Business Valuation – Guideline Companies

Business valuation is as much an art as it is a science. The Science is a series of prescribed processes and analyses you need to perform on the path to reaching credible results, which most accountants (myself included) learn a classroom. The Art comes from the doing: there is significant professional judgement that must be applied to reach credible results.

This is part of an ongoing series to explore some of the complexities and nuances of business valuation in the context of complex litigation. In it, we refer to The Science and The Art of business valuation, generally referring to difference between the theoretical, prescriptive practice of business valuation and the more nuanced realities, respectively.

Guideline Companies and Transactions

One approach to business valuation is to consider how the marketplace values similar companies. This can be done by both by considering (i) how much was paid to acquire the entirety of similar, closely-held companies, (ii) the market capitalization of similar publicly-traded companies, or (iii) how much was paid to acquire shares of the subject company (when such information is available). These are broadly referred to as guideline companies or guideline transactions, though they are sometimes described as “comparable.” Both are common practice and generally accepted within valuation circles.

Next step: select your guideline transactions. How do you find them? Good, old-fashioned research! The Science makes this process easy: in a classroom seating, there are no shortage of companies sold or publicly traded companies that are similar to the subject company and close enough to the date of value to be meaningful applied. The Art is rarely so conveniences. For context, I struggled to write the viewpoint of The Science without laughing at the absurdity of it.

Once you’ve selected your guideline companies or transactions, they need to be related to your subject company. This is usually calculated as a multiple of earnings (or revenue). But how do you chose which of the guideline multiples to use? Pick individual guideline companies/transactions that are most directly comparable to the subject company? Use some measure of central tendency? Seemingly pick a number from thin air? This is a part of the process that The Science once again glazes over, and says to simply “do it.” The Art once against is about knowing from experience. Things to consider (this is not intended to be an exhaustive list):

  1. How does does the profitability of the subject company compare to the profitability of the guideline companies? Generally speaking, a more profitable company will demand a higher price multiple.
  1. How comparable are these companies, really? Sometimes there isn’t good market information available, necessity drives innovative thinking, and your guideline companies aren’t really that good. These guideline transactions, no matter how well-intended, might be worth giving lesser weight.
  1. Ask your client. No matter how informed appraisers are, our clients are going to be more familiar and better informed regarding their business than we are.

Ultimately, the objective it to condense your guideline transactions down to a single multiple.

What’s left over?

For more information on this subject, consider reading the other articles in this series:

Absurd rhetorical device notwithstanding, business valuation is both a science and an art. The Science may tell you what to do, The Art is in knowing how to do it. The good news is there are any number of competent appraisers who can help you do just that.