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Investment firms and other companies operating within the financial services sector utilize various valuation methods aimed at valuing a company. Valuation is an incredibly important factor in determining investment decisions across the industry and requires a high level of analysis and information gathering.
While various news outlets, third-party information providers, and other players in the financial services industry engage in published valuations of companies, most investment firms will conduct their own in-house valuations using various methods. Aside from using digital tools such as an M&A software tool, one of the most common methods for valuing a company during the investment banking deal sourcing process is called the precedent transaction analysis.
Precedent Transaction Analysis
In simple terms, precedent transaction analysis attempts to accurately value a company’s share price by comparing its value to previous M&A transactions that have already been completed.
While precedent transaction analysis varies in accuracy, they represent a consistently utilized valuation method within the current financial services landscape. Read on to learn how to do a precedent transaction analysis and some of the key dynamics associated with the process.
Before delving into the ins and outs of precedent transaction analysis, it will be useful to acquire a comprehensive understanding of why investment firms value companies in the first place.
Company valuation provides investors and other key actors in the financial services sector with a snapshot of the value of a given security. This enhances investment decision making processes and enables companies to pay fair value when making a significant investment into a business.
When a financial services firm is trying to determine the value of a given investment, it will typically employ one of two methods.
- Absolute Valuation looks at the investment in terms of its intrinsic value by analyzing internal financials and growth outlook without comparing it to other businesses.
- Relative Valuation takes the opposite approach and attempts to value an investment by comparing its financials to other similar companies.
Typically, a relative valuation can be achieved quicker, as it does not require an extensive gathering of internal company information that may not even be accessible depending on the investment firm’s relationship with the target.
Precedent transaction analysis is most closely aligned with a relative valuation because of its inherently comparative features.
Precedent Transaction Analysis: The Basics
Investment banks, private equity houses, and corporate management firms commonly engage in precedent transaction analysis to help value a potential M&A transaction. The process requires the firm to look at previous transactions of similar companies to output a relative price for a single share.
The purpose of conducting a precedent transaction analysis can be twofold:
- A firm is interested in gauging the equity value of a given share in a company because it has potential interest in engaging in an investment
- The firm is analyzing the wider market to gauge what competitors and other firms have paid previously and are likely to pay in the future for a given company per share
Simply put, precedent transaction analysis is a useful process for investment firms whether they are indeed interested in making a purchase or just monitoring the wider market.
When conducting a precedent transaction analysis for a private company, there are a few key points to consider when determining what types of precedents (similar companies and transactions) to choose.
- The companies selected as precedents should have a reasonably similar financial structure and expected value as the company being analyzed.
- Precedents should operate in the same industry as the company in question.
- Previous transactions should be comparable to the potential transaction being analyzed in terms of size and scope.
- The buyer should always be considered. Is the potential buyer similar to the precedent buyer?
- How recent was the precedent transaction? Recent transactions will undoubtedly be more accurate and effectively output more useful results.
Because of these factors, the accuracy of precedent transaction analysis can vary.
Advantages and Disadvantages of Precedent Transaction Analysis
Just like any valuation method, precedent transaction analysis has its own distinct advantages and disadvantages.
The major benefits of the process include the following:
- Information used to conduct the analysis is accessible and publicly available
- Can be applied to the negotiation process as a starting point or to argue against price disparities
- Based on historical facts and figures, validating its accuracy during negotiations
- Helps allow firms and other players to gauge the market, anticipate consolidation, and analyze both buyers and sellers
While these points help validate the application of precedent transaction analysis, it does still have some drawbacks:
- Because historical data is applied, it can be argued that current conditions within the market make the use of this data inaccurate
- Sometimes information applied during the process is from bad sources
- Supply and Demand shift constantly which can devalue the accuracy of results
Despite these drawbacks, precedent transaction analysis is widely applied as a starting point to value the equity shares of a given company, as the process can be easily achieved without accessing proprietary company data.
How to Conduct a Precedent Transaction Analysis: Step-by-Step
Before going through the steps to achieve a precedent transaction analysis, there are a couple points to consider:
- The final output of the analysis will be an expected valuation range of your target company
- This is determined by a comparison of its financials to the multiple ratios that were utilized to measure the value of your selected precedents (between a low and a high expected value)
To conduct a precedent transaction analysis on your own, complete the following five steps.
#1 Begin Searching for Comparable Precedents
The first step to conducting a precedent transaction analysis is to uncover relevant precedents that can form the basis of the analysis. As mentioned previously, the entire process can be conducted by searching through publicly available information such as:
- Industry presentations on previous transactions
- Public Tender materials
- Online Resources and News Articles
- Securities Data Corporation database
- Other internal firm-based resources
- SourceScrub’s data-scrubbing tools
Once you have selected a list of precedent transactions, further analysis will be required before you determine whether the precedents are suitable for the analysis.
To help you get through this process, SourceScrub provides investment firms with unmatched scrubbing tools to sift through company data quickly and easily. Learn more about the platform by scheduling a demo today.
#2 Screen Your Initial List
Your precedents should be screened before you begin exporting any of the data you have collected. Remember some of the key points mentioned above when determining whether previous transactions can be used to value your target now.
- Are the previous companies and transactions in the same industry and a comparable size? Are they public or private?
- What are the financial implications? Look at comparable revenues and EBITDA
- How different was the structure of the previous deal to what you expect moving forward with the target?
- What factors make the company different or similar? (Products, Location, Customers, Organizational Environment, Management)
- Is the buyer in the same category? (PE firm, Public, Strategic, etc.)
Once you have applied this information to your selected precedents, begin narrowing down the list to those companies that fit in most with the potential deal in question.
If a potential precedent is missing any key information, it will not be a suitable option for a precedent transaction analysis. SourceScrub provides investment firms with all the data they need to quickly go through the process of narrowing down your list of precedents.
#3 Select Your Multiples
Once you have determined which precedents you are going to utilize for the cash flow analysis, it is time to select your multiple ratios.
When conducting a precedent transaction analysis, two multiple ratios are typically applied:
- Enterprise Value / Revenue
- Enterprise Value / EBITDA
Make sure you scrutinize these multiples before moving forward and consider whether they logically compare to your target within the current market landscape. If there seems to be something off, that will decrease the accuracy of your analysis.
#4 Apply that Info to Your Target
Once you have determined which multiple ratios you are going to select for your analysis, apply them to your list of precedents to output a valuation range.
The valuation range will be an average of your precedent’s ratios, resulting in a high and a low value of your multiple. When applied to the actual value of your target company, this will give you a valuation range in total value.
For example, if you are utilizing Enterprise Value / Revenue as your multiple, apply that to your selected precedents which will provide you with a guide for determining a suitable range (ex: 1 x EV/Revenue – High, 10 x EV/Revenue – Low). Then apply your target company’s financials to that range to output the actual valuation range.
#5 Analyze the Results
The valuation range of your target business is the final result of your precedent transaction analysis. It is important to consider the accuracy of your results before taking too much stock in them.
Go back and look through your initial list of transactions and make a general comparison in relation to those deals. Always be sure to graph these ranges to identify any disparities.
While precedent transaction analysis may not provide you with an unquestionable valuation of a given company, it is a simple way to get a quick look at the valuation of a potential transaction and help guide negotiations moving forward.
- Corporate Finance Institute. Precedent Transaction Analysis. https://corporatefinanceinstitute.com/resources/knowledge/valuation/precedent-transaction-analysis/
- Investopedia. Precedent Transaction Analysis. https://www.investopedia.com/terms/p/precedent-transaction-analysis.asp
- Street of Walls. Precedent Transaction Analysis. http://www.streetofwalls.com/finance-training-courses/investment-banking-technical-training/precedent-transaction-analysis/
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