Comparing Comparables: The Problem with Transactional Data
Calculate a more accurate valuation by knowing the issues identified with transactional data.
The Direct Market Data Method (DMDM) relies on the principle of substitution. A buyer will not pay more than the price at which he/she can obtain an equally desirable substitute. The DMDM uses parameters of comparison in the form of income multipliers, which can be either gross net or discretionary cash flow. The three most popular databases that supply the transactional data are Institute of Business Appraisers (IBA), BizComps and Pratts Stats.
Wide Range in Calculated Values
When attempting to value a company using DMDM, it is not uncommon to experience a wide range in value between the price to earnings (P/E) and price to sales (P/S) ratios. In using the transactional data, one must remember that we are comparing businesses and, in most cases, these are complex entities. Unlike real estate, whereby land and improvements can be measured fairly accurately using a comparison of price per square foot, businesses are much more complex and have many variables that can have a significant impact on value.
Identified Issues with Transactional Data
There are several reasons for the wide ranges that occur between the two multiples when using the databases. The three databases obtain their data mainly from business brokers and other intermediaries. The reporting systems for each of the databases are not standardized and some are limited regarding details of the transactions. The fundamental problem in collecting data is the reporting forms supplied to collect the data. Business sale structures can be very complex, forcing the broker to elaborate on the form in order to describe the input, especially when it comes to the selling price. Many sales contain exchanges, earnouts or an additional price based on some contingency and forces the business broker to elaborate when reporting the selling price of the business. The person inputting the data into the database is faced with deciding the selling price. Unfortunately, the industry lacks consistency in common terms such as owner’s discretionary cash flow and net income (before or after tax).
The BizComps database removes the inventory from the selling price, but many times sales include inventory and is not mentioned or, if mentioned, no inventory value is given. Inventory values given to the other databases, and included in the price, have usually not been valued or even counted for accuracy. In my experience, the seller's value of the inventory is almost always incorrect as it does not include adjustments for slow moving, never moved or dead inventory.
FIFO and LIFO Accounting
Adding to the dilemma on inventory is FIFO and LIFO accounting. The sales contained in the databases were sold as asset sales and generally do not include current assets or liabilities, but many times, in order to make the sale, the owner will include the receivables and/or allow the buyer to assume some of the liabilities.
Real Estate and Improvements
Another problem with reporting the sales consistently are real estate and improvements. Companies in the databases do not include real estate and improvements and a fair market rent has been deducted from the company’s earnings, but was the rent used really fair market? Location of the business is given only in terms of general geographic area, which could have a significant effect on value for some businesses whereby location is paramount to success. In other cases, the sales with high multiples are not arms length and the business was purchased based on acquiring a valuable location or a competitor paying over market value to eliminate a major competitor. As many Baby Boomers are retiring, they are transferring the businesses to sons and daughters and these may also not be at arm’s length.
Prior Revenues and Earnings
Another problem, which in my mind is significant, is that prior revenues and earnings are not provided. Without a history of the company’s historical performance we do not know if the company was in rapid decline or significantly increasing in revenues and earnings.
Despite Issues, Data Still Valuable
Despite the reporting problems inherent in the databases, if analyzed correctly, the data is very valuable. The least it can do is set a range of multiples that you can narrow down. Business appraisers will sort the sales in the databases according to revenues and then choose a group containing sales that are close to the company or a sales range that would not change the operating ratios significantly. Once the comparable group is established, the companies in the group need to be carefully analyzed in relation to their closeness to the subject company. Companies whose sales to earnings ratios are significantly different than the subject should be discarded. A close look at the location should be made, if that is important, and the date sold.
I think it is safe to say that most people feel that there was a world of difference in business after the beginning of 2009. However, before you form this conclusion in your analysis, take into consideration that all values are derived from anticipated future performance. As we all can remember, interest rates were extremely high back then and required return on investment had to compensate for this; and the higher the return required, the lower the value (usually). Currently, interest rates are at an all-time low and the required return is much lower; so, in some cases, the older sales may not be that different.