The problems with using comparables as a valuation methodology

One method of valuing a business is to use comparables. In the world of small businesses, this is often a mistake. Let’s look at some of the reasons why.

I ran a report from a prominent data provider (who now offers free valuations based solely on these comparables) at the request of a buyer who was purchasing non-emergency medical transportation companies. Let’s look at some of the issues with the report. To begin with, although the data provider was a reasonably large player and the database contains about 17,000 transactions no category narrow enough to match what my buyer was interested in, so we ended up using a category titled “Services – Local Passenger Transportation.” We got a result based on 34 sales over a 5 year period, a period that included wide fluctuations not just in the market for small businesses but also in things like the price of gasoline that had disproportionate impact on this industry.

The average Cash Flow Multiplier was about 2.4, the median was 1.9. So, could my client conclude that a seller who was asking 1.5 times EBITDA was a bargain and one who was asking for 3 times EBITDA was asking top dollar? Not really. If we look at the descriptions and limit ourselves to transactions that had occurred within the last year, we find only 2 transactions are left, not enough to base any real conclusions on. Their multiples of cash flow were 2.47X and 3.64X.

What is more important than what we know about these companies is what we don’t know. In this report we have no idea how strong the balance sheets of each company was and medical transportation is a capital intensive business. Even if we had the balance sheet, there are many things that can affect the numbers on that balance sheet making two balance sheets hard to compare without an in depth analysis. For example, choosing a different method of depreciation can materially affect the value of the balance sheet.

There are also things that are never reflected on a financial statement. A business in a rural area will sell for less then one near a major city. A business that is growing is more attractive than one that is not. Unless you know a lot about the businesses being compared you can’t decide how relevant the information is.

Most business comparable reports don’t contain enough data to allow a reasonable assessment of true value. It’s like trying to assign a value to a house based only on the square footage, the number of bedrooms, the number of bathrooms, and the fact that it is in Los Angeles. To get real value you would need to know what shape the house was in, what neighborhood, etc. Anybody who tries to value a home on the basis of broad averages would be laughed at. Unfortunately, businesses that are even harder to value fairly based on comparables are often valued in just that way.

In the next post I’ll talk more about the problems with using comparables to value a small to mid-size business and the one after that I’ll talk about where they can be useful.

One Response to “The problems with using comparables as a valuation methodology”

  1. Erick says:

    I agree. Valuations on multiple comparables may lead to value ranges that are completely erroneous as every company is unique. It is better to assess the particular company and deploy a capitalization of earnings or cash flow approach or the discounted cash flow method.