or selling their company, the information in these databases can also provide insight into industry trends. But it’s important to carefully review the details of each transaction and understand how each database reports financial metrics to avoid inaccurate conclusions.

(This is Blog Post #1474)