The value of corporate control and the comparable company method of valuation

The value of corporate control and the comparable company method of valuation

John D. Finnerty

The comparable company method of valuation does not account for the value of corporate control. Therefore, the method must be adjusted if it is being used to value a company involved in a change-of-control transaction. We provide two alternative ways to adjust the comparable company method for the value of corporate control. The efficacy of the adjusted comparable company method is confirmed on 51 highly leveraged transactions (HLTs) from Kaplan and Ruback (1995).

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The accurate valuation of a firm is arguably the most important application of valuation theory in corporate finance. “Comparable” valuation methods are a set of methods that use comparable situations to infer the value of a firm. The comparable company method of valuation is one such technique. Comparable valuation methods estimate a firm’s value by multiplying a ratio estimated from comparable firms (valuation multiple) times the firm’s earnings before interest, taxes, depreciation, and amortization (EBITDA), earnings before interest and taxes (EBIT), revenue, or some other performance measure. In our opinion, EBITDA has emerged as the most commonly accepted performance measure on which to base valuation multiples.

The comparable company method has been used extensively to value firms in research and practice for many years. Liu, Nissim, and Thomas (2002) examine several valuation methods, and find that the comparable company method works very well for valuing shares of publicly traded firms. Further, when used with the expected future EBITDA (as opposed to the most recent historical EBITDA), it is the most accurate method among those examined.

Unfortunately, the comparable company method can break down when it is used to estimate the “acquisition value” of a firm that is undergoing a change of control. The breakdown is because the method ignores the value of corporate control. Typically, the comparable company method uses valuation multiples that are derived from observed stock market prices of comparable publicly traded firms. Such stock prices are determined by routine market trades that do not involve a change of control. Therefore, valuation multiples based on these stock prices must be adjusted for the value of corporate control if they are being used to value a firm that is undergoing a change of control.

Jensen and Meckling’s (1976) seminal article shows that the separation of ownership and control engenders conflicts of interest that lead to significant agency costs. Indeed, it has become accepted doctrine that corporate control has significant value (Stulz, Walkling, and Song, 1990; Nathan and O’Keefe, 1989; and Lease, McConnell, and Mikkelson, 1983). The value of corporate control is empirically observed when a firm with diffuse ownership (and therefore a separation of ownership and control) undergoes a change-of-control transaction. Often, the transaction reconnects the firm’s ownership and its control, as in the case of a leveraged buyout. In such cases, the price paid is typically well in excess of the market value prior to the transaction. This empirically observed value differential is an obvious premium, presumably paid to acquire control. In the merger and acquisition literature, such a premium is generally referred to as a “take-over premium.” (1)

In this article, we explain how to adjust the comparable company method for the value of corporate control. We then demonstrate the efficacy of the adjusted comparable company method to value a sample of 51 firms involved in highly leveraged transactions (HLTs).

I. Adjusting for the Value of Corporate Control

“Control premiums” provide a basis for measuring the value of corporate control. Mergerstat Review annually reports control premiums paid in relatively large change-of-control transactions that occurred during the previous year within each industry, along with overall industry median control premiums. (2) Thomson Financial Securities Data and other financial data services also collect control premium data. A control premium is the amount above the pre-announcement share price an acquirer paid for a transaction firm, divided by the pre-announcement share price:

(1) Control Premium = Acquisition Price – Market Price/Market Price

where “acquisition price” is the share price paid by the acquirer and “market price” is the pre-announcement market-traded share price for the common stock in the change-of-control transaction firm.

The average of recently reported control premiums for an industry can be used to value a “target” firm within that industry. The estimate of the target firm’s “acquisition share value” is:

(2) Acquisition Share Value = (1 + Average Control Premium)(Market Price)

where “market price” is the pre-announcement market price of the target firm’s stock. The acquisition equity value is the acquisition share value times the number of outstanding shares.

The control premium is positively related to the potential acquisition-related benefits and is negatively related to the bargaining power of the bidder. Walkling and Edmister (1985) find that firms with declining financial leverage and firms with poor performance (and thus low valuation ratios) command above-average control premiums. They find that when two or more bidders compete for a target, the control premium averages 30 percentage points above the sample mean and that control premiums in nonconglomerate mergers exceed control premiums in conglomerate mergers by seven percentage points. Slusky and Caves (1991) find that control premiums increase with financial and business synergies, the presence of a rival bidder, and opportunities for reducing managerial inefficiencies in the target firm. A change of control can mitigate the agency problems in the target firm if the acquiror can implement better business practices and eliminate self dealing and other costly forms of “managerial” behavior. Slusky and Caves find that agency factors explain more than twice as much of the variation in control premiums as real and financial synergies combined. The control premium is smaller 1) the larger the proportion of the target’s shares owned by five percent or greater shareholders who are not officers or directors, 2) the larger the proportion of the target’s shares held by managers and directors, (3) and 3) the smaller the proportion of directors who are also managers.

When the target firm’s stock is not publicly traded, an estimate of its market price can be constructed using the market prices of comparable firms in the same industry. Estimates are usually based on performance measures such as the price-to-cash-flow-per-share ratio or price-to-book-value ratio. For example, a target firm’s market price might be estimated as the average price-to-cash-flow-per-share ratio for a chosen set of comparable firms times the target firm’s cash flow per share. The market price estimate is then used in Equation (2) to estimate the acquisition share value.

Mergerstat Review also reports industry average acquisition multiples. An acquisition multiple is the ratio of the transaction firm’s total invested capital (TIC, the sum of common equity, preferred equity, and debt) to its most recent historical EBITDA:

(3) Acquisition Multiple = TIC/EBITDA

An industry average acquisition multiple can also be used to infer the value of a target firm undergoing a change of control. The estimate of a target firm’s acquisition TIC value is:

(4) Acquisition TIC Value = (Average Acquisition Multiple)(Target Firm’s EBITDA)

where “target firm’s EBITDA” is the most recent historical EBITDA. The acquisition equity value is the acquisition TIC value minus the sum of its preferred equity and debt.

In some cases, an estimate of the target firm’s expected future (as opposed to the most recent historical) EBITDA may be available. However, this seemingly superior information should not be used with the average control premium from Mergerstat Review data because Mergerstat Review “s control premiums are based on the transaction firms’ most recent historical EBITDA. Using an estimate of the target firm’s expected future EBITDA with the comparable company method requires an estimate of the control premium that is based on the comparable firms’ expected future EBITDA. We are not aware of an empirical source for estimates of the control premium calculated on this basis. However, later on, we calculate acquisition values using an estimate of the value of corporate control that is based on a rule of thumb for the control premium, which is widely used in practice. We show that it can be applied to expected future EBITDA to obtain plausible acquisition values.

An estimate of the target firm’s expected future EBITDA can be used in conjunction with other valuation methods that do not need to be adjusted for the value of corporate control because such methods naturally account for the value of corporate control. For example, the comparable transaction method and the more focused comparable industry transaction method both account for the value of control because the valuation multiple they use is based on matched comparable transactions in which there is a change of control. (4) So-called compressed-APV methods of valuation (Kaplan and Ruback, 1995) also account for the value of corporate control because they value the future net cash flows that the new owners expect to receive.

In the next section, we use the adjusted comparable company method to value the 51 firms in Kaplan and Ruback’s (1995) sample of highly leveraged transactions (HLTs). The 51 HLTs come from the 124 management buyouts in Kaplan and Stein (1993) and the 12 leveraged recapitalizations in Kaplan and Stein (1990) for which sufficient additional data could be obtained. See Kaplan and Ruback (1995) for details concerning the data and other aspects of their study.

II. Using the Adjusted Comparable Company Method

We first calculate an average control premium for each of the 51 firms, which is the median control premium reported in Mergerstat Review for the target firm’s industry and transaction year. We then use these average control premiums in Equation (2) to estimate the acquisition value of each firm. We also estimate the acquisition value of each firm using its expected future EBITDA with the comparable transaction method and the comparable industry transaction method. (5) Valuation error, which is the natural log of the estimated value relative to the transaction value, (6) provides a measure of valuation accuracy on which to compare the results of the three methods. The results for the three methods are shown in Columns (A), (B), and (C) of Table I.

A. Value Estimation Using the Median Industry Control Premium

Panel A of Table I shows the median, mean, standard deviation, and interquartile range of the valuation errors for the estimates of the 51 firms by each of the three methods. Panel B of Table I provides four comparative measures of the valuation errors for the methods: 1) percentage within 15%, 2) mean absolute error, 3) mean squared error, and 4) the percentage of positive valuation errors.

The comparable company method using the most recent historical EBITDA, and adjusted for the value of corporate control based on the industry median control premium, provides value estimates that are very consistent with the other methods’ estimates based on the expected future EBITDA. For example, the median valuation error is 24.1%, compared to 28.3% and 25.9% for the other two comparable methods.

Note that the results show that the percentage of positive valuation errors is substantially above 50%. That is, in a substantial majority of the cases the estimated value exceeds the price paid. This would be expected for this type of transaction, because it is based on the acquirors’ expectations. Despite the well-known fact that acquisitions do not create value on average, each acquirors’ motivation for the transaction is to create value for themselves. (7) Therefore, acquiring control of the firm implies a belief that the transaction will create value. In other words, these HLT firms are being taken over precisely because the acquirors believe the takeover provides a positive net present value for themselves–although past outcomes do not on average support such a belief. Consequently, valuation errors based on the acquiror’s expectations of future earnings should be positive, and in fact they are.

B. An Alternative Method of Estimating the Control Premium

When an estimate of the control premium is not available (perhaps no transactions took place, or there were too few to provide a meaningful unbiased estimate), a rule of thumb that is often used in practice says the value of corporate control is 25% of the pro-announcement equity value of the target firm. (8) This rule of thumb offers an alternative way to adjust for the value of corporate control. The target firm’s pro-announcement equity value is estimated to be its expected future EBITDA times the average TIC-to-EBITDA ratio for a set of comparable companies minus the sum of its preferred equity and debt. The estimate of the target firm’s acquisition equity value is then 1.25 times its pro-announcement equity value.

We also estimated the acquisition values of the 51 HLTs using the target firm’s expected future EBITDA and 25% in place of the median industry control premium. The results are shown in column D of Table I. The results are very similar to those of the other methods. For example, the median valuation error using a 25% control premium with the adjusted comparable company method is 27.2%, compared to 28.3%, 25.9%, and 24.1% for the other three methods.

III. Valuation Using Historical EBITDA

In the previous section, we noted that decision makers who undertake a change-of-control transaction do so on the basis of expecting to create value for themselves. This explains the significantly positive valuation errors reported in Table I, which are “forward-looking” valuations that reflect the purchasers’ viewpoint.

An alternative valuation viewpoint is that of an on-going firm. What is the value to the current owners? Or, in other words, what price would the current owners require to be willing to sell the firm? For current owners who are outsiders, the primary source of information is accounting statements. Therefore, for them, the target firm’s most recent historical EBITDA provides a basis for such a valuation estimate.

To compare the methods from this valuation viewpoint, we re-estimated the acquisition values of the 51 HLTs using the target firm’s most recent historical EBITDA for three of the comparable methods: the adjusted comparable company method with a 25% control premium, the comparable transaction method, and the comparable industry transaction method. The results of these estimations are presented in Columns (A), (B), and (C) of Table II. The three methods provide substantially equivalent valuation estimates of the 51 HLTs. For example, the median valuation errors are respectively 5.1%, 5.9%, and -0.1%, and the mean valuation errors are 5.7%, 0.3%, and -0.7%, respectively. Note that these mean and median valuation errors are close to zero, and the percentage of positive valuation errors is only slightly above 50%. These results contrast with the valuation estimates based on the target firm’s expected future EBITDA, but they are precisely what would be expected for this valuation viewpoint. This is because, from the sellers’ viewpoint, these valuation estimates are in line with sales of other comparable firms. These valuation estimates do not include buyer estimates of potential sources of value creation. Also, minority owner sellers do not give up the value of corporate control because they do not have control in the first place. Consequently, valuation errors based on the target firm’s most recent EBITDA should be close to zero, and the results in Table II show that this is indeed the case.

IV. Conclusion

Corporate control accounts for a significant portion of a firm’s value. The comparable transaction method and the comparable industry transaction method account for the value of control, because they use matched comparable change-of-control transactions in which the new owners acquire control of the new company. Unfortunately, the comparable company method does not account for the value of corporate control. Therefore, the comparable company method will consistently underestimate the value of a change-of-control transaction if the estimate is not adjusted for the value of corporate control.

This article describes procedures for adjusting the comparable company method for the value of corporate control. The value of corporate control is embodied in the control premium. Control premiums are available from Mergerstat Review, which annually reports control premiums paid in transactions that occurred during the previous year, but other potential sources also exist. Alternatively, when an estimate of the industry control premium is not available (perhaps no comparable transactions took place, or there were too few to provide a meaningful unbiased estimate), a control premium of 25% on the acquisition equity value can be used to obtain a rough approximation. Adjusting the comparable company method with either control premium estimate produces acquisition value estimates of the 51 HLTs in Kaplan and Ruback (1995) that closely approximate those obtained using the comparable transaction method and the comparable industry transaction method.

Although adjusting the comparable company method by adding a simple 25% control premium to acquisition equity value provides estimates that are consistent with other valuation methods, such an adjustment is arbitrary and lacking in conceptual foundation. On a cost-benefit basis, one can imagine situations in which the simple 25% premium would be sufficient. (9) However, for research purposes, using the industry median control premium is certainly more conceptually sound and therefore preferable if the data for such an adjustment are available. Either method’s estimate could be further adjusted for factors that create benefits and/or impose costs in connection with a particular acquisition.

We believe the importance, usefulness, and attractiveness of the comparable company method are clearly demonstrated in its persistent use (Gilson, Hotchkiss, and Ruback, 2000; Barry, 1999; Kim and Ritter, 1999; Lee, Meyers, and Swaminathan, 1999; and Andrade and Kaplan, 1998). In fact, its use is appropriate because of its sound theoretical basis, combined with data availability, simplicity, and ease of application. Indeed, Liu et al. (2002) find the method to be the most accurate method for valuing the stock of publicly traded firms. However, using the comparable company method to value firms in change-of-control transactions without properly adjusting for the value of corporate control can lead to substantially inaccurate valuations. We demonstrate here that the comparable company method, when properly adjusted for the value of corporate control, can be used to accurately value a firm involved in a change-of-control transaction.

Table I. A Comparison of Alternative “Comparable” Methods of Valuation

Valuation error statistics are calculated for valuation estimates of 51

highly leveraged transactions (HLTs) using alternative “comparable”

methods of valuation and based on the firm’s expected future EBITDA

(earnings before interest, taxes, depreciation, and amortization).

Valuation error is the natural log of the estimated value relative to

the transaction value. The transaction value equals: 1) market value of

the firm’s common stock; plus 2) market value of the firm’s preferred

stock; plus 3) value of firm debt; plus 4) transaction fees; minus 5)

firm cash balances and marketable securities, all at the time of the

transaction. Debt not repaid in the transaction is valued at book

value; debt that is repaid at the repayment value. Percentage within

15% is the proportion of HLTs in which the valuation error is less

than or equal to 15% in absolute value. Percentage positive is the

proportion of valuation errors that are positive. Observations for the

comparable industry transaction method are reduced by data availability

to 38. The HLTs are from Kaplan and Ruback (1995), which contains

additional information about the transactions. The median industry

control premium is the median control premium reported in Mergerstat

Review for the target firm’s industry and transaction year. For

consistency with the Mergerstat Review data, column (A) statistics

are based on the target firm’s most recent historical EBITDA. Columns

(B), (C), and (D) are based on the target firm’s expected future

EBITDA.

(A)

Adjusted

Comparable

Company

Method with

Median (B)

Industry Comparable

Control Transaction

Premium Method

Panel A. Summary Statistics for Valuation Errors

1. Median 24.1% 28.3%

2. Mean 24.1% 20.8%

3. Standard Deviation 30.3% 31.2%

4. Interquartile Range 37.0% 41.0%

Panel B. Comparative Measures for Valuation Errors

1. Percentage within 15% 19.6% 23.5%

2. Mean Absolute Error 32.9% 32.0%

3. Mean Squared Error 14.8% 13.9%

4. Percentage Positive 80.4% 78.4%

(D)

Adjusted

(C) Comparable

Comparable Company

Industry Method

Transaction with a 25%

Method Control

(N = 38) Premium

Panel A. Summary Statistics for Valuation Errors

1. Median 25.9% 27.2%

2. Mean 18.4% 24.4%

3. Standard Deviation 35.1% 31.7%

4. Interquartile Range 42.3% 40.0%

Panel B. Comparative Measures for Valuation Errors

1. Percentage within 15% 23.7% 25.5%

2. Mean Absolute Error 32.9% 33.2%

3. Mean Squared Error 15.4% 15.8%

4. Percentage Positive 76.3% 82.4%

Table II. A Comparison of Alternative “Comparable” Methods of

Valuation, Based on the Target Firm’s Most Recent Historical EBITDA

Valuation error statistics are calculated for valuation estimates of 51

highly leveraged transactions (HLTs) using alternative “comparable”

methods of valuation and based on the firm’s most recent historical

EBITDA (earnings before interest, taxes, depreciation, and

amortization). Valuation error is the natural log of the estimated

value relative to the transaction value. The transaction value

equals: 1) market value of the firm’s common stock; plus 2) market

value of the firm’s preferred stock; plus 3) value of firm debt;

plus 4) transaction fees; minus 5) firm cash balances and marketable

securities, all at the time of the transaction. Debt not repaid in the

transaction is valued at book value; debt that is repaid at the

repayment value. Percentage within 15% is the proportion of HLTs in

which the valuation error is less than or equal to 15%

in absolute value. Percentage positive is the proportion of valuation

errors that are positive. Observations for the comparable industry

transaction method are reduced by data availability to 38. The HLTs

are from Kaplan and Ruback (1995), which contains additional

information about the transactions.

(A) (C)

Adjusted Comparable

Comparable (B) Industry

Company Method Comparable Transaction

with a 25% Transaction Method

Control Premium Method (N = 38)

Panel A. Summary Statistics for Valuation Errors

Media 5.1% 5.9% -0.1%

Mean 5.7% 0.3% -0.7%

Standard Deviation 26.4% 22.3% 28.7%

Interquartile Range 35.8% 32.2% 23.7%

Panel B. Comparative Measures for Valuation Errors

Percentage within 15% 45.1% 47.1% 57.9%

Mean Absolute Error 20.5% 18.1% 20.5%

Mean Squared Error 7.1% 4.9% 8.0%

Percentage Positive 56.9% 58.8% 57.9%

We thank Steven Kaplan and Richard Ruback for their help and graciously providing us with their data. We thank Tim Burch and Pat Fishe for helpful comments, and Ken Wu and Alberto Chang for help with computing.

(1) The takeover (or change-of-control) premium can be viewed in two ways. One can add a control premium to the market price of a publicly traded share to get the price that would apply in a change-of-control transaction. Equivalently, one can start with a change-of-control value (estimated by a valuation method that accounts for the value of control), and subtract the “discount for lack of control,” which compensates for the agency costs faced by a holder of a small minority stock ownership interest. The former approach is more frequently used because the prices at which small minority ownership interests change hands are the transaction prices observed daily in stock markets.

(2) See Houlihan, Lokey, Howard, and Zukin (2002).

(3) These empirical results are consistent with the incentive-alignment effect of manager and director shareholdings and inconsistent with the entrenchment effect.

(4) The comparable transaction method defines comparable firms as those that have recently undergone the same transaction as the target firm. The comparable industry transaction method’s definition further restricts the comparable firms to the subset of comparable transactions within the same industry as the target firm.

(5) In this application, the set of possible comparable firms is drawn from among the 136 HLTs in Kaplan and Stein (1990 and 1993) involved within one year in a corporate change-of-control transaction comparable to that of the target firm. The added requirement of matching the target

firm’s industry reduced the number of observations available for the comparable industry transaction method to 38.

(6) The transaction value equals: 1) the market value of the firm’s common stock; plus 2) the market value of the firm’s preferred stock; plus 3) the value of firm debt; plus 4) transaction fees; minus 5) the firm’s cash balances and marketable securities, all at the time of the transaction. Debt not repaid in the transaction is valued at book value; debt that is repaid is valued at the repayment value.

(7) potential sources of value creation include economic synergy, information (knowledge that the firm has been undervalued), a reduction in agency costs, and the potential to “self-deal” after obtaining control.

(8) This rule of thumb was pointed out to us by business appraisers at Houlihan, Lokey, Howard, and Zukin, publishers of Mergerstat Review. Hanouna, Sarin, and Shapiro (2001) analyze 9,566 acquisitions of US and non-US public firms between 1986 and 2000. They measure the control premium as the difference between the premiums paid for acquiring majority and minority positions and calculate a premium of around 20% to 30% for control. The median control premium for domestic US transactions in 27%.

(9) These might include certain types of practitioner applications of the method.

References

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John D. Finnerty is a Professor of Finance at Fordham University and a Managing Principal of Finnerty Economic Consulting, LLC. Douglas R. Emery is a Professor of Finance at the University of Miam.

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