Minority Value Multiples Can Trade Higher Than Enterprise Value Multiples: Sometimes it’s Cheaper to Buy the Whole Company
Many investors, analysts and business appraiser’s believe1 that publicly traded price multiples / minority equity value multiples can be used to estimate enterprise value, control level value of a business, or by simply applying an incremental premium for control to a selected publicly traded minority multiple. Typically this method can be done by using a sample of comparable publicly traded companies, observing a range of P/E2 multiples and selecting a multiple within the range or typically by analyzing enterprise transaction multiples. At this point, a simple premium for control is applied and market value of debt is added to arrive at an enterprise value.
For example, if a sample of comparable publicly traded companies has a P/E multiple range of 10x to 14x and the appraiser selects 12x, he would then apply a premium for control of 25% (historically observed average in studies), add the market value of debt and arrive at an enterprise value multiple north of 15x earnings.
However, this mathematical calculation many times is not a supportable method to estimate a marketplace transaction for enterprise value.
As business appraisers, our job is to “Mirror the Marketplace” when valuing businesses. In doing so, the above methodology and the implicit assumption made is that minority value serves as a reasonable baseline, or starting point, for enterprise value. Very few appraisers understand that the most accurate explanation of the relationship between minority value and enterprise value is that there is no functional relationship between minority multiples and enterprise value.
Why is this explanation true?
The reason is based on stock market dynamics and trading history, but primarily because: The economic and financial drivers that influence an enterprise buyer are fundamentally different than a minority buyer. List of drivers for the typical minority buyer:
- Has a contained and restricted insight into earnings and growth prospects;
- Has limited or nearly no insight into the long term business plan & its associated risks;
- May have controlled information into the competitive environment; and
- May have narrow views into the future outlook for new products, pricing strategies and risk profile, etc.
The opposite is often true for the enterprise buyer. These factors have a significant and dramatic impact on enterprise value. As a result, there are times when a minority price pro-rata can significantly exceed what a prudent enterprise level buyer will pay, pro-rata, for a company. Vice versa, there are times when the enterprise value can be much more than the amount indicated by an application of an average premium for control percentages.
A publicly traded restaurant company operated 22 locations across the U.S. After a brief due diligence period, it was discovered that two of these locations generated 3x to 4x the profit of an average company store, 40% of the total company annual cash flow and had short-terms remaining on their leases (3 and 5 years). These two locations were also unique in they were located in a resort area, with a landlord who had a history of increasing rent dramatically, to “milk out” the excess profits, after the initial lease period. This piece of information was not known to the public as it was a trade secret of the landlord and lessor, but not shared with the public. Therefore, it was likely that the future profits of the restaurant company from current stores would go down significantly at the end of the current lease period. As a consequence, the value, and its associated multiples, to a prudent enterprise buyer would be substantially less than the minority multiples observed in the public market.
In contrast to the above case study, there are other times when new products are coming online with risk and growth prospects that are not reflected in current or historical earnings. As a consequence, when the new products hit the market, the earnings may jump and significantly increase the enterprise value above and beyond the observed minority price.
As a result of the above Case Study, it is clear that an appraiser must go through a proper due diligence process to understand of the impact of the cost, income, and market approach to truly understand the enterprise value of a company. It is also clear that assuming a publicly traded minority value as a reasonable basis to calculate enterprise value can lead to a significant error in due diligence and negatively impacts the credibility of an enterprise value opinion.
This article was originally published in Valuation Viewpoint, July 2014.
1 Based on studies and articles
2 Price to Earnings Ratios