Question

What are comparative advantages and limitations of valuing a company's common stock using the market-based (also known as multiples-based) method?

Answer 1

There are three types of valuation method used commonly,

1)Cost approach(Based on the cost to build the same asset or replacement cost)

2)Market Approach

3)Discounted cash flow(Forecast future cashflows)

Let us discuss the Market approach in detail, Market approach is method that values the businesss or asset based on 1)Public company comparables & 2)Precedent transaction.

Public company comparables-It is a process used to evaluate the value of a company using the metrics of other businesses traded publically having the similar size in the same industry.In most situations, direct comparability is hard to attain since a majority of public companies are not only larger but also more dissimilar to the subject.so our methods should be little flexible to find out the entity having similar nature.

Precedent transaction-It is the analysis of previous transactions which have taken place involving companies of similar market cap / revenue / location / industry to the company being valued.The Precedent Transactions Method involves deriving value using pricing multiples that are based on observed transactions of companies in the industry of the subject company.

It is not that a easy method since it will be difficult to find out such transactions and details of that,but it will be easy to get atleast the transaction value.In cases where there is no direct comparability, other data can be used but not before considering such things as their market or products.If the recent transactions details are avialable then it will be very easy for our business valuation.

So the pillars of this methods are,

1.Finding out similar company in same industry providing similar goods/service.

2.Size of the sililar company and profitability

3.Location & other macro factors affecting the valuation.

4.Avialability of such data.

These pillars also coming as advantage and disadvantage.

Advantage of using market based method

valuation won't become so unfair to any of the parties because the details we are taking to compare are real and public.

It removes the subjective forecasts.

Once data is avialable the valuation will be easier and simple.

Disadvantage of using market based method

Accuracy and correctness of the data we are using is always wont be correct.

It will be difficult to find the similar sized ,profitable entity in the similar industry.

It is less flexible method comparing to other methods