The Law of One Price Market-Based Analysis
"An extract from The Asia-Pacific Arbitration Review 2014 - a Global Arbitration Review special report - www.GlobalArbitrationReview.com."
Is market-based comparables analysis pertinent to oil company valuations?
One of the most common standards of value is ‘fair market value’, which may be loosely defined as the value that would be reached in an arm’s-length negotiation between a willing buyer and seller, each acting in their own interest, neither under compulsion. Fair market value is often used as a proxy for the value that would be reached by anonymous market participants. The willing buyer and seller are assumed to be typical of the market as a whole and not to embody any specific characteristics. Thus, the fair market value of, say, a pipeline may differ from its value to the owner of the power station that depends upon the gas it delivers.
Two of the most commonly used methods for assessing the value of assets are discounted cash flow (DCF) modelling and market-based (or ‘multiples’) analysis.1 A DCF model calculates a single monetary asset value, in present-day terms, by discounting a set of future cash flows at a rate that reflects their risk. Cash flows may be subject to a range of potential risks, whether they are ‘macro’ risks present in the asset’s general environment, or ‘micro’ risks specific to the investment and the market(s) in which it operates. DCF models often incorporate assumptions that rely on the valuer’s judgement and may be used to assess value under any standard, ‘fair market’ or otherwise.
Although markets exist for assets that are identical to one another (ie, commodity markets), most markets trade heterogeneous assets. No two pieces of real estate are the same; companies differ in their operations, customers and managements; bond prices vary with their issuer, maturity and coupon; the values of Picasso paintings differ from one to another, and from those of paintings by other artists. A market-based assessment of value is therefore often an inference based on prices of similar, but not identical, assets with publicly available prices.
A market-based approach to valuation seeks to identify the value of an asset from the market prices of comparable assets. A market-based valuation is expressed by reference to an appropriate characteristic (or ‘metric’) of the asset, such as its profits, sales or book value. For example, the value of a company might be expressed as, say, twice its sales or 12 times its earnings. Unlike a DCF model, a market-based approach assumes that market value is the appropriate valuation standard, although adjustments might be made to reflect the specific circumstances of a given transaction.