Market Approach to Valuation.pdf

Market Approach to Valuation.pdf - ZEW Economic Studies...

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Unformatted text preview: ZEW Economic Studies Matthias Meitner Vol. 35 The Market Approach to Comparable Company Valuation Dieses Buch ist beim Physica-Verlag erschienen und kann auf folgenden Internetseiten käuflich erworben werden: ISBN 978-3-7908-1722-5 “Value is a relative term. The value of a thing means the quantity of some other thing, or of things in general, which it exchanges for.” –– John Stuart Mill Principles of Political Economy, 1848 “Bewerten heißt vergleichen” –– Adolf Moxter Grundsätze ordnungsmäßiger Unternehmensbewertung, 2nd edition, 1983 Acknowledgements First and foremost I am indebted to my supervisor, Prof. Wolfgang Gerke, who motivated me and energised this work from start to finish. His wit, vast experience and captivating style of teaching stirred in me an early fascination and enthusiasm for finance when I was a student at Erlangen-Nürnberg. I am grateful to my cosupervisor, Prof. Volker H. Peemöller, for his kindness and encouragement. Furthermore, I would like to thank Prof. Wolfgang Franz, President of the Centre for European Economic Research (ZEW), for supporting this dissertation. The many discussions with my colleagues at the ZEW saved this work from turning into an empirical disaster. Special thanks go to Prof. François Laisney, Marcus Kappler, Dr. Michael Schröder, Wolfgang Sofka (the “matching-expert”) and Dr. Peter Westerheide. I also thank Prof. Richard Deaves who made my two months visiting scholarship at McMaster University in Hamilton, Ontario/Canada a complete success. The many helpful comments from Carolin Amann, Christoph Beckmann, Dr. Felix Hüfner and Andreas Kucher are highly appreciated. Kelly Holzscheiter, Jan Hoon, Waldemar Rotfuß, Christian Schwab and Elena Todorova provided excellent research assistance. My thanks also go to the Global Competency Centre of PricewaterhouseCoopers for providing grant assistance to this work. Finally, I want to express my deep gratitude to my dear mother for supporting me during my studies and for believing in me. Mannheim, Germany, February 2006 Matthias Meitner Table of Contents 1 Introduction .................................................................................................1 1.1 Motivation ...............................................................................................1 1.2 Research Aims.........................................................................................3 1.3 Reading Guide .........................................................................................4 2 Foundations of Comparable Company Valuation....................................7 2.1 Definitions and Scope..............................................................................7 2.2 Comparable Company Valuation Within the Business Valuation Framework...............................................................................................9 2.2.1 Value Theories.................................................................................9 2.2.2 Value Versus Price ........................................................................13 2.2.3 Approaches to Company Valuation...............................................18 2.2.4 Purposes of Appraisal....................................................................25 2.2.5 Classification of Comparable Company Valuation .......................27 2.3 Rationale and Style of Comparable Company Valuation ......................30 2.3.1 Immediate Valuation Models ........................................................30 2.3.2 Single-Factor Valuation Models....................................................32 2.3.3 Multi-Factor Valuation Models .....................................................34 2.4 Special Tasks in Comparable Company Valuation ...............................35 2.4.1 Quality of Accounting Variables ...................................................35 2.4.2 Aggregating the Peer Group Results .............................................38 2.4.3 Premiums and Discounts ...............................................................42 3 Interrelation of Comparable Company Selection and Valuation Model Choice .............................................................................................47 3.1 Determinants of Comparable Company Selection.................................49 3.1.1 Degree of Similarity of the Peer Group Companies ......................49 3.1.2 Degree of Market Efficiency and Pricing Quality .........................55 3.1.3 Consequences for Comparable Company Valuation with Special Regard to the Peer Group Selection ..................................68 3.1.4 Implications for the Choice of the Valuation Model .....................71 3.2 Determinants of Valuation Model Choice .............................................73 3.2.1 Value Relevance of the Reference Variables.................................73 3.2.2 Future Similarity Between the Target Company and Comparable Companies.................................................................91 3.2.3 Technical Limitations of Valuation Models ..................................93 X Table of Contents 3.2.4 Consequences for Comparable Company Valuation with Special Regard to the Choice of the Valuation Model .................. 96 3.2.5 Implications for the Selection of Comparable Companies ............ 98 3.3 Comparable Company Valuation as an Integrated Process ................. 100 4 Processing Comparable Company Valuation ....................................... 103 4.1 Immediate Comparable Company Valuation ...................................... 103 4.1.1 Valuation Process ........................................................................ 103 4.1.2 Problems Associated with Immediate Comparable Company Valuation Models........................................................ 104 4.2 Single-Factor Comparable Company Valuation.................................. 105 4.2.1 Valuation Process ........................................................................ 105 4.2.2 Problems Associated with Single-Factor Comparable Company Valuation Models........................................................ 108 4.3 Multi-Factor Comparable Company Valuation ................................... 120 4.3.1 Existing Models........................................................................... 120 4.3.2 Derivation of a Two-Factor Model Based on Book Value and Earnings ................................................................................ 125 5 Empirical Study....................................................................................... 139 5.1 Data ..................................................................................................... 139 5.1.1 Sample Selection ......................................................................... 139 5.1.2 Variables...................................................................................... 141 5.2 Value Relevance.................................................................................. 142 5.2.1 Previous Empirical Results.......................................................... 142 5.2.2 Variable Definition...................................................................... 144 5.2.3 Hypotheses and Econometric Methodology................................ 146 5.2.4 Results ......................................................................................... 163 5.3 Pricing Accuracy ................................................................................. 188 5.3.1 Previous Empirical Results.......................................................... 188 5.3.2 Variable Definition and Methodology......................................... 190 5.3.3 Results ......................................................................................... 193 6 Concluding Remarks .............................................................................. 197 6.1 Implications for Business Valuation.................................................... 198 6.2 Implications for Future Research ........................................................ 202 7 Appendix .................................................................................................. 205 7.1 Detailed Derivation of the Two-Factor Comparable Company Valuation Model.................................................................................. 205 7.2 Proof of the Convergence of R2 ........................................................... 206 7.3 Industries Included in the Empirical Study ......................................... 208 7.4 Descriptive Statistics ........................................................................... 209 7.4.1 Descriptive Statistics by Creditworthiness .................................. 209 7.4.2 Descriptive Statistics by Industry Structure ................................ 210 7.4.3 Descriptive Statistics by Asset Heaviness ................................... 211 Table of Contents 7.5 7.6 XI Annual R2 for Single-Factor Models ...................................................212 Adjusting Creditworthiness for the Impact of Earnings ......................215 List of Figures ....................................................................................................219 List of Tables......................................................................................................221 References ..........................................................................................................223 1 Introduction 1.1 Motivation Company valuation is one of the most important tasks of financial analysts, investtors, consultants, and managers. It not only provides the basis for their decision to purchase or sell whole companies or shares of a company. It is also indispensable for the application of a sound value based management and successful restructuring. However, the process of valuing a company is complex and not standardised at all. There are many different interpretations of what “value” means, and there are many different approaches to determine this value. The valuation approach that enjoys the most widespread popularity in theory and practice is the direct valuation approach, which is based on the net present value concept. The discounted cash flow method is an example for this approach. However, in order to better deal with project flexibility it is sometimes proposed to apply a real options approach. This approach shares high reputation amongst theoreticians and is subject to a vast range of academic papers, but so far it is of almost no importance in valuation practice. The direct opposite of real options valuation – in terms of popularity amongst academics and practitioners – is the relative valuation approach. While this approach is of paramount relevance in real world valuations, literature generally dislikes it and calls it a “quick and dirty method of valuation” (Benninga and Sarig, 1997: 330) that lacks theoretical foundation. Comparable company valuation is a variant of relative valuation. It is based on the principle of arbitrage and values companies based on how other, similar companies are valued. If these similar companies are publicly listed, then the valuation method is called the market approach to comparable company valuation. The wide recognition of the market approach to comparable company valuation amongst practitioners has three causes. First, it is easy to use. In fact, once comparable companies and the valuation model are chosen, the application is straightforward and does not require any specific skills. Second, comparable company valuation relies on existing market prices of companies. Therefore, no explicit forecasts of the cash flow development of the valuation objective are necessary. Moreover, comparable company valuation better reflects the current mood of the market than direct valuation approaches. Third, a relative valuation is easier to present to clients and customers than direct valuations. In contrast, there are also three crucial reasons for the lack of academic acceptation of comparable company valuation. The first reason is a purely technical one. Comparable company valuation requires certain valuation circumstances that direct valuation approaches do not (necessarily) require. In particular, these circum- 2 1 Introduction stances are a set of companies that are similar to the valuation object and a functioning market that fairly prices these comparable companies. In this context, opponents of the comparable company valuation approach point out that the stock market is far from being perfectly efficient and that it is hardly possible to find two identical companies (not to mention the problem of finding more than two equal companies). The second reason is rather ideological in nature. Comparable company valuation is often accused of being a static investment approach that does not conform to basic valuation principles because of a lack of future orientation.1 The third reason concerns the concrete application of comparable company valuation models. Because of the trade-off between easy-to-handle valuation models and the difficulty of properly determining the input factors, comparable company valuation risks suffering from a “garbage in – garbage out” problem. To put it more precisely, comparable company valuation models can be easily used but even more so, easily misused (see e.g. Damodaran, 2002: 453). These two different attitudes make comparable company valuation one of the most controversial valuation approaches. While conflicting standpoints of theory and practice are nothing unusual in finance2, it seems that – with regard to the attempt to bridge the gap between these two positions – the potential is not tapped to its fullest extent here. In fact, most theoretical research sticks to formal discussions. Valuation models are typically judged by the plausibility of their assumptions, not by their ability to accurately value companies. One of the biggest problems in this context is that the forecasting challenges – which are inherent in every valuation approach – are often suppressed in the discussions.3 Consequently, still little is known about the differences of forecasting requirements between different valuation approaches and how forecasting problems can be reduced. As a consequence, most theoretical research is limited in terms of its usefulness to investors since it cannot serve as a guideline in valuation practice (see also Born, 1995: 7-9; Bernard, 1989: 87-91). The empirical literature does not add much to reduce this discrepancy, either. Of course, recently some studies have well contributed to a better understanding of how comparable company valuation functions (see e.g. Herrmann, 2002; Richter and Herrmann, 2002; Liu et al., 2002; Bhojraj and Lee, 2002; Baker and Ruback, 1999; Beatty et al., 1999). However, their number is few and they rarely render concrete advice for how to deal with real world valuation problems. What is especially noticeable is the lack of differentiating research (both theoretical and empirical), i.e. research that considers that valuation models cannot reasonably be applied for every company and in every valuation situation, or re1 2 3 For a list of academic criticism of comparable company valuation, see Peemöller et al. (2002: 199-201). Just think about the severe theoretical criticism of the Capital Asset Pricing Model (see e.g. Hering 2003: 283-296) which could not prevent that this model is by far the most popular tool to determine the cost of equity in real world direct valuations. A good forecast is at least as important as a reasonable valuation model. Lee (1999: 414) states in this context that the “essential task in valuation is forecasting. It is the forecast that breathes life into a valuation model”. 1.2 Research Aims 3 search that analyses which valuation model is best to use under certain circumstances.4 This non-existent situational research is a major obstacle in better understanding the whole comparable company valuation process, and one of the main reasons for practitioners’ low acceptance of academic findings. 1.2 Research Aims The purpose of the research presented here is to contribute to the literature by providing a systematic study on the nature and significance of the market approach to comparable company valuation from a German perspective. Due to the variety of unresolved issues in comparable company valuation, this study does not address one big research question but rather several smaller questions. The answers to these questions should – as a whole – help draw a more complete picture of the comparable company valuation process. Light will be shed on comparable company valuation from both a theoretical and empirical perspective. The empirical part consists of three smaller surveys amongst financial analysts and institutional investors, and of a broad econometric study. In spite of the sometimes rather formal proceeding (both in the theoretical and the empirical part) special emphasis is on economic content and usefulness to practitioners. In order to ensure this usefulness to the practice, a differentiated proceeding is sometimes necessary. This especially means that many aspects should be discussed, analysed and empirically tested dependent on different valuation circumstances. By doing this, concrete advice can be given to appraisers on how to behave under these valuation circumstances. It is important to notice that while the theoretical part of this examination concerns all facets of the comparable company valuation process – selection of comparable companies, valuation model choice, application range etc. – the focus of the empirical part is clearly on valuation model choice. The following five batteries of questions will be addressed in this study: • How does comparable company valuation fit into the business valuation framework? What is the link to other valuation approaches? What is the application range of comparable company valuation? • What are the determinants of the two main tasks in comparable company valuation (the selection of comparable companies and the valuation model choice)? How can appraisers interpret the influence of these determining factors? How can they deal with changes in these determinants? • What are the implications and problems associated with classical single-factor comparable company valuation models (such as the price-earnings ratio)? What forecasts are necessary in order to adequately apply these models? 4 Some of the rare examples are provided by Kim and Ritter (1999) who analysed the aptitude of multiples in the pricing of Initial Public Offerings, and Gilson et al. (2000) who examined the valuation of bankrupt firms. 4 1 Introduction • Can multi-factor models (i.e. models that make use of more than one accounting reference variable) help overcome some of the problems associated with single-factor models? How do the two accounting variables book value of equity and earnings interact in comparable company valuation? What determines the relative valuation roles of book value and earnings? • What determines the height of the multiples at which companies trade? 1.3 Reading Guide The study as a whole is divided into six chapters. After the general introduction provided here, chapter 2 presents the foundations of comparable company valuation, and discusses how this approach fits into the business valuation framework. Part of this chapter is an overview of different value theories, the relationship between the terms “value” and “market price”, the links between comparable company valuation and other valuation approaches, as well as the application range of comparable company valuation. Additionally, some special issues in comparable company valuation – such as the requirements concerning the quality of accounting variables, the aggregation of valuation ratios and the use of premiums and discounts are discussed. Chapter 3 provides a detailed ana...
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