Market or Comparables Approach
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The market or comparables approach is one of the three main valuation approaches commonly used for the purpose of quantum damages assessment in international arbitration.
Within the valuation community, the market approach is typically defined as a valuation method that determines the value of an asset based on observable market prices of other assets with similar characteristics, referred to as ‘comparables’. The comparables valuation method relies on the economic principle of ‘law of one price’, which states that two assets with similar characteristics should trade at a similar price, otherwise an arbitrage opportunity would exist.
In general, the most compelling evidence of the market value of an asset is the actual price received in an arm’s-length transaction for the sale of that very asset. Hence, if the asset subject to the dispute is directly listed or has been sold recently, it is possible to use stock price data or recent transaction prices as a basis for estimating the market value of the asset directly. In practice, however, a robust measure of the relevant market price of the asset under dispute may not be available, because, for example:
- the business is privately held or is a subsidiary of a larger group;
- transactions involving the asset have happened but are outdated and may not reflect current market conditions; or
- the business is listed but the changes in market values may not directly reflect the ‘damage’ that has been suffered (e.g., the changes also reflect the possibility of litigation or the market is illiquid).
In such cases, valuation experts may have to rely instead on listed market prices or prices paid in recent transactions of ‘comparable’ assets to estimate the market value of the asset under dispute. The comparables valuation method is generally regarded as a complement to the traditional discounted cash flow (DCF) method. Both rely on the same fundamental principle that economic agents value assets based on the expected future benefits from owning these assets. In the case of the DCF method, expected benefits in the form of cash flows are explicitly modelled and discounted back to the valuation date using an appropriate discount rate, which reflects risks around the expected cash flows. In the case of a comparables valuation, prices of the comparable assets themselves reflect the expectations of market participants around future cash flows and risks for these assets. As a result, the comparables method and the DCF method complement each other and, when implemented correctly, should produce valuation results that support each other, given that they are both based on fundamental drivers of value: the future expected future benefits of owning a given asset.
There are many challenges with applying a comparables-based valuation framework, not least the challenge of finding relevant market comparators, which may be difficult if the asset has rare characteristics or uncommon product markets. There are also challenges involved in adjusting comparator data for different characteristics, such as operating geographies, regulatory environment or competitive position. However, notwithstanding these challenges, the use of a comparables valuation framework is a very common approach and, since it is based on real market data, it has a strong intuitive appeal for application in damages assessments. It can also provide important cross-checks to other methods of valuation.
The rest of this chapter is structured as follows. First, we discuss the key steps of a standard comparables valuation approach. Then we present two case studies, illustrating when the comparables valuation method may be appropriate and when not. Finally, we discuss possible extensions to a standard comparables valuation approach that can be used in arbitration cases.
Key steps of implementing a comparables-based valuation
The key steps in estimating the market value of an asset using the comparables valuation method include the following:
- Step 1: Understand the characteristics and valuation drivers of the asset being valued (these may include geography, sector, profitability, growth prospects, cost structure, competitive position, etc.).
- Step 2: Obtain a set of comparable assets with observable market prices.
- Step 3: Calculate appropriate valuation multiples for the comparable assets (e.g., enterprise value (EV) to earnings before interest, tax, depreciation and amortisation (EBITDA)).
- Step 4: Apply the comparables-based multiples to the asset being valued.
- Step 5: Review the results and cross-check with alternative valuation methods.
Step 1: Understand characteristics and valuation drivers of asset being valued
As with any other valuation technique, the first step in a comparables-based valuation is to understand the asset being valued and to identify the key value drivers. It is important to have a good understanding of the asset’s characteristics, such as its geography, industry, business model, recent financial performance, the economic environment in which it operates, the outlook for the business and industry as a whole and any other relevant factors that may affect the asset’s value.
If the asset being valued is a large or even a publicly listed company, then it is typically possible to obtain relevant information from the company’s annual accounts, financial data providers, analyst reports or specialised industry reports. If the asset is small, privately held or rarely traded, information may be less readily available. In this situation, it is important to review all available materials concerning the company’s business operations and finances (including, for example, management accounts, documentation prepared for any historical sales of the asset or management business plans) to extract information that may be used to determine the relevant value drivers.
This step is very important, since a comparables-based valuation is only as good as the comparators themselves, and a thorough understanding of the asset being valued is the necessary prerequisite for identifying good comparators. In addition to the company’s characteristics, it is also important to understand the industry-specific value drivers and fundamental metrics, which are useful both for finding relevant comparators and for identifying appropriate valuation multiples.
For example, consider a situation in which the valuation expert is trying to estimate the market value of a private company (i.e., stock price data is not available) that is a telecommunications provider in a small emerging market country. Without further research, a naïve approach may be to identify relevant comparators as international listed telecommunications companies. However, further research may reveal that the target company offers primarily a fixed line telephony service and has been experiencing declining revenues and profit margins for the past few years because of tough competition in the mobile market, which had been growing at the expense of the fixed line market. Using this additional information about the company’s characteristics, the valuation expert would screen the universe of listed comparators more effectively, identifying only companies that provide a similar service (i.e., primarily fixed lines) and have been subject to similar market trends as relevant comparators for the target company.
Step 2: Obtain a set of comparable assets with observable market prices
The second step in a comparables-based valuation is to identify a set of assets with observable market prices that most closely resemble the characteristics and value drivers of the asset being valued. Ideally, the valuation expert wants to find comparable assets that closely match all the characteristics of the asset being valued as identified in Step 1. Of course, in reality, no two assets are identical, and the focus, therefore, should be on key value drivers that affect expected cash flows and risks.
When searching for comparators, the general approach is to start with the universe of all potentially comparable assets with observable market prices, and to narrow down the list using a set of selection criteria that is transparent and replicable.
For example, if the valuation required identifying a comparator set for an oil and gas company operating in Europe, the first step could be to build an initial candidate list based on the asset class, industry and operating geography (e.g., European publicly listed equities within the oil and gas industry). When building the initial list, it is also important to check that the market prices for potential comparators reflect a reliable estimate of their market values, for example by ensuring that the stock prices of listed candidate comparators are liquid, or when considering comparable private transactions, ensuring that these were undertaken on an arm’s-length basis, since a comparator is useful only if there is a reliable estimate of its market price.
There is no universal method of narrowing down the initial list to obtain the final comparator set and a significant degree of judgement is required at this stage. Ultimately, the objective of the selection process is to ensure that the comparators and the target asset share similar prospects in terms of expected future cash flows and risks, which are the key drivers of value. Factors that drive future cash flows and risks will differ across assets, but we provide some examples in Table 1, below, of quantitative and qualitative factors that can be analysed when assessing comparability of the candidates to the target asset.
Table 1: Examples of quantitative and qualitative factors considered when selecting comparators
In addition to the above factors, it is also important to consider whether there are any idiosyncratic factors affecting the market prices of potential comparators. For example, valuation experts may want to exclude comparators that are experiencing financial distress, are involved in merger or acquisition activities, or are undergoing corporate restructuring, since these company-specific events would affect the market prices of these assets, making them potentially not comparable to the asset being valued.
Finally, there is often a trade-off between the number of comparators and comparability: although it may be beneficial to have a larger comparator set to increase the reliability of the analysis, this often comes at a cost of reducing comparability. There is no rule on the minimum number of comparators required for a comparables-based valuation and judgement is needed. In some cases where listed comparators are abundant, it may be possible to obtain a relatively sizeable comparator set even when applying strict screening criteria. However, often in disputes, the asset being valued has some unique characteristics such that few comparable assets may be available. In these cases, the valuation expert may need to apply judgement and make necessary adjustments to the available comparators to extract a relevant estimate of market value for the target asset.
Step 3: Calculate appropriate valuation multiples for comparable assets
Once the comparator companies are selected, the next step is to select and calculate their valuation multiples, which typically measure the ratio of value in the numerator to a scaling factor, such as size or cash flows, in the denominator.
As with the selection of comparators, the choice of the valuation multiple is a matter of judgement and depends on the asset being valued. In general, valuation multiples can be divided into two groups:
- equity multiples: ratios of the market value of equity to some measure of fundamental value, such as earnings or sales; and
- enterprise value multiples: ratios of the market value of the entire company (i.e., the value of equity plus debt) to a measure of fundamental value for the entire company.
The scaling factor in the denominator can reflect a measure of earnings, revenues or other fundamental driver of value that is specific to the asset. Table 2, below, provides some examples of valuation multiples for different fundamental value drivers.
Table 2: Examples of common valuation multiples
|Fundamental measure||Equity multiples||Enterprise value multiples|
When choosing the relevant multiple to use, the valuation expert needs to consider the specific situation of the asset being valued and its main value drivers. Certain ratios are considered to be more relevant for some sectors (e.g., equity multiples are typically used to value financial services firms, since neither enterprise value nor operating income can be easily estimated for banks or insurance companies).
In addition, valuation experts sometimes consider valuation multiples that are calculated based on sector-specific operating measures. For example, for commodity companies such as oil exploration and production companies or mining companies, whose earnings are generated by selling the underlying commodity, the valuation multiple can be scaled by the number of units of the commodity in reserves (e.g., EV per barrel of oil in reserves or EV per ounce of gold in reserves). For subscription-based companies, such as internet service providers, the valuation multiple can be scaled by the number of subscribers (e.g., EV-to-subscribers). Similarly, for retailers, the value can be scaled by the number of customers (e.g., EV-to-number of customers).
It is better typically to use several valuation multiples to avoid placing undue weight on any single measure. If different multiples lead to different implied valuations, then it is important to understand the reasons behind the differences and select the relevant ratios that best reflect the fundamental drivers of value. It can also be important to take account of the time profile of multiples to identify comparators that have been growing at similar rates.
Once the valuation multiples are selected, the next step is to calculate the multiples for the selected comparator set. When calculating the multiples, adjustments may need to be made, for example to account for transitory, non-recurring components of earnings that are company specific; transitory components of earnings ascribable to cyclicality (business or industry cyclicality); differences in accounting methods (when different companies’ stocks are being compared) or potential dilution of earnings per share (if a price-to-earnings ratio is being used). Additional adjustments may also be necessary to account for different rights (e.g., voting or cash flow rights) associated with different classes of equity.
Step 4: Apply comparables-based multiples to asset being valued
After the valuation expert has identified a set of close comparators and calculated their valuation multiples, the next step is to apply the multiples to the asset being valued to estimate the implied market value.
To obtain a single market value estimate, it is common to use the median or the average of the valuation multiples from the comparator set. Another option is to use a range for the multiples if the valuation expert believes that neither the mean nor the median of the comparators is representative of the target company. The use of a range also captures the uncertainty in the market value estimate. Afterwards, the valuation expert can analyse where the target company lies within the range, for example, based on which comparator is the most comparable to the target company in terms of the relevant value drivers.
The final step is to multiply the selected comparator multiple with the relevant fundamental measure of value for the target asset (e.g., EBITDA, earnings) to arrive at the estimated market value of the asset being valued.
Step 5: Review results and cross-check with alternative valuation methods
The final step of the multiples-based valuation involves sense-checking the results and comparing with other valuation methods.
One useful sense check is to step back and look at the range of the valuation multiples for the comparators and implied value for the target asset. If this range is very wide, this may indicate that some of the selected comparators were in fact not very comparable to the target asset across some important dimension and it would be necessary to go back and re-evaluate the comparator set or control for the differences in some other way. When using different valuation multiples, it is important to compare the valuation results with each other and understand the drivers of any observed differences (e.g., differences between implied values using revenue and EBITDA multiples could be explained by differences in companies’ cost structures or profit margins). This analysis may reveal that a certain valuation multiple is more relevant than another or help to determine where in the range of comparator multiples the target asset is likely to lie.
Finally, it is important to cross-check the results of the multiples-based valuation against alternative valuation methods, notably the DCF. As explained in the Introduction, the two methods both rely on the same fundamental principle that the value of an asset is based on the expected future benefits of owning this asset and hence, when implemented correctly, should produce valuation results that support each other. If this is not the case, then the valuation expert should investigate whether the comparators selected are truly comparable to the target asset or whether the DCF assumptions need to be revised to reflect market expectations of future cash flows and risks for comparable assets.
Examples of using comparator-based valuations in different contexts
In this section, we present two stylised examples to illustrate that, in some circumstances, the evidence from the comparator-based valuation may represent a reliable basis for estimating a market value of the target asset, while in others, the results may not be as robust.
Applying comparator-based valuation to a hypothetical US-regulated electric utility
We consider a hypothetical valuation of a privately owned regulated electric utility operating in the United States. The use of comparator-based evidence has a long tradition in US rate base proceedings, where it has been used for the purpose of estimating the cost of capital of regulated utilities, and the techniques used by experts for selecting relevant comparators for cost of capital estimation can also be used for a comparator-based valuation of the company itself.
For regulated utilities, the key driver of future cash flows and risks is the regulatory regime to which the utility is subject, as this determines the prices that the utility can charge its customers and consequently the profits it can earn for its investors. US electric utilities are typically subject to ‘cost of service regulation’, with regulated revenues set such that the utility recovers its costs, including a fair and reasonable return on its invested capital. The high-level regulatory rules for electric (and, indeed, also gas) utilities are common across all US states and, therefore, a reasonable starting point for selecting comparators for the hypothetical target company would be to consider all US publicly listed electric and gas utilities.
Given that the United States is a large and developed market, the initial list would be likely to include a large number of comparators, which could be further narrowed down based on relevant criteria. Experts who estimate cost of capital for US regulated utilities commonly apply a range of quantitative and qualitative criteria to exclude candidate companies from the initial comparator list, including, for example, removing comparators that do not derive the majority of their earnings from regulated activities; removing comparators that are too small or too big relative to the target company; removing companies with credit ratings below investment grade if the target is above investment grade; removing non-dividend-paying companies when the target pays dividends; or removing companies that have recently been involved in mergers or acquisitions or are undergoing restructuring.
Applying these criteria would provide a set of relevant comparators for which the valuation expert can proceed to calculate valuation multiples. In this hypothetical example, we assume the expert chooses the standard EV-to-revenue, EV-to-EBITDA and EV-to-EBIT (earnings before interest and tax) multiples, commonly used in business valuation. An additional multiple that could be used for regulated utilities includes EV-to-regulated asset base. The regulated asset base measures the invested capital of a utility business, which is commonly used as a basis of calculating the allowed rate of return and, hence, represents an important driver of value.
In Figure 1, below, we show the hypothetical results of the valuation multiples calculation for the comparator companies, alongside descriptive statistics for the distribution of the valuation multiples.
Figure 1: Illustrative example of valuation multiples for comparable US regulated utilities
Table 3: Characteristics of the distribution of comparator multiples (illustration)
|Central tendency measures|
As Table 3, above, shows, the mean and median of the multiples are very close, which indicates the limited presence of outliers. Moreover, the dispersion of the different valuation multiples, as measured by the standard deviation, is relatively narrow. This suggests that the comparator set includes a relatively homogeneous group of companies with similar value drivers in terms of expected future cash flows and risks.
The valuation expert can proceed, therefore, with estimating the market value of the target company based on the comparator multiples with a reasonably high degree of confidence. Given the limited variation in the multiples, and if the expert has no reason to believe that the target company is different from the median company, the expert may use the median for each multiple as a basis of estimating the market value for the target company. This is illustrated in Table 4, below.
Table 4: Illustrative example of estimating market value using multiples approach
|Fundamental value for target||US$ millions||A||1,500||560||335|
|Comparator multiple (median)||Multiple||B||4.3x||11.1x||19.2x|
|Implied market value of target||US$ millions||C=A*B||6,450||6,216||6,432|
The calculation shows similar implied market values for the target company, irrespective of which valuation ratio the expert uses. The expert could then proceed to compare the results of the multiples-based analysis with alternative valuations based on DCF to help conclude a final market value estimate.
As demonstrated above, the hypothetical comparators-based valuation for a US-regulated electric utility appears to provide robust results. This is because the United States represents a mature, developed market with a large number of candidate comparator companies relevant for the analysis, and the regulation of electric utilities operates under similar rules across all US states. This means that the key fundamental drivers of value (e.g., regulatory regime, country risk, institutional risks, macroeconomic factors) are common across all candidate comparators, and once the valuation expert removes comparators subject to company-specific risks (e.g., companies with low credit rating, companies in distress, companies who do not pay dividends), the expert obtains a relatively narrow set of valuation multiples, which in turn provides a relatively narrow implied market value for the target company.
Applying comparator-based valuation to a telecommunications company in a small evolving island country
As shown in Example 1, comparable-based valuation can be an effective tool when there are a number of comparable assets with observable market prices available that operate under similar economic conditions. However, this valuation method can become less effective if the asset being valued is more unusual in one or more aspects of its operating environment, making it difficult to identify suitable comparators.
Consider a second example in which the asset being valued is a privately owned telecommunications company operating in a small evolving island country called Cobra Island. Let us assume that a valuation expert has applied a comparator-based valuation approach and identified a set of listed telecommunications providers from various countries, producing a range of EV-to-EBITDA multiples, as summarised in Table 5, below. The expert then proceeded to value the target company in Cobra Island based on the median EV-to-EBITDA ratio.
Table 5: Illustrative example of multiples for comparator telecommunications companies
|Telco A||Fook Island||5.2x|
|Telco B||San Theodoro||7.3x|
|Telco C||Nuevo Rico||1.7x|
A review of the expert’s evidence reveals that, unlike in the previous hypothetical example of US utilities, the range of comparator multiples is very wide (from 1.7x to 12.4x), with the maximum multiple more than seven times higher than the minimum. In other words, this means that the price per unit of EBITDA that investors pay for the selected comparators is very different, which indicates that the comparator valuations are driven by factors that have not been controlled for by the expert. A valuation simply based on the median of the EV-to-EBITDA is unlikely to be robust in this example, unless the expert has analysed and confirmed that the median comparator company is indeed comparable to the target company.
One potential issue with the above analysis is that the comparator companies are from different countries. There are a range of country-specific factors, such as macroeconomic, institutional, regulatory or tax, that could cause differences in expected cash flows and risks for telecommunications operators in these different countries, resulting in the observed wide range of valuation multiples.
In addition to country risk, the differences in valuations may also be driven by differences in other operating characteristics across the comparators. Even though they are all telecommunications companies, there could be inherent differences in operational factors, such as subscriber growth rates, penetration rates for different market segments, average revenues per subscriber or sparsity of the network.
However, factors such as country risk or differences in operational factors can be qualitative in nature and it may be difficult to make adjustments to the comparator valuation multiples for these factors. One option would be to restrict the sample to include only companies with similar country risks and operational risks, but in practice this may involve subjective judgement and it may be difficult to identify the comparators.
Overall, this example illustrates that a standard comparators-based approach may become more difficult to implement when the asset being valued has qualitative characteristics (e.g., country risk or operational characteristics) that it does not share with potential comparator companies. In such cases, the valuation expert can try to identify the comparators that appear most to resemble the target company, although this may be difficult to implement in practice as qualitative factors cannot easily be measured or adjusted for.
Potential extensions of comparables-based valuation approach applicable in damages estimation
In the previous sections, we discussed how the standard comparables-based approach is applied in the context of business valuation. We now present some potential extensions in which comparables-based evidence may be used for estimating quantum damages in the context of international arbitration.
Applying comparables-based approach to value an asset with unique characteristics based on historical transaction prices
As discussed above, the application of a comparables-based approach can only be successful if the valuation expert is able to identify comparable assets with observable market prices. However, frequently the assets subject to disputes in arbitration cases have unique characteristics, which implies that comparable assets with observable market prices are simply not available. In these types of cases, it may be possible to rely on historical transaction prices for the asset under dispute and roll forward the historical price, which captures the unique characteristics of the asset to the valuation date, using comparator-based evidence on changes in market prices of similar assets over time.
For example, consider a situation in which the valuation expert is trying to value a luxury hotel in an evolving country. The asset under dispute is the only luxury hotel in the relevant area and the market values of other hotels in the region are not available. In this case, it may be difficult to find relevant comparator hotels to be used as a basis of the valuation. However, assume that the valuation expert knows that, five years prior to the valuation date, the investor purchased the hotel for US$20 million. The expert could therefore analyse market information on changes in real estate prices (e.g., changes in prices of commercial property, or changes in transaction prices of other hotels in the region or country). Even though the available comparator evidence may not provide relevant indicators of the level of value for the target asset because of its unique characteristics, it may provide relevant evidence on the changes in values of similar types of assets over time, which can then be applied to the historical purchase price to estimate an up-to-date market value, as illustrated in Figure 2, below.
Figure 2: Increase in market value of comparable assets may be used to estimate increase in market value of target asset
The above method may work when the conditions and operating environment of the asset are relatively constant over time. Using the historical transaction value and rolling it forwards with a price index may be a good proxy for estimating the market value at a subsequent point in time.
Using different comparators to value different segments of company activities
Another situation in which the valuation expert may not be successful in finding relevant comparators would be where a company engages in a range of different activities. In such a case, the valuation expert may nevertheless be able to find good comparators for different segments of a company’s activities and value the business as the sum of these different activities.
For example, consider a privately held mining company that generates revenues from producing gold, zinc and copper from its various mines. Assume that there are no comparable companies operating the same portfolio of mines in the relevant proportions. However, the valuation expert may be able to divide the company’s mine portfolio into three segments and value them separately, based on relevant comparators for each segment. The sum of the values for each segment then provides an estimate of the total market value of the company, as illustrated in Figure 3, below.
Figure 3: Assets may be valued using comparators for individual business segments instead of asset as a whole
The above method may work well when no relevant comparators exist for the company’s activities as a whole but where good comparators exist for the individual segments in which the company operates – in this case, gold, zinc and copper.
The above decomposition analysis may also be applied when the valuation expert is trying to estimate damages for a company with observable market value but where only a part of the assets is subject to dispute. The expert can use the same approach described above to estimate the market value of the assets that are not subject to dispute and calculate the value of the assets under dispute as the residual. This method may work if good comparators exist for the segments of the company that are not subject to dispute and where the value of the asset subject to dispute constitutes a sizeable portion of the overall business. In such cases, the valuation expert can be relatively confident in the valuation of the asset not subject to dispute, which in turn gives the expert confidence in the valuation of the asset subject to dispute calculated as the residual.
The market or comparables-based valuation method serves as an alternative and complement to the income-based and asset-based valuation methods. The most compelling evidence of the market value of an asset is the actual price paid in an arm’s-length transaction for that asset or the listed price in a liquid market. Comparables-based valuation is an alternative in cases when direct market data on the value of the asset is not available. The use of comparables-based valuation to estimate accurately the market value of an asset critically depends on the availability of relevant comparator companies with observable market prices. It will be more effective, therefore, in situations where there are a number of listed assets or market transactions, ideally in the same geographical locations and with similar economic characteristics as the target asset. The valuation expert should go through a rigorous screening process to select relevant comparators and present objective evidence to determine an appropriate comparator set. In many cases, comparator evidence may not give precise answers on market valuations, but it may determine plausible ranges that can be used as cross-checks against other valuation methods (such as DCF). Comparator evidence can also be used to determine values for other parts of listed businesses not subject to the dispute or to roll forward historical prices for assets when direct comparators are not available.
 Richard Hern is a managing director, Zuzana Janeckova is an associate director and Yue Yin is a consultant at NERA Economic Consulting
 The three main methods for estimating the market value of an asset or business are: (1) market-based approach: estimates market value of an asset or business by reference to similar businesses, business ownership interests, and securities that have been sold in the market (comparables analysis); (2) income-based approach: estimates the market value of an asset by calculating the present value of expected future benefits (e.g., discounted cash flows or dividends); and (3) asset-based approach: estimates the market value of a business as the market value of its assets less the market value of its liabilities (e.g., based on adjusting the assets and liabilities in the balance sheet to their market value).
 An arbitrage is defined as a trade that leads to a certain profit with no risk. In efficient markets, market participants move market prices by trading on these opportunities, eliminating them as a result.
 The ratio of enterprise value (EV) to earnings before interest, taxes, depreciation and amortisation (EBITDA).
 Aswath Damodaran (2013), ‘Valuing financial services firms’, Journal of Financial Perspectives, Ernst & Young Global Financial Services Institute, Volume 1 – Issue 1, p. 14.
 Aswath Damodaran (2012), Investment Valuation: Tools and Techniques for Determining the Value of Any Asset, Third edition, pp. 572–73.
 Valuations based on the median are less sensitive to the presence of outliers or missing data than arithmetic averages.
 Jeff D Makholm (2015), ‘A Half-Century of Computing the Cost of Capital for Utilities at NERA’ (NERA Economic Consulting).