The Market Approach: Diving Into the Guideline Transaction Method

Valuation professionals rely on a variety of commonly accepted methods to determine a company’s value. Each of these methods fall under one of three approaches: asset approach, income approach, or market approach. Professional valuation standards require the valuator to consider each approach when determining a value. The market approach is comprised of two primary methods: the guideline transaction method and the guideline public company method.

Both the guideline transaction method and the guideline public company method value a company based on multiples of revenue, EBITDA, or other metrics. A key differentiator between the two methods is that the population of multiples in the guideline public company method comes from the trading multiples of publicly traded companies (i.e., major exchanges such as NYSE, NASDAQ, etc.). The guideline transaction method data, however, is based on pricing multiples from the reported sale of companies.

When applying the guideline transaction method, the valuation analyst’s primary goal is to compile a population of transactions involving companies similar to the subject company being valued. This process typically includes searching databases based on comparable SIC (Standard Industrial Classification) and NAICS (North American Industry Classification System) codes and keywords related to the subject company and its industry.

In the example below, a search resulted in 15 comparable transactions:

After compiling a comprehensive list of transactions, the valuation analyst must then consider the multiples indicated by the guideline transaction data. While looking at the entire group of comparable transactions may be appropriate, it is often necessary to analyze subsets of the larger group to determine which multiples are more applicable to the subject company based on size, profitability, and proximity to the valuation date, as shown below.

It is not uncommon to see EBITDA multiples consistent with the median data points applied. Revenue multiples, however, must take into account the subject company’s profitability in relation to the guideline transaction companies to appropriately consider how efficiently the subject company converts revenue into profit (subject companies with above-average profit margins will likely call for a revenue multiple above the median to account for this superior profitability, and vice-versa).

After determining the most appropriate multiples, the valuator multiplies the subject company’s metric (i.e., revenue, EBITDA, etc.) by the selected multiple to determine the indicated enterprise value.

To simplify the guideline transaction method, let’s apply the process to a real-world situation. I am currently in the very preliminary stages of purchasing a home. A key strategy I’ve relied on during my search is analyzing the sale prices of similar-sized homes in nearby neighborhoods (Zillow and Redfin have become my most popular iPhone apps). While these comparables may not apply perfectly to my dream home, the data serves as a useful tool in helping me understand the market and whether my planned purchase price is within an acceptable range for similar homes in the area. The guideline transaction method in business valuation functions in much the same way: it provides market-based data to support a conclusion about the value of an asset.