Adjusting multiples of comparable companies

I realize that many people are in favour of using the market approach to valuing a business and adjusting the multiples of publicly traded companies to take into account different size of the companies, growth prospects, profit margins etc. I must admit I have an inherent problem with such an approach. For example, if by adjusting the multiples you get from EV/EBITDA = 6,7 to EV/EBITDA = 6,4, you haven't really done much. If, on the other hand, you get from EV/EBITDA  6,7 to EV/EBITDA = 4,0 - is this really still the market value? Because let's be honest, adjustments reflect your views (or some other analyst's views) and the model that you use for adjustments. And such models don't have much empirical backing.

This is why I'm in favour of using multiples of publicly traded companies to value shares in private businesses only as a sanity-check (i.e. control) method, to see to it that your DCF valuation (as a primary method) isn't way out of any realms of reality.

Another thought on small-stock premiums

There is another issue I'd like to raise regarding the small-stock premiums. Appraisers usually choose between data from Ibbotson (now Morningstar) or Duff&Phelps, at least the majority do. Although the same logic applies to other data sources as well. Ibbotson calculates their data on equity risk premium and small-stock premiums using long-term average of returns dating back to 1926. Up till last year the long-term equity risk premium was app. 7% (now it is down to 6,5%!). This was then used to calculate CAPM expected rates of return, and the return in excess of CAPM was attributed to small-stock effect, since companies were grouped into size deciles. Similar approach was used by Duff&Phelps, whereas they only use data going back to 1963. Therefore their average equity risk premium was app. 5%. And of course also small-stock premiums were different. 

The point I want to make here is that we need to be consistent when using either of these data sets. We cannot simply use Ibbotson's ERP of 7% and Duff&Phelps data on small-stock premiums and vice versa. This much is usually clear. However, some appraisers heavily rely on Ibbotson for small-stock premiums, while on the other hand disagree with them on the equity risk premium part and decide to use a different one, somewhere in the 4-6% range. I have my doubts whether this is then consistent, since a smaller ERP would also yield higher small-stock premiums, if you observe the past data.

The use of small-stock premium data for companies outside USA

A while ago I wrote an article concerning this topic and I'd like to share some of my findings and proposals from that article.

Empirical studies have shown that smaller companies on average tend to earn a higher rate of return, i.e. investors demand a higher rate of return when investing in small companies as compared to large companies. Such findings have been well documented (and sometimes even linked to the so-called January effect). So, data providers (such as Ibbotson or Duff&Phelps) provide data on small-stock premiums for different size groups, whereas these data are based on data from the USA. 

These size groups (and limits for belonging into each group) may be OK for companies in the USA and even some larger and more internationalized equity markets. However, for smaller countries and markets most of the companies would automatically fall in the group of smallest companies, and we would have to use (in some cases an absurdly) high small-stock premium, even for companies that are generally among the largest in a certain market. The argument in favour of using these premiums directly is that equity markets are globally linked and there is a complete and rather cheap way to move capital around, so investors should use the same criteria when choosing to invest in any market. But really, in a very small market - how many international investors are there and what's their share as compared to domestic investors? Furthermore, I haven't seen many research reports by local analysts following the stock market that use small stock premium in their calculation of the rate of return at all.

This is why I believe that the use of data on small-stock premiums based on US data should be adjusted to reflect the characteristics of a local market. Of course, it is up to the appraiser to decide what he thinks is the right approach. So we have the following options:

1. Simply use US data and their size limits to define size groups.

2. Arbitrarily decide the size of the small-stock premium we will use in each case, although this is a completely subjective approach.

3. Redefine the size limits using the data from the local stock exchange. 

The latter approach is the one I believe to be the most appropriate. Of course, as far as the market value is concerned it is finally up to the market participants to define which approach they will use and this is what will determine the market value in the end, be it the "right" way or not.