Determining a Price Target: Precedent Transaction Analysis

Precedent transaction analysis is one of the most commonly-used methods of deriving implied valuation range of a business.

Precedent transaction analysis, also referred to as M&A comps involve using key financial ratios of past mergers and acquisitions (M&A) of companies in similar circumstances to determine the fair value of the company being analyzed. M&A comps allow for investors like yourself to conduct valuation research for yourself, rather than blindly relying on third-party sources. Be sure to have an understanding of financial ratios and comparable company analysis from past investBETA articles before moving forward.

How do you do it?

1. Research the business extensively
2. Select comparable M&A transactions
3. Locate financial information
4. Spread and benchmark key data and statistics
5. Evaluate a price target and range

Research

You absolutely must have a strong understanding of the company you wish to analyze as well as the larger market it occupies to use M&A comps effectively. This includes not only the financial structure but also the business model, history, operations, as well as future prospects. Primary information directly listed by the company is optimal, but reputable reports and analyses may also provide useful secondary information.

Do not underestimate the importance of the research stage. It is the foundation of the entire process and it can make or break your analysis.

Locate Information

Once you have acquired sufficient knowledge of your business and industry, you can move onto look for similar companies who have been targets of mergers and acquisitions. Lots of M&A data can simply be found by looking at company financial statements and press releases on their websites. Other investment analyses may also contain important data, but be sure to only use any raw data from these documents and not any extrapolated information.

An example of a Bloomberg terminal

The most comprehensive set of data will be found through the SDC Platinum database through a “Bloomberg terminal”. Many universities and institutions offer students the option to book these terminals free of charge, so take advantage of that if you are able. If not, many investment banks also provide trading platforms like Questrade’s IQ Edge or Interactive Broker’s TWS platform that give access to other databases. Do not worry if you don’t have access to a Bloomberg terminal or a proprietary platform, make the most of what you have at your disposal.

Select Companies

The companies that you decide to choose as comparable acquisitions should all have had similar financials at the transaction date in similar economic conditions. Those financials can include debt ratios, cashflows, etc. Different industries will give different ratios more importance depending on their nature and overall prospects. The companies should also be of a similar scale. It would not make sense to determine Walmart’s value based on a local family-run grocery store.

A key piece of information that can be overlooked is the purchasing party’s intentions as well as other specific circumstances and context for transactions. Although these factors may not immediately qualify or disqualify a potential comparable acquisition, understanding the backstory of each situation can help to better interpret multiples. Generally, a strategic buyer with an intention to use their expertise to operate the business more directly is willing to pay more than a financial buyer who would allow operations to continue as usual.

Market conditions on the other hand frequently disqualify potential candidates. For example, a website called GeoCities was acquired by Yahoo in 1999 at the peak of the “dot-com bubble” for $300 million. This wouldn’t be a very useful transaction for a website no matter how similar the business, because the entire tech sector crashed the following year, with the NASDAQ index falling over 75%.

Spread and Benchmark

Once you’ve selected your companies and gathered all of your data, you must prepare a spread for each transaction. It should include all key statistics, ratios, and multiples pertaining to purchase price, the form of consideration, etc.

Once you have made detailed spreads for all of your individual transactions, you can combine or benchmark your information into what is known as an output sheet. In this step, you are to re-examine all of your business profiles to pinpoint which pieces of information differ and would be specifically useful to compare. You may find many of your data points become useless and don’t move beyond this stage.

There are two ratios used in almost all M&A comps analyses and they are the equity value-to-net income and the enterprise multiple. The equity value-to-net income ratio is just a fancy name for the P/E ratio. The enterprise multiple can be found by dividing enterprise value by EBITDA over the previous 12-month period. Enterprise value can be calculated with: (market capitalization) + (value of debt) + (minority interest) + (preferred shares) — (cash and cash equivalents)

An example of an output sheet

Evaluate

Once you have conducted all the grunt work, you can finally use your output sheet to determine a valuation. The transactions you have selected and the data points you deemed to be the most relevant to your analysis will ultimately determine your price target and range.

In your benchmark, you should have calculated means and medians for all included quantitative data points. You will also want to highlight the highs and lows for each category. If you followed along properly, you shouldn’t have any wild outliers. Your means and medians will provide very useful guides for your ultimate price target, but fundamental valuation is an art as much as it is a science. You may decide to use adjusted averages to give certain transactions higher priority. Once decided on the price target, you can use the highs and lows for reference when determining a fair price range.

Congratulations! You now understand the steps used in precedent transaction analysis to determine price targets and ranges. Don’t worry if you don’t feel confident to try it out yourself just yet. After going over some pitfalls you should avoid, we’ll go through an example step-by-step.

Pitfalls

One of the mistakes that is often made in the location of data is using data points from different dates for one transaction. Although it may be compelling to use the most-recent and easily-available statistic, it will only do you harm by distorting your report. Your numbers should be consistent and optimally from as close to the transaction date as possible.

Another mistake that many people make subconsciously is cherry-picking transactions that satisfy preconceived notions or biases. Your goal in any form of analysis is to remain unbiased. If a stock you invest in loses value, it won’t matter what you want or hoped would have happened, you will lose money.

Example

Big thanks to Jai Betala for this detailed exemplar:

Zomarke

Zomarke is a company specializing in producing promotional items for companies. It is based in North America, and manufactures all goods in East Asia. It currently trades on the NYSE and is looking to acquire a t-shirt manufacturer, teeCheaps. They currently have an equity value of $785, and an enterprise value of $1350. The price for this acquisition is not yet decided and Zomarke is looking to get the fairest deal.

Looking at the recent mergers and acquisition data for the novelty goods industry, we get the following data.

Similar to the comparable company analysis, this is where we benchmark the data and find what is comparable for Zomarke’s acquisition. Since they are acquiring a t-shirt manufacturer, we utilize the acquisition of “Naren Tees” in the benchmarking process and they have a market valuation similar to Rughwani Manufacturing. This allows us to place a premium multiple in the range of 39% — 43%. When we look at the price of the stock for teeCheap 30 days out, it can be expected that the price of the stock will be trading 39%-43% less than the acquisition price. This allows us to find if the stock price will be expensive or cheap.

Conclusion

There’s no getting around it. Access to information can largely affect your data and ergo the conclusions that you draw. Changes in the market may be hard to account for, especially in high-innovation industries like technology. Despite all of this, with enough practice, any investor can become highly skilled at determining a fair valuation and using the precedent transaction analysis valuation method to their advantage.

Hopefully this article helped you learn what precedent transaction analysis is and why it is so important. If so, be sure to review key takeaways and take a look at some next steps you can take to support us and further your learning!

Key Takeaways

1. Precedent transaction analysis is one of the most commonly-used methods of deriving implied valuation range of a business.
2. Mergers and acquisitions of companies in similar circumstances are used to determine fair valuation.
3. Five core steps: Research, Select companies, Locate information, Spread and benchmark, Evaluate.
4. Ensure to avoid mismatching information dates
5. Remain as unbiased and fair as possible
6. Go make some money!

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