Academic researchers and market analysts like public market data because it comes from the unbiased open market where value is continually assessed on an arm’s length basis by a large number of potential investors, and because it is readily measurable for most liquid, minority interests.
It is tempting and relatively easy to use financial or valuation ratios from public market data as a basis for deriving a market value for a private company. However, such an approach is difficult to apply in practice, and we discuss those difficulties in section A below.
Although an analysis of public market data may not be useful for valuing comparable private companies, such an analysis can tell us a lot about the behavior of investors and underlying valuation principles, which apply to every private market transaction.
Recently, we undertook the valuation of a substantial privately-held drilling company with drilling and service rigs located in a number of international locations. Although this company was a private company, we did look at public market valuation ratios for three “comparable companies” that were similar in scope, size, and services.
Frankly, I was skeptical as to the usefulness of this analysis. In our experience, we have generally found that comparing select financial and valuation ratios to public companies in similar industries does not yield an appropriate precision or measurement of market value.
In this situation, we found our experience to be confirmed, but some interesting observations arose that impart a lesson for all those seeking a valuation of their business.
In our real-life example, three comparable, publicly-held drilling companies were identified, consisting of Trinidad Drilling (TDG), Western Energy Services (WRG), and Akita Drilling (AKT).
- Fundamental data – oil prices, revenue, and EBITDA[2]
- Common valuation ratios – enterprise value to EBITDA (EV/EBITDA)[3], price to revenue[4], and price to book[5]
- Month-end closing stock price
Briefly, in 2012 and 2013, oil prices were historically strong, with WTI in the $90 plus and $100 US plus range. During the last half of 2014, oil prices rapidly declined and the industry has struggled in 2015 and 2016. The financial data and valuation ratios reflect the market prior to, during, and immediately after the decline in commodity prices. As well, given the sudden decline in commodity prices, we plotted changing stock prices, by month, for the last six months of 2014 (in Table 2).
- Three major observations to be made when valuing a private company
Observation #1 – Value is at a point in time, it can change rapidly
From July 2014 to December 2014, stock prices for TDG decreased 51%, WRG decreased by 43%, and AKT decreased by 24%. Value changes rapidly.
I have found that many private company shareholders are slow to acknowledge value changes to the downside. In public markets, value can dissipate quickly – just ask shareholders of Yellow Pages Media, Nortel, or Pengrowth. The market values for these companies changed due to rapid economic disintegration and changing economics.
Could change have been anticipated? Maybe, but the point to be made is that equity investments come with risk. This risk is amplified for private companies who operate on a smaller scale with greater dependencies on certain customers and/or suppliers, dependencies on key managers or employees, or who operate with a limited range of products.
A business valuation worth paying for is a valuation that focuses on risk, not just returns. Risk assessment includes an analysis of the market, the product, the competition, management, and the underlying economics. Just because a private investor made an investment in the past, at a certain price, has little or no bearing on the value today.
It is easy to take some numbers, apply a rule-of-thumb multiple, and arrive at a private company valuation, without any market context. However, a failure to consider current market circumstances is a real limitation and it ignores market realities and fundamental business risk.
Observation #2 – Value is prospective, not historical
For our comparable companies, while they were experiencing a rapid decline in stock price in the later half of 2014, the historical revenues and EBITDA were still increasing or remained the same.
From 2013 to 2014, for our three comparable companies, average revenue grew 16% and average EBITDA grew 7%. Yet, over that same time period, the closing stock price decreased by an average of 29%. Simply put, stock market prices (values) did not move in line with historical operating results.
This may seem like common sense, but it is clear that market prices move based on what is anticipated, not based on historical performance. This observation applies to both public and private companies.
If share prices only reflected historical results, then one would expect valuation ratios to be relatively consistent, year-to-year, especially for well-established companies with small operational changes. EV and EBITDA would move in line, as would stock price to revenue and stock price to book.
However, in looking at annual changes in our basic valuation ratios (EV/EBITDA, price to revenue, or price to book) in Table 1, it is clear that the range of valuation ratios can change wildly and are moving independently of historical results during times of rapid change.
As a valuator, I look at historical results as telling a story. It shows how a company’s fortunes can change as markets change. History helps identify the key areas of uncertainty and risk, and it helps identify potential questions and discussion points in order to better understand the business that is being valued and to identify dependencies upon key customers, suppliers, or product lines. History will show revenue and expense relationships that may be useful in order to project future performance. But of itself, history does not measure value.
Hence, any quick and dirty valuation of a private company that only applies a rule-of-thumb to historical results is, again, potentially unrealistic and unreliable.
Observation #3 – Value is not precise
We prepare private company valuation reports for investment purposes (buying or selling), for tax reasons, and for legal reasons (for judges, lawyers, and litigants). In the end, a conclusion must be drawn, and although we try our best to identify all key points and draw specific conclusions, undertaking a business valuation is not a precise science.
The public data in Table 1 shows that for any ratio, for any given point in time, that there are variations in the valuation ratios. These variations result from the unique circumstances of each company. For example, in 2013, the EV/EBITDA valuation ratio ranges from 5.7 to 12.17. That is a significant variation in a highly relevant valuation ratio.
As we draw our conclusions, valuators usually identify a range of value. That range may vary by 5%, or 10%, or even 20% in value. In our experience, especially in a litigation setting, litigants get carried away in the mechanical accuracy of the calculation, but I think that often misses the point.
A valuation is not a mechanical exercise but a thought-provoking analysis. Does the valuation make common sense? Is it logical? Does it cover all the key points? Does it indicate an understanding of the business opportunities and risks? Finally, as a hypothetical investor, would you invest in that business at that determined value?
- Conclusion
Although this brief analysis dealt with three oil and gas drilling companies, the same analysis and concerns apply to almost every private company business valuation in every industry. Market comparatives are generally not relevant, or at best, should only be a secondary check where value is derived from one of the mainstream valuation methodologies.
Instead, I encourage valuators and their clients to think beyond a formula to what makes common sense. Focus on risk assessment and understanding both the client’s operation and the market in which the client competes. Such an approach leads to better and more useful valuations.
