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.
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.
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.
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:
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.
Because of these factors, the accuracy of precedent transaction analysis can vary.
Just like any valuation method, precedent transaction analysis has its own distinct advantages and disadvantages.
The major benefits of the process include the following:
While these points help validate the application of precedent transaction analysis, it does still have some drawbacks:
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.
Before going through the steps to achieve a precedent transaction analysis, there are a couple points to consider:
To conduct a precedent transaction analysis on your own, complete the following five steps.
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:
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.
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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.
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.
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:
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.
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.
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.
1. Corporate Finance Institute. Precedent Transaction Analysis.
2. Investopedia. Precedent Transaction Analysis.
3. Street of Walls. Precedent Transaction Analysis.
