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Home > Mergers and Acquisitions Checklists > Using the Market-Value Method for Acquisitions

Mergers and Acquisitions Checklists

Using the Market-Value Method for Acquisitions


Checklist Description

This checklist examines the market-value method of valuing a company for acquisition purposes and considers the pros and cons of adopting this approach.

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Definition

The capitalization of a publicly traded company is calculated simply by multiplying the market price per share by the number of shares in issue.

For the purposes of valuing a potential acquisition, however, the basic market-value method involves the study of a range of related companies, ideally at a similar stage in the growth cycle and in the same industry or sector, to determine a range of price-to-earnings (P/E) ratios for comparable companies. The resulting lowest and highest of these P/E ratios can subsequently be used to establish a base valuation band for the target company. Alternatively, an average P/E for the group could be used to calculate a central valuation.

This base valuation method assumes that the prevailing market prices across the group of comparable companies fully reflect all available information relating to their businesses and prospects, as the “efficient” market has already priced in all relevant valuation information.

In almost all acquisitions, the valuation will then need to be upwardly adjusted to reflect an appropriate acquisition premium. The level of this premium typically depends on transaction ratings, which are researched based on factors such as the P/Es that are eventually paid for comparable deals, frequently adjusted to reflect present market conditions.

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Advantages

  • The market-value method is widely recognized, and was adopted as the industry-standard method of valuing companies ahead of acquisitions. Although other approaches have found favor more recently, the market-value method remains a standard valuation tool for the due-diligence processes undertaken ahead of acquisitions.

  • The method provides a fundamentally sound basis for company valuation as long as a number of truly comparable companies can be identified.

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Disadvantages

  • Because of its reliance on prevailing market prices, the method is applicable only to publicly traded companies. Alternative valuation tools must be employed to establish the values of private companies.

  • While P/E ratios are relatively easy to establish for actively traded large-cap stocks, smaller, less liquid stocks may attract infrequent share transactions. For example, microcap stocks traded on junior or fledgling markets may experience sparse trading activity at times, making P/E ratios more difficult to assess.

  • Disputes can arise over which companies should be included in the comparables category for calculating P/Es. Because of the lack of hard and fast rules, a prospective buyer could lean towards comparables with lower P/Es, while a more optimistic seller might prefer to include related companies with more demanding P/E multiples.

  • The appropriate level for an acquisition premium can be difficult to determine. Proposed acquisition valuations often need to be revised upwards to improve the chances of success of a deal.

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Action Checklist

  • Before relying on the market-value method, you need to be satisfied that the underlying market is truly efficient. Be aware that some scope exists, particularly among less liquid, sparsely traded smaller companies, for unscrupulous manipulation of market prices ahead of an acquisition.

  • Consider the potential benefits of using a range of P/Es across comparable companies to give a wider valuation band.

  • Research the acquisition premiums paid in comparable acquisitions, making adjustments for changes to the operating environment.

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Dos and Don’ts

Do

  • Make every effort to achieve a non-contentious valuation using reasonable comparisons with other companies in the industry.

  • Pay close attention to the risk of potential accounting differences between comparable companies, as these could have significant impacts on the resulting average P/E ratios.

  • Be prepared to revise the proposed acquisition price depending on stakeholder reaction. In many cases, an improved valuation can have a significantly higher prospect of securing the acquisition.

Don’t

  • Don’t blindly attempt to use P/E ratios from large-cap companies when seeking to apply the market-value method to smaller companies. Large differences in ratios frequently occur across the capitalization spectrum and can lead to major valuation errors.

  • Don’t overlook other means of valuing target companies. Although the market-value method was traditionally the industry standard, discounted cash flow techniques have increasingly found favor in recent years, to the extent that they have now largely displaced the market-value approach in all but due-diligence processes.

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Further reading

Books:

  • Hitchner, James R. Financial Valuations: Applications and Models. 3rd ed. Hoboken, NJ: Wiley, 2011.
  • Reed, Stanley Foster, Alexandra Lajoux, and H. Peter Nesvold. The Art of M&A: A Merger Acquisition Buyout Guide. 4th ed. New York: McGraw-Hill, 2007.

Article:

  • Weaver, Samuel C., Robert S. Harris, Daniel W. Bielinski, and Kenneth F. MacKenzie. “Merger and acquisition valuation: Panel discussion.” Financial Management 20:2 (Summer 1991): 85–96. Online at: www.jstor.org/stable/3665732

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