One of the fundamental keys to becoming a successful investor is understanding what something is worth.
After all, “Price is what you pay, value is what you get” (Warren Buffett).
For most investors, this means using a Discounted Cash Flow model (DCF) to determine what a stock is worth.
However, there is another way to figure out the appropriate price to pay for a company.
Precedent transaction analysis is a valuation tool used by investment bankers to gain a clear perspective of what something is worth.
In this article, we will explain what precedent transaction analysis is, how it’s used, and why it’s worthwhile adopting it in your investment strategy.
If you are curious about alternative methods of valuation, check out what we have in store.
What is Precedent Transaction Analysis?
Precedent transaction analysis, or PTA for short, is a comparable company analysis technique used primarily by investment bankers to determine the value of a business relative to market demand.
PTA analyzes similar companies in the same industry that were purchased in the past and compares the price at which they were purchased and other financial details to figure out how much a company in that market should be worth.
To do this, investors will collect data on relevant past transactions, including the purchase price, financial metrics, and more, then use it to figure out a reasonable price range for the main company or stock they wish to value.
PTA is particularly useful because it provides meaningful insights into current market conditions and investor sentiment toward the industry.
Moreover, PTA paints a clearer picture of what a business is worth, meaning that it will be easier for an investor to know if the stock is overvalued or undervalued.
Remember, when comparing stocks, every business is different. Therefore, PTA is best used as a tool for comparing transactions but should not be used as the final determinant of what something is worth.
To truly know what you should pay for a business, you will need to commit time and effort to understand everything about a business and its financial state.
After doing so, you should be in a position to make a reasonable assessment of what it is worth.
All-in-all, PTA will help you get closer to accomplishing your goal.
Want to learn how to know when a stock is overvalued? Check out this article.
DCF Analysis vs. Precedent Transactions
As an alternative or a compliment to precedent transaction analysis, the discount cash flow model is a commonly used method for determining what something is worth.
Essentially, the DCF forecasts future cash flows over a specified period.
Then, an investor will discount those cash flows back to the present day using a predetermined discount rate; typically a risk-free rate such as the yield on 10-year US Treasury bonds.
In doing so, you will figure out the present value, or intrinsic value of a business, meaning that you now know what it is worth today.
To take it a step further, if you are analyzing a stock, the last thing you need to do is divide the present value of the company by the total number of shares outstanding.
Then, you can use that share price and compare it to the stock’s current stock price.
If the intrinsic value is above the current stock price, the business is undervalued, and if the intrinsic value is below the current stock price, the business is overvalued.
Due to the use of pre-determined growth rates and discount rates, the discount cash flow model can be highly subjective.
Therefore, it’s important to understand that your final price may not be accurate and that it’s better to be conservative rather than over-optimistic.
To learn more about how to value a company using a discounted cash flow model, check out this article.
What are the Benefits of Using Precedent Transaction Analysis
Using precedent transactions is a useful valuation tool to incorporate into every investor’s investment strategy.
Here are a few of its biggest benefits:
Provides a Benchmark for Valuation
The objective of using precedent transaction analysis is to understand what something is worth.
While it may not be able to determine the exact price of a stock, it will create a clearer picture of what others are willing to pay for a business in a specific market.
This is especially useful when a business is young or isn’t profitable yet, given that other valuation methods, like the Discount Cash Flow model, rely heavily on historical data to accurately predict price.
After conducting a PTA, you can use your findings to figure out whether you’d be overpaying for stocks or not.
Simply compare its financial metrics to the rest of the market, and if it is higher than usual, be careful. If not, it may suggest to you that now is the perfect time to buy.
Based on Actual Market Transactions
Since precedent transaction analysis is based on previous market transactions, much of the hard work has already been done for you.
Not only that, but in many instances, these transactions are conducted by financial professionals meaning that you can be confident that the valuations were done accurately and with thorough due diligence.
Therefore, all you have to do is compare the data from the transactions and see where the asset you are analyzing fits in the equation.
Quick and Effective Valuation Method
Expanding on the second advantage, precedent transaction analysis is a quick and effective way to evaluate the price of a business without doing much work.
Given that all the information is gathered for you and made publicly available, most of the blood, sweat, and tears have already been exhausted, meaning that all you need to do is give the data a quick readthrough.
If you are someone who doesn’t have the time to conduct proper research or doesn’t understand how to value businesses well, then precedent transactions might be the answer to your prayers.
When is Precedent Transaction Analysis Used?
Precedent transactions are used when an investor is looking to better understand what a business is worth, more specifically, if it’s a privately held company looking to be acquired.
An investor will use PTA to try and compare the value of a company to its industry peers for a multitude of reasons.
This may be conducted to stress test their other valuation methods, to determine a value for a non-cash flow generating, to see if a business is undervalued or valued, or simply to compare whether one stock is a more worthy investment compared to another.
Whatever the reason, precedent transactions can be a useful benchmark for determining the equity value of a company.
That being said, an investor should understand that each business is unique and that even though it may appear undervalued, different circumstances result in different valuations.
To truly understand when a business is undervalued, it should be so obvious that it almost doesn’t require consideration.
Want to learn more about private markets and venture capital? Check out this video.
How to Perform Precedent Transaction Analysis?
When performing a precedent transaction analysis, you will need to follow these steps.
We will use a full example to help demonstrate.
Step #1: Identify the Target Company
Before you can begin the PTA, the first thing you need to do is decide on a stock you would like to evaluate.
In this example, we will explore the eclectic vehicle market and use the Rivian (RIVN) as our target stock.
Step #2: Collect and Calculate the Transaction Data of Competing Stocks
Once we determine our target company and market, the next step is to gather the relevant transactions from our market competitors.
Since we are evaluating publicly traded companies and not private businesses, this simply means collecting the various valuation multiples and financial data; if you were evaluating private companies, you may look at precedent transactions that include the acquisition price and transaction date as well.
In this example, we will use the Price to Sales (P/S), Price to Book Value (P/BV), and Enterprise Value to EBITDA ratios (EV/EBITDA), while also looking at the Operating Margin, Return on Equity (ROE), Debt to Equity (D/E) of the businesses.
Note that if the financial info for Rivian weren’t available (ie. Rivian was a private company), you would use the average of the industry peers or some similar calculation to determine what Rivian should be worth.
Fortunately, all of the information is there already, so we can include it in our comparative table as well.
To find all the financial information used in this example, go to Yahoo Finance and click on the “Statistics” tab when evaluating an individual stock.
Step #3: Compare the Multiples to the Target Stock
After gathering all of the data and calculating the industry average, you can now determine whether Rivian’s current market valuation is overvalued or undervalued and if the stock is worth the investment compared to other businesses in the same industry.
For Rivian to be considered undervalued, you want Rivian’s:
- P/S less than the Industry Average P/S
- P/BV less than the Industry Average P/BV
- EV/EBITDA less than the Industry Average EV/EBITDA
Note that if a ratio is negative, such as Rivian’s enterprise value to EBITDA, we must exclude it because it means that the business is losing money instead of it being undervalued.
For Rivian to be considered a healthy business financially, you want Rivian’s :
- Operating Margin greater than the Industry Average Operating Margin
- ROE greater than the Industry Average ROE
- D/E less than the Industry Average D/E
To demonstrate where it fits in this equation after comparing each metric, we have associated a box on the far right of the table, where “green” means that Rivian met the criteria, and “red” implies that it didn’t.
One last thing to consider is that we did not exclude any outliers, such as Tesla’s EV/EBITDA when calculating the industry averages.
In your own precedent transaction analyses, you may want to do so as it offers a more accurate assessment of the market.
After conducting this PTA, it appears that Rivian is considered overpriced at the moment and is not necessarily the strongest company financially.
As such, it is better to hold off investing and look for investment opportunities elsewhere for the time being.
Bonus Step: Calculating the Equity Value of the Company
To take things a step further, here is an outline of how to calculate the equity value or intrinsic value of the comparable transactions, which can then be used to measure against Rivian’s current stock price; this a quick and friendly reminder that this is a simple calculation and there is typically more work that goes into this process.
Since Rivian’s EV to EBITDA ratio is negative, this gives us the perfect excuse to put the industry average EV/EBITDA to the test and to figure out Rivian’s equity valuation range; if Rivian were a private business, the process would be the same as it is in this example.
To figure out the equity value, we must first isolate the implied enterprise value in the formula by multiplying the industry average EV/EBITDA ratio by Industry average EBITDA.
Then, we need to determine the equity value by reverse engineering the enterprise value formula.
Here are the Enterprise Value and Equity Value Formulas:
- Enterprise Value = Equity Value + Total Debt – Cash on Hand
- Equity Value = Enterprise Value – Total Debt + Cash on Hand
From there, we now know the average equity value or intrinsic value for the electric vehicle market.
However, given that Tesla, Volkswagen, and General Motors are much bigger companies compared to Rivian, it would have been better to use companies that were closer in size.
Otherwise, you end up with results, like in this example, that claim that Rivian could be purchased at an implied equity value of $146.6 billion, even though its market capitalization sits at $11.5 billion.
So, if there is any takeaway from all of this, it is that you need to be precise in your assessment because otherwise, your valuation will be far from reality, leading you to make a poor investment decision.
Final Thoughts: Why use Precedent Transaction Analysis?
As you can see, precedent transaction analysis is quite a useful tool when it comes to comparing companies in the same industry.
While its full potential may be reserved for the big investment bankers or private equity firms looking to acquire businesses fully, retail investors still have the opportunity to use its tools to their advantage.
That being said, PTA should primarily be used as a supplement to other valuation methods, such as DCF, since there can be large discrepancies in your price and what the business is worth if the comparable companies vary greatly.
Furthermore, you may run into challenges if the business or stock you are targeting operates in a different market than the companies you are comparing it to, even though they fall under the same sector.
So, while it may be beneficial to use it in your valuation process, the best thing to do is to supplement it with a more precise valuation method to ensure that you have the most accurate value possible.
Not to mention that it will be easier to value a company the more you understand it.
All-in-all, this is a great tool and a worthwhile valuation method for every investor.