2 things to keep in your mind for the market approach model!

 

Market Approach Model, Selection of Comparable companies, and Calculation of Valuation Multiples

 

The market approach model (relative valuation) is useful when estimating a private company’s market value. The way is to estimate the market value of a target company by referring to a market multiple of listed companies on the stock market similar to the target company’s business.

 

market approach formula

 

You can also judge which companies are undervalued by comparing their market multiples across them. For example, suppose that Firm A, B, and C with a similar business have a PER of 13, 26, and 28, respectively. In this case, if the other conditions are the same, you could judge that Firm A’s share price is the most undervalued.

 

Multiple of a target company   vs.   Multiple of comparable companies

 

The figure below is the most common procedure you can follow when assessing a target company’s market value using the market approach model (relative valuation). First, you analyse a target company and then select comparable companies listed on the stock market similar to the target company’s business. Then you calculate the valuation multiple of the comparable companies and use it to value the target company.

 

market approach process

The process of using the market approach model (relative valuation)

 

The market approach model (relative valuation) is intuitive and straightforward.

 

However, it is easy to make mistakes in the figure’s second and third steps.

 

One is finding comparable companies similar to the target company, and another is deriving a significant multiple from the peer group.

 

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Selection of comparable companies for the market approach model

 

Comparable companies have the level of similar risk and growth rate while operating similar businesses to a target company. If you find such companies, valuing the target company becomes very easy. One of the easiest ways to find comparable companies is to select companies in the same industry or sector as the target company.

 

However, this method is not always correct. Each business may have different attributes, even if they belong to the same group. Accordingly, the risk and growth rate of their companies may be different. As an easy example, Toyota and Tesla belong to the same automobile manufacturing industry. However, Toyota’s business is mostly made up of traditional automobile production, while Tesla’s is electric vehicle production. Besides, Tesla is also engaged in the renewable energy business. In the stock market, Toyota’s PER is 15, and Tesla’s 1,700.
(Source: Thompson Reuters, January 2021)

 

If you are struggling to find comparable companies in one country, you may expand overseas to find them. For example, when you need a valuation multiple of the semiconductor industry, you could discover comparable companies in Asia, the US or Europe. In that case, based on your own analysis, you may need to remove specific firms or arbitrarily adjust the level of multiple by comparing the attributes, risks and growth rate of the industry across the firms.

 

When you need comparable companies’ PER, using PEG (Price/Earnings-to-Growth) can be one of the alternatives.

 

PEG is the PER divided by the growth rate. If you judge the level of stock prices only by the PER across companies with a different growth rate, you may reach an error. PEG shows the level of PER compared to a company’s growth rate. Therefore, companies with a high PER and a high growth rate have a valid PEG value. This method could reduce an error that occurs when assessing the level of stock prices with only PER.

 

Plus, if particular companies’ multiple is too high to significantly increase the overall average, you need to remove those companies from the peer group. That could be originated because the stock price is temporarily too high or the financial indicator is remarkably low, making the valuation multiple increased. It is good that you are familiar with the level of market multiples of the industries or companies you are interested in. If so, you will be able to recognise even a little change in the multiples’ level and find outliers that are far from the average.

 

 

Calculation of market approach valuation multiples

 

The figure below shows the items that can constitute the numerator and denominator of valuation multiples. As shown in the figure, if the denominator is a financial indicator related to equity value, the numerator should be equity value, while if the denominator is a financial indicator related to EV, the numerator should be EV. For example, if the denominator is EBITDA, the numerator should be EV. EBITDA includes interest as well as income. Thus, it constitutes of all cash flows attributable to both shareholders and debtholders. Therefore, EV, not equity value, must come to the numerator.

 

market approach formula components

Items used in the numerator and denominator of the market approach multiples

 

You should also apply the criteria for selecting items in the numerator and denominator in the market approach multiples equally to all comparable companies. For example, the peer group’s PER is simple as ‘Share price/EPS’. However, the share price may be one from the latest date or the past 6-month average or the past 1-year average. For EPS, depending on the purpose of the analysis, you can select one among Current EPS, Trailing EPS, or Forward EPS. In addition, the shares’ number used to calculate EPS is either the current number of outstanding shares or the number of diluted shares assuming all options have been exercised. Although the PER calculation is simple, there are various methods of calculating the share price and EPS, so you must unify all companies’ calculation criteria.

 

If the above criteria are not applied consistently in the market approach model, errors may occur to the valuation multiple across the companies. For example, assume that Firm A uses the next year’s EPS, and Firm B uses the previous year’s one. If both companies are all the growth company, Firm A’s PER will be relatively low, and B’s high. It is because the next year’s EPS is higher for growth companies.

 

One thought on “2 things to keep in your mind for the market approach model!

  1. Pingback: Why analysts prefer relative valuation multiples? | JCINUS [제이씨이너스]

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