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What is Precedent Transaction Analysis?
Precedent Transaction Analysis, also known as "M&A Comps," "Comparable Transactions," or "Deal Comps," is a method of determining the value of a business by comparing it to previously completed mergers and acquisitions involving similar companies.
Precedent Transaction Analysis (also known as "Comps") typically employs the same multiples as Comparable Companies' Analysis (also known as "Comps." Enterprise Value/Sales, Enterprise Value/EBITDA, and Earnings Per Share (EPS) are the most commonly used metrics, with Enterprise Value/Sales being the most popular. However, unlike in Comparable Company Analysis, the basis for value comparison is the price paid by the purchaser for a business, rather than the market value of the company's securities traded on a stock exchange (as in Comparable Company Analysis). These prices can differ due to the existence of a control premium, which is the value ascribed to the ability to control a business rather than simply owning a portion of its equity. In most cases, Precedent Transaction Analysis will produce valuations that are higher than those obtained through standard Comparable Company Analysis.
Additionally, Precedent Transaction Analysis tends to place a greater emphasis on the value of a business at the point at which an acquisition of the business can be completed, rather than the value of a business right now. This is due to the fact that transactions take time to complete, whereas current market values for a business can be determined at any time. Deals can sometimes take as long as a year (or even longer!) to close, and the Precedent Transaction Analysis should take this into consideration as well.
As a result of all of these factors, Precedent Transaction Analysis should be included in the valuation of any company where a change of control (such as through an acquisition) is contemplated.
Precedent Transactions techniques are used by investment bankers and leveraged buyout investors (also known as "financial sponsors") to determine the value of a company. The information provided below is a detailed overview of the techniques.
Uses of Precedent Transactions
To determine the worth of a private company that does not have public trading comparable.
A market demand for acquiring a company is determined by looking at the total dollar volume and the number of recent transactions in a particular industry.
To provide data analytics for the purpose of assessing merger and acquisition activity and consolidation trends.
A company's acquisition target list is used to identify potential bidders, and a company's acquisition target list is used to identify potential sellers when buying a business.
Assisting the Board of Directors in determining whether an acquisition or sale of all or part of an existing business is fair, or when a company is in the process of being acquired.
Identifying Precedent Transactions
Industry and financial characteristics - The business and financial characteristics of the target company should be comparable to those of the target company.
Size of the deal - It is more relevant to consider transactions that are similar in size to the one under consideration rather than transactions that are significantly smaller or larger.
Transaction-specific characteristics - The background and circumstances surrounding a transaction must be understood in order to extract meaningful insights from this information.
Timing - Because recent data is more relevant than older data, the benchmark is more relevant.
Steps in Precedent Transaction Analysis
Selecting the Comps
To begin, investment bankers choose companies that are very similar to the one in which the transaction is about to take place, and then conduct due diligence on them. The problem is that businesses are not the same as homes in this regard. This indicates that they are not homogeneous in any way. However, even if two companies sell identical products and operate in identical markets, there could still be many different factors that influence their respective valuations.
Investment bankers search for the best comparable transactions by considering factors such as the industry, geography, size, and even the time period in which the comparable transaction took place to identify the most similar transactions. When comparing similar transactions, it is critical to consider the time period involved. Due to the fact that the time value of money is a fundamental principle at play, this is the case. It would be necessary to adjust the value of similar transactions that took place five or seven years ago in order to reflect the current market value. In the case of large corporations, the specifics of these transactions are almost always made public knowledge. This is one of the reasons why conducting a precedent transaction analysis for them is relatively simple to accomplish. Information about smaller private companies, on the other hand, has to be obtained from databases that have been created specifically for this purpose in order to be retrieved. A single transaction cannot be used as the basis for a new valuation, which is an important point to remember. The new valuation must be derived by taking an average of six to ten previous transactions as a starting point.
Creating the Financial Model
After the data from the precedent companies has been analyzed, it is necessary to incorporate it into a financial model. For example, in order to identify the most important numbers, we must examine the income statement, the balance sheet, and even the cash flow statement, among other financial statements. It is a problem, however, that these numbers are rarely made available in the general public. Acquisition of another public company by a public company is an extremely rare occurrence. In most cases, at least one of the parties to the transaction is a private corporation. Due to the fact that private companies are not required to disclose their data to third parties, obtaining this information becomes extremely difficult.
Calculating the Multiples
Once a company's valuation has been expressed in the form of a comparable, it can only be used to calculate the valuation of another company. For example, the enterprise value to EBIT ratio or the price equity ratio are frequently used to express the value of a company in financial terms. This is due to the fact that such an expression creates a valuation model that is ready to use.
For example, if the price-to-earnings ratio (P/E ratio) is calculated at 20, we can use this to determine the value of our company. Consider the following scenario: If we know that a company's earnings are $1 million, we can use the price-to-earnings ratio to calculate the price, which would be 20 times $1 million, or $20 million.
The multiples that are used in various industries are quite different from one another. The price-to-book ratio, for example, may be significant in some industries while being insignificant in others.
Corroboration of the valuation through the use of various multiples is also common practice. For example, the value derived from the price to book value ratio, as well as the value derived from the price to earnings ratio, are frequently compared to see if the values remain consistent even when different multiples are employed. In order to account for the fact that a higher multiple is used if the buyer acquires a controlling stake in the company that is being sold, As a control premium, this is a common practice in the industry and is known as the control premium.
Aggregating the Values
Because the precedent transaction analysis does not rely on a single value, it is necessary to aggregate data. In the case of price earning ratios or price to EBIT ratios, for example, there will be a range of values. Companies frequently employ statistics such as the mean of all values or the 75th percentile of all values in order to make effective use of them. Ultimately, the statistical value that has been derived will be the one that is used to determine the value of the underlying company.
Numerous investment banks have pre-built software tools that are used to query databases and return precedent transaction analysis based on the parameters that have been specified. However, in order to make sense of the numbers being quoted, an investment banker with specialized knowledge is required.
Pros and Cons of Precedent Transaction Analysis
Pros
Using publicly available information
When we say realistic, we mean that previous transactions have been successfully completed at specific valuation levels. As a result, the analysis identifies a range of plausible multiples or premiums to publicly traded stock prices that have been offered.
Acquisition consolidation, foreign purchases, financial purchasers, and other trends, for example, may be evident. In addition, it may be possible to determine which players in the industry are consolidators or highly acquisitive.
It assists in determining the level of market demand for various types of assets (i.e. frequency of transactions and multiples paid).
Cons
Data on previous transactions that is made available to the public can be limited and misleading.
The market conditions at the time of a transaction can have a significant impact on the valuation of a transaction (e.g. business cycle, competitive environment, scarcity of the asset)
It is not possible to account for all aspects of a transaction in valuation multiples (e.g., the existence of commercial agreements or governance issues.
The values obtained frequently vary over a wide range and, as a result, are only of limited value.
Transactions in the past are rarely directly comparable to current transactions; each transaction has its own set of unique circumstances.
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