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The Perils of Using Market-Based Data in Business Valuation and Damages Quantification
Many cases that require the quantification of economic damages include a valuation component. In determining the fair market value of a business interest, it is generally appropriate to consider market-based data, either in the primary valuation or as a supporting methodology. However, while the market-based approach has several benefits, it relies on a number of implicit assumptions which, if not addressed properly, can result in incorrect or misleading results. The focus of the market-based approach is ‘price’ as opposed to ‘value’. It assumes that the market prices assets accordingly. Awareness of the limitations of market-based data will benefit counsel in reviewing expert reports and in cross-examination.
There are two primary valuation approaches employed in determining the value of a business that is expected to operate as a going concern: the income-based approach and the market-based approach.1 The income-based approach calculates value based on the present value of expected future cash flows; the most widely used income-based approach is the discounted cash flow (DCF) methodology. In contrast, the market-based approach calculates value with reference to assets that are similar to the subject asset. The most popular market-based approaches consider either comparable publicly listed companies or historical transactions that involve comparable companies.
Using market-based data to ascertain value has obvious benefits. First, the data generally represents the price that the market would bear for an asset with certain characteristics, and therefore it is conceptually easy to defend. Second, there is evidence suggesting that market participants act based on market-based data. While they consider future cash flows, they judge whether an asset is under or overvalued by reference to market-based approaches.2 Finally, the key strength of the market-based approach is that it is relatively straightforward to apply and understand. For these reasons, it is widely applied in valuation and quantification of economic losses.
While the market-based approach has its strengths, it relies on numerous implicit assumptions. These assumptions, often glossed over, may have a significant impact on the valuation conclusion.
The importance of addressing the assumptions increases with the emphasis placed on the results of the approach; that is, in cases where the market-based approach is used as the primary valuation methodology, an in-depth assessment of each comparable is likely necessary. There is always a cost–benefit trade-off to conducting an in-depth analysis, and the valuator must use his or her judgement to ensure that an appropriate level of due diligence has been conducted in each case.
General overview of market-based approach
The market-based approach is a relative valuation; value is determined with reference to how similar assets are priced in the marketplace. For example, a prospective purchaser of a condominium may determine the price that he or she is willing to pay for a particular unit by reference to historical sales of other condominium units. This application of the market-based approach in this situation involves the following three steps:
- Identify a universe of comparable assets. In this example, the purchaser may consider transactions that involve units in the same condominium complex or in the same neighborhood. In the valuation of a business, the valuator may consider businesses in the same industry to be comparable.
- Translate market data into a valuation benchmark (or ‘multiple’) and apply it to the subject asset. A valuation benchmark typically depends on a characteristic common to both the subject asset and comparable asset. There must be a strong correlation between this characteristic and value. In our example, it is reasonable to assume that, all else being equal, a larger condominium would sell at a higher price than a smaller condominium; therefore, a reasonable valuation benchmark would be the price per square foot. In the valuation of a business, common benchmarks include price-to-earnings, enterprise value3 to EBITDA,4 or an industry-based metric, such as enterprise value per room in the hotel industry and enterprise value per ton of resource or reserve in the mining sector.
- Make adjustments for any differences between the comparable asset and the subject asset. Suppose that the subject condominium had significant upgrades (such as new appliances or flooring) relative to the comparable units. This difference would have to be accounted for in the valuation analysis. With businesses, differences in competitive advantage, growth prospects and geographical market may be accounted for if necessary.
By way of a numerical example, if comparable condominium sales indicated a range of US$450 to US$500 per square foot, one would expect to pay US$450,000 to US$500,000 for a 1,000-square-foot condominium (ie, the subject asset). Any additional amenities applicable to the subject asset would command a higher premium (ie, valued separately) or justify a price at the top of the range.
Clearly, the market-based valuation approach relies on the ability to identify assets that are comparable to the subject asset and, if possible, quantify any differences between the comparable and subject assets.
What is a ‘comparable’ company?
Risks, cash flows and growth
The market-based approach assumes that the risks and growth prospects associated with the future cash flows of the comparable companies are representative of those of the subject company. Generally, valuators will use companies in the same industry as the subject company as a proxy for the risks associated with the subject company. The valuator may also consider size, geographical markets, nature of products and services, and financial leverage in determining whether a firm is comparable to the subject company. In practice, it is difficult to find companies that are truly ‘comparable’ to the subject company. This is particularly true of industries with few participants and those that are isolated to certain geographic regions, such as developing countries.
Inconsistencies in accounting practices among various companies further compound the comparability issue, particularly when applying a valuation benchmark based on revenues or earnings (such as price-to-earnings or enterprise value to EBITDA). The implicit assumption in the market-based approach is that accounting policies of comparable companies are consistent with those of the subject company. However, this is seldom the case. Even if the companies follow the same set of accounting rules (ie, GAAP, IFRS), accounting policies by their nature provide some degree of flexibility in order to allow management to account for increasingly complex business transactions. One firm may, for example, recognise revenue more aggressively than its peers or capitalise certain expenditures rather than expense them and still be in accordance with the same accounting standards. Differences in accounting policies may be dealt with by way of adjustment or by using a larger sample of comparable companies.
Arbitral tribunals on the lack of comparability
Arbitral tribunals have considered the lack of comparability in their assessment of damages. In CMS Gas Transmission Company v The Argentine Republic (CMS Gas Transmission Company), the tribunal accepted the use of the DCF over the market-based approach.5 In doing so, it was noted that there were ‘significant differences’ between TGN (the subject asset) and the three companies put forward by the respondent’s expert as comparable with respect to ‘asset levels, business segments, financing policy, and other issues’.6
In Occidental Petroleum Corporation and Occidental Exploration and Production Company v The Republic of Ecuador (Occidental Petroleum Corporation), it was the tribunal’s view that the DCF ‘is the most widely used and generally accepted method in the oil and gas industry for valuing sales or acquisitions’.7 The tribunal adopted the claimants’ expert’s view that the use of a comparable company transaction method was not appropriate in that case because ‘each oil and gas property presents a unique set of value parameters: size, quality of oil, type of contractual relationship, environmental or remedial obligations’.8
As arbitral tribunals have recognised, there is an inherent difficulty in identifying proper comparable companies in applying the market-based approach. This discussion of comparability applies to any market-based valuation methodology.
Comparable public companies method
Price v value and efficient market hypothesis
The comparable public companies methodology derives one or more valuation benchmarks by reference to the stock price of a comparable company.9
An implicit assumption in this approach is that a company’s stock price is representative of its fair market value –10 in other words, that the market has reasonably ‘priced’ the stock in relation to its value at a point in time. Economists generally refer to this as ‘efficient market hypothesis’. In reality, market prices are volatile and may fluctuate in the short-term as a result of factors such as changing investor sentiment, news releases, ‘day trading’ and the activity of large institutional investors. The market price of a security may also fluctuate relative to changes in the overall market – such as in the event of a ‘crash’ or ‘boom’. Accordingly, while the price of a security may revert to its value in the longer term, the two may be disparate when considered as at a point in time.
In cases where a security is thinly traded, the stock price may not be reflective of fair market value, and as such, a seller may face a discount or premium to the listed share price when liquidating their interest.11 Similarly, in cases where a particular company has a relatively small market capitalisation or there is little interest shown by large institutional investors and analysts, the seller of a large block of shares may experience a discount to the stock market price upon liquidation.12
Tribunals and experts on price v value
In CMS Gas Transmission Company, the comparable public companies put forward by the respondent’s expert were listed on the Argentine stock exchange.13 In rejecting the comparable public companies method in favour of the DCF, the tribunal considered that the ‘market capitalization in illiquid markets [such] as Argentina is not the most adequate method to value companies’.14
In CME Czech Republic B V (The Netherlands) v The Czech Republic, the subject asset was an equity interest in a Czech television services company; the valuation date was 5 August 1999.15 The claimant’s expert tested his DCF valuation through the use of a comparable companies approach, based on the average enterprise value to EBITDA ratios of 29 broadcasting companies in the United States, Europe and Asia in 1998.16The respondent’s expert criticised the analysis for being ‘backward looking’, as it predated the valuation date.17 Further, the comparable companies used in the analysis included major Western European broadcasters; the respondent’s expert contended that capital markets in Eastern and Central Europe do not value broadcasters based on the same trading multiples.18 While the criticisms of the claimant’s expert evidence appear to be valid based on how it was described in the Award, the tribunal did not address the market-based approach in their ruling on damages.
Overall, stock prices may not be representative of fair market value. The difference between price and value tends to be more obvious in cases where liquidity issues – pertaining either to the individual security at hand or to the entire market – are present.
Comparable company transactions method
The comparable company transactions methodology derives one or more valuation benchmarks by reference to transactions involving comparable companies. In order for a transaction to be useful to the valuation analysis, it should:
- relate to a comparable company;
- meet the definition of value;
- represent intrinsic value (ie, rather than including synergies); and
- be at or around the notional valuation date.
Does the transaction reflect fair market value?
Application of the comparable company transactions valuation method implies that the consideration in a historical transaction involving a comparable company was representative of its fair market value. To illustrate why this may not be the case, one can refer to the following definition of fair market value:
the price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.19
The elements of an open market transaction may differ – at times significantly – from the definition of fair market value in a notional valuation. Consider each of the elements of the fair market value definition above:
- Expressed in terms of cash. Open market transactions frequently include some non-cash component as consideration such as debt, shares, and earn-out arrangements. In these cases, consideration should be adjusted to reflect its equivalent cash value (which may require assumptions).
- Acting at arm’s length. In open market transactions, vendors and purchasers may not be dealing at arm’s length. This may shift consideration in favour of one party.
- Open and unrestricted market. Legal and contractual obligations may restrict the sale of assets or shares. For example, shareholders’ agreements may give other shareholders the right of first refusal or otherwise require their approval for the sale of shares. In some industries, government approval is required for a change in ownership or control. A prospective purchaser may pay less due to such restrictions because they tend to reduce the liquidity of their shares.
- Under no compulsion to act. Market participants may be compelled to act. For example, a company experiencing financial difficulty may be compelled to sell and thus be willing to accept a price that is lower than fair market value for its assets or shares. In contrast, a buyer that is growing by acquisition may be compelled to buy and pay a premium above fair market value.
- Informed and prudent parties. In the open market, there may be an information asymmetry amongst parties that transact. For example, the seller of a business generally has more information about factors that may affect price than the buyer does. This phenomenon exists for both private and public companies. Additionally, actors driving open market transactions may not act prudently.
In reality, an open market transaction may contain one or more of the elements above that may preclude it from meeting the definition of fair market value. It is generally up to the judgement of the valuator to determine the extent to which these factors may have caused the consideration to deviate substantially from fair market value. Often the ability of the valuator to determine whether a transaction is useful is limited by the available information since transaction details are seldom publicly available.
Arbitral tribunals on fair market value
In the context of treaty arbitration, tribunals tend to consider the various components described above. For example, in CME Czech Republic B V (The Netherlands) v The Czech Republic, in considering whether an offer to purchase the asset met the definition of fair market value, the tribunal considered ‘arm’s-length negotiations’ in addition to a valuation and due diligence report to support the purchase price.20 In Tecnicas Medioambieltales Tecmed SA v The United Mexican States, the tribunal considered that a price obtained in a public tender is an efficient manner to determine the price (which it later considered to be the value) of the assets.21
In Southern Pacific Properties (Middle East) Limited v Arab Republic of Egypt, the claimants relied on transactions and offers involving shares of the subject company as benchmark transactions.22 The tribunal stated that ‘the purchase and sale of an asset between a willing buyer and a willing seller should, in principle, be the best indication of the value of the asset’, especially in the case of a ‘perfectly competitive market having many buyers and sellers in which there are no external controls or internal monopolistic arrangements’.23 However, the tribunal ultimately did not accept the share transactions as benchmarks because ‘there was a very limited number of transactions and there was no market as such for the shares that were sold’ and ‘the price at which the shares were sold was privately negotiated’.24
Special interest purchasers
‘Special interest’ purchasers further complicate open market transactions. Special interest purchasers may be willing to pay an amount over and above the intrinsic value of the business. In exchange for the additional consideration, buyers hope to increase future cash flows, decrease risk, or create new growth opportunities over and above that of the individual entities. Synergies are difficult to identify and compute; generally, the purchaser is in a better position to identify and quantify post-acquisition synergies. To the extent that a comparable company transaction includes consideration for post-acquisition synergies, this may result in an over-valuation of the subject company.25
Timing of comparable transactions
Timing is important when applying the comparable transactions approach because transactions rarely fall on the same day as a notional valuation date. Fair market value exists as at a point in time; expectations of market participants regarding relevant economic, industry or business factors may differ significantly at various points in time. Therefore, even if the price of a transaction is equal to its value, that value may not be representative of value at another point in time, particularly if a significant amount of time has elapsed or if the pace of change in the industry is rapid.
Arbitral tribunals on timing
Experts should consider timing and relevant trends (and their impact on changes in price/value over time) in their application of this valuation approach. This is particularly important in the resource sector, where expectations of future commodity prices may be vastly different at the date of the transaction and at the valuation date. In the Occidental Petroleum Corporation case, the tribunal adopted the claimant’s expert’s view that ‘there is also the difference in oil prices which, the claimants submit, can make the comparable [transaction] unreliable’.26
When applying the comparable company transaction method in the context of an economic damages analysis, it is important to consider the extent to which the comparable transaction price is affected by or incorporates the measures that form the basis of the complaint in the litigation or arbitration. In the Occidental Petroleum Corporation case, the tribunal concluded that a transaction involving the subject asset was executed at a time when the caducidad, or termination of a participation contract (ie, the subject of the arbitration), was under consideration by the Ecuadorian authorities.27 An award of damages based on a valuation that incorporates the alleged wrongdoing would generally be unfairly punitive to the plaintiff or claimant.
The market-based approach can be useful in that it provides a representation of the price that market participants are willing to pay for a particular asset. It is a highly relevant valuation method either on a stand-alone basis or in the corroboration of a conclusion from another valuation approach. The approach tends to be credible in cases where actual comparable companies can be identified. While it is practical and easily understandable, its straightforward nature is at times deceptive. As explained in this article, there are several implicit assumptions in the market-based approach – that companies are comparable, that stock prices represent value at a point in time, that transaction prices represent value as at the valuation date – which, if not properly considered and addressed, may skew the valuation conclusion. Overall, market-based data represents price as opposed to value; for the reasons discussed, consideration of this distinction is critical in formulating an overall valuation conclusion, as markets are not always efficient in reality.
The onus is on the expert to be cognisant of and properly address the various nuances of the market-based approach. He or she should know how and when it is appropriate to use the approach because it may be used as a primary or secondary valuation methodology. Finally, with the increasing sophistication of tribunals and courts, it is important that counsel is also aware of both the strengths and the inherent limitations of market-based data and its place in the quantification of economic damages.
- In this article, I do not discuss other going-concern valuation approaches, such as the asset-based approach.
- Aswath Damodaran, Damodaran on Valuation, 2nd ed, p. 234.
- Enterprise value is the total value of the business, including its interest-bearing debt and equity components.
- Earnings before interest, tax, depreciation and amortisation.
- CMS Gas Transmission Company, ICSID Case No. ARB/01/08, Award (12 May 2005), para. 411.
- Ibid, para. 412.
- Occidental Petroleum Corporation, ICSID Case Number ARB/06/11, Award (5 October 2012), para. 779.
- Ibid, paras. 781 and 787.
- In applying this approach, the stock price is generally used to determine the total equity value or the enterprise value or both.
- It is believed by some that publicly traded stocks may include a minority discount (ie, to reflect the fact that the normal trading block of shares would not have the ability to unilaterally control the enterprise) or a premium associated with increased liquidity (ie, over and above that of shares of a private company) or both. I do not address these topics in this article.
- In the case of a thinly traded security, there are relatively few transactions between buyers and sellers, and as such, the fair market value of the security may be higher or lower than its quoted price.
- Ian R Campbell and Howard E Johnson, The Valuation of Business Interests (Canadian Institute of Chartered Accountants, 2001), p. 10.
- CMS Gas Transmission Company, supra note 5, para. 412.
- CME Czech Republic B V (The Netherlands) v The Czech Republic (UNCITRAL), Final Award (14 March 2003), paras. 4 and 97 [CME v Czech Republic].
- Ibid, para. 166.
- Ibid, para. 367.
- Definition per the Canadian Institute of Chartered Business Valuators. This definition is consistent with International Valuation Standards (2013) definition of ‘fair value’, which is ‘the estimated price for the transfer of an asset or liability between identified knowledgeable and willing parties that reflects the respective interests of those parties.’
- CME v Czech Republic, supra note 15, para. 514.
- Tecnicas Medioambieltales Tecmed SA v The United Mexican States, ICSID Case No. ARB (AF)/00/2, Award (29 May 2003), para. 191.
- Southern Pacific Properties (Middle East) Limited v Arab Republic of Egypt, ICSID Case No. ARB/84/3, Award on the Merits (20 May 1992), para. 192.
- Ibid, para. 197.
- Assuming that a prospective acquirer of the subject company would not expect similar post-acquisition synergies the purchasers in the comparable company transactions.
- Occidental Petroleum Corporation, supra note 7, para. 781.
- Ibid, para. 786.