MSG Team's other articles

9565 How Are Exchange Rates Determined ?

The Foreign exchange market is far more complicated as compared to stock or bond markets. Predicting the foreign exchange rate includes predicting the performance of entire economies. There are a multitude of factors which come into play when exchange rates are being determined. This article lists down and explains some of the important factors which […]

9394 Free Cash Flow to Operating Cash Flow Ratio – Meaning, Formula and Interpretation

The free cash flow to operating cash flow ratio is different from other ratios. It is different in the sense that it is comparing two measures of cash flow. Usually cash flow ratios compare a cash flow item to an item on the income statement or on the balance sheet. Here are the details of […]

12405 Bankruptcy as a Strategy – Part 2

In the previous article, we have already studied that all bankruptcies are not involuntary. In many cases, the shareholders and/or the management of the company make a conscious decision to file for bankruptcy. This happens because the benefits that may accrue as a result of filing bankruptcy are greater than the loss of reputation and […]

11307 What Are Smart Cards and How are They Better than Credit Cards ?

Credit cards have become an increasingly important part of every consumer’s finances. Banks now have more credit card customers than they have savings bank accounts. However, the product is relatively new. As a result, banks may not have anticipated the scale to which this business would grow. They are therefore working on with a rudimentary […]

9518 The Harshad Mehta Scam in India (1992)

Harshad Mehta was the son of a peon. He was born in abject poverty and when he migrated to Mumbai, he had a mere Rs 40 i.e. less than $1 in his pocket. However, over the years Harshad Mehta rose meteorically to become one of the most influential and powerful brokers on the Bombay Stock […]

Search with tags

  • No tags available.

Investment bankers use several different types of methodologies while arriving at the valuation of a company. One of the most commonly used analysis is called precedent transaction analysis.

What is Precedent Transaction Analysis?

Precedent transaction analysis is a relative valuation methodology, just like comparables analysis. This means that these methodologies do not derive the value of the company from the underlying cash flow but instead derive the valuation based on the valuation of other companies or other transactions that have gone through. The basic idea is to come up with a valuation based on what the valuation of similar companies under similar circumstances have been.

This type of valuation is also used in our everyday life. For instance, when we indulge in real estate transactions, we often try to find out the price points at which houses in similar locations have been sold. This value is used to derive the value of a property in question.

Steps in Precedent Transaction Analysis

Investment bankers generally undertake precedent transaction analysis in a more structured form. This is where there are multiple steps that are followed while conducting the analysis. The details of the steps have been listed below:

Step #1: Selecting the Comps: Investment bankers begin the process by selecting companies that are very similar to the one in which the transaction is about to take place. The problem here is that companies are not like houses. This means that they are not homogenous. Even if companies sell similar products and operate in similar markets, there could still be many factors that could influence their valuation.

Investment bankers try to find the best comparables using factors such as industry, geography, size, and even the time period when the comparable transaction took place. The time period is very important while looking at comparable transactions. This is because there is a fundamental principle of the time value of money involved. If similar transactions took place five or seven years ago, their value would have to be adjusted to reflect the current valuation.

In the case of big companies, the details of these transactions are generally made public. This is the reason why conducting a precedent transaction analysis for them is fairly easy. On the other hand, when it comes to smaller private companies, information has to be pulled up from certain databases that have been specifically created for this purpose. It is important to note that a single transaction cannot be made a basis for a new valuation. The new valuation has to be derived as an average of six to ten precedent transactions.

Step #2: Creating the Financial Model: After the precedent companies have been analyzed, we need to put their data into a financial model. For instance, we need to look at the income statement, balance sheet, and even the cash flow statement in order to identify the important numbers. The problem is that these numbers are seldom available in the public domain.

A public company acquiring another public company is a rare occurrence. Generally, at least one party to the transaction is a private company. Since private companies have no compulsion to disclose their data to third parties, obtaining this data becomes quite difficult.

Step#3: Calculating the Multiples: The valuation of one company can only be used to derive the valuation of another company once it is expressed in the form of a comparable. For instance, the valuation of companies is often expressed in the form of enterprise value to EBIT or in the form of a price equity ratio. This is because such an expression creates a plug and play valuation model.

For instance, if the P/E ratio is derived at 20, then we can use this to derive the valuation of our firm. For example, if we know that the earnings of a firm are $1 million, then we can use the P/E ratio to derive the price, which would be 20 times $1 million i.e., $20 million.

The multiples which are used in different industries are quite different. For instance, in some industries, price to book value is an important multiple, whereas, in other industries, the ratio may be irrelevant.

It is also common to corroborate the valuation using various multiples. For instance, the value derived from price to book value ratio, as well as the price to earnings ratio, is often compared to see whether the values remain consistent even if different multiples are used. It is important to take into account that a higher multiple is used if the buyer is taking a controlling stake in the company being sold. This is a common practice in the industry and is called a control premium.

Step #4: Aggregating the Values: Since the precedent transaction analysis does not depend upon one value, data has to be aggregated. For instance, there will be a range of price earning ratios or price to EBIT ratios. In order to use them effectively, companies often use statistics such as the mean of all the values or the 75th percentile of all the values. The statistical value derived is the one that is actually used to derive the valuation of the underlying company.

There are many investment banks that have readymade software tools that are used to query databases and return precedent transactions analysis based on the parameters provided. However, an investment banker with specialized knowledge is required to make sense out of the numbers being quoted.

Article Written by

MSG Team

An insightful writer passionate about sharing expertise, trends, and tips, dedicated to inspiring and informing readers through engaging and thoughtful content.

Leave a reply

Your email address will not be published. Required fields are marked *

Related Articles

Conflict of Interest in Investment Banking

MSG Team

The Components of an Investment Bank

MSG Team

Chinese Walls in Investment Banking

MSG Team