Benchmarking Valuation: What, Why, How, Advantages, and Disadvantages
Updated: Oct 14, 2022
Today more than ever, the justification for a business is essential to its success. Most companies spend substantial amounts of money to compare their performance against competitors in the same industry. This allows the company to identify and study those activities that are driving profits while cutting others that are not.
A lot of business owners get asked about their business valuation all the time. The valuation process for your business is a multi-faceted, complex, and controversial one. The approach’s cos the number of variables you wish to include in your analysis. In practice how do you know what to include? That's where Benchmarking Valuation Method (BVM) comes in. It is a proven method that any business owner or manager can use when valuing their business.
Benchmarking has become an essential corporate activity given the fact that the performance of the company is only as good as its worst-performing business unit. If a company can consistently beat its competition, it may be able to charge higher prices and increase profitability levels.
Table on Contents
What is the Benchmarking Valuation Method?
Benchmarking Valuation — comparing your situation to others with similar goals, resources, and challenges. The benchmarking valuation method describes valuation as the process of thoroughly understanding various companies' financial information, and their prospects for the future and comparing their attributes with others in the same industry.
This method uses factors such as how much money similar companies have made and what kind of return, they have seen on their investments.
The term “benchmarking” is used because it provides a frame of reference against which to compare values.
For example -If you want to know what your house should sell for in today's market, you can look up comparable houses that have sold recently in your neighborhood. These past sales will give you an idea of what buyers are willing to pay for similar properties.
The two main factors used in comparing companies are:
Industry –
The industry or sector the company operates within can significantly impact its value.
For example- If your company sells products within an industry where there's significant growth, then there will likely be more demand for your product than if it were operating within an industry where there's little growth or even decline. This can lead to higher profits/revenue and therefore higher valuations as well.
Size –
Size also affects valuation greatly because larger companies generally have greater access to capital markets (i.e., stock exchanges) and therefore tend to have more liquid share prices than smaller ones do.
The benchmarking valuation method uses three key elements:
1) Current market price or value of comparable public companies in the same sector or industry.
2) Historical financial performance of those companies.
3) Proforma financial projections for each company.
Different Types of Benchmarking Valuation Method
Benchmarking valuation can be done in two ways:
1. Internal benchmarking –
This involves comparing your business with other similar businesses that are owned by different companies. This type of benchmarking helps you to see how your business compares to others with similar characteristics, such as size and location. Internal benchmarking can also help you identify areas where your business needs improvement or change.
2. External benchmarking –
This involves comparing your business with other similar businesses that are owned by different companies but are in the same industry as yours (e.g., restaurants). External benchmarking allows you to see how your own company performs against its competitors in terms of sales, profits, assets, and more.
Formulas Used for Benchmarking Valuation Method
The most common types of ratios used in this method are:
Return on Equity (ROE)-
The return on equity is defined as the ratio of net income to shareholders' equity.
Return on Assets (ROA)-
The Return on Assets (ROA) is defined as the ratio of net income to the average total assets.
Debt-to-Equity Ratio-
The debt-to-equity ratio is defined as the ratio of total liabilities to total shareholders' equity.
Dividend Yield (DY) Ratio-
The dividend yield is defined as the ratio of annual dividends per share to the price per share.
PEG Ratio-
The PEG ratio is defined as the ratio of price per share divided by earnings per share to the growth rate of earnings.
Net Profit Margin (NPM)-
The net profit margin is defined as the ratio of total revenue minus total expenses to the total revenue multiplied by 100.
Operating Profit Margin (OPM)-
The operating profit margin is defined as the ratio of operating profit to net sales multiplied by 100.
Asset Turnover Ratio (ATR)-
The asset turnover ratio is defined as the ratio of revenue to assets.
Liquidity Ratio (LQR)-
The current ratio and Quick ratio are the 2 types of liquidity ratios. The current ratio is defined as the ratio of current assets to current liabilities. Quick A quick ratio is defined as the ratio of current assets minus inventory to current liabilities.
Why Benchmarking Valuation is Important?
Benchmarking is a key component of effective performance management. It is the process of comparing your company's performance with that of its competitors to gauge your progress and determine if you are performing better or worse than them.
Benchmarking helps you to identify the best practices in your industry, understand how these practices can be applied to your business, and identify areas where you can improve performance.
By benchmarking valuation, you will know:
How much money your company should be worth?
The price you should pay for buying or selling a similar business.
What price you should expect when selling out of the business?
This allows entrepreneurs to focus on their core competencies without having to worry about becoming an expert in valuations or financial analysis.
Applications of Benchmarking Valuation Method
Benchmarking Valuation Method has many applications in the real world. Some of them are:
Pricing - Pricing decisions are often made by comparing prices charged by competitors with their cost structures and profitability. This can be done by developing detailed product costing models for each competitor or by benchmarking the profitability ratios used in their pricing decisions against those for similar products sold elsewhere in the industry or market segment being targeted.
Determining the cost of production for a company- This method helps companies optimize production processes by comparing their costs against those of others and then adjusting where necessary.
For example - When a company wants to reduce its production costs by making changes in the production process or adopting new technologies such as automation or robotics, which will help reduce human labor costs while increasing efficiency levels at the same time it can compare with its peer competitors.
Business Valuation- The market value of a company should reflect the value that investors place on its future cash flows. Benchmarking has been used to estimate the cost of capital (required rate of return) for firms by comparing it with the cost of capital of comparable firms to minimize agency costs where internal managers have different objectives than shareholders.
Investment Analysis – Investors can use this method while deciding whether to invest in a project or not.
How to Perform Benchmarking Valuation with Example?
First, try and find a similar company that has been sold recently. You can start with online sites like BizBuySell—which has a search function—or Capital IQ (you can find this on Bloomberg terminals in financial libraries).
Bigger companies are easier to value than smaller ones, but big companies generally aren’t sold very often. So, if you’re searching online, go ahead and look for a large company of 500 employees, or even more.
Once you find a similar business that was sold recently, calculate the value of the deal per employee to get a benchmark for your business.
If the company sold for $10 million and it had 500 employees, then the benchmark is $20,000 per employee
$10 million / 500 employees = $20,000 per employee
Then take your benchmark ($20,000 per employee) and multiply it by your headcount. So, if you had 200 employees that would give you a valuation of $4 million.
$20,000 per employee x 200 employees = $4 million
Advantages of Benchmarking Valuation Method
Benchmarking valuation can provide several benefits, including:
Identifying key drivers of value creation and destruction
Benchmarking valuation provides insights into how well a company is performing against its peers. This helps management identify areas where they need to improve and areas where they are performing well. It also helps managers understand how their strategies are impacting the overall market performance of their organization.
Identifying potential acquisition targets
A strategic buyer looking at an acquisition target will use benchmarking valuation to compare the target company against its peers to identify potential synergies between them.
It is easy and simple to understand and apply.
It is simple to calculate.
It does not require any new skills or data collection methods for valuation purposes. A person needs only to know the current market value of a property and some basic information about it.
It can be used for both tangible and intangible assets.
It can be used for both public and private companies, as well as for companies that have been around for a long time or those who have just started in business
It is less time-consuming and cheaper compared to other valuation methods.
The result obtained from this method is always accurate because it uses reliable sources such as the internet or real estate agents, who know local property prices and trends.
It helps determine if a firm has undervalued assets or overpaid for assets that were purchased at too high of a price. This can help you avoid buying or selling at inflated prices and keep an eye on how much money you're leaving on the table by not selling when it makes sense to do so (or buying when it makes sense).
It is a versatile valuation method.
Disadvantages of Benchmarking Valuation Method
Benchmarking valuation method has many disadvantages. The following are some of the major ones:
It is not a rigorous process. It does not involve any complex calculations. It is based on a simple comparison. This can lead to errors or miscalculations.
It does not consider the specific features of an organization and its industry. It uses only generic data, which may not be relevant to the specific organization under consideration.
It has no standard format or standard criteria for evaluation purposes; hence it is difficult to compare different firms and their performances.
It does not consider factors such as growth potential or risk.
Not always easy to compare with each other.
For example- how does one compare an airline with a business that makes toys for children? The two may be in the same industry but there are no common factors between them that could be used to make the comparison.
Comparing companies from different countries can be difficult because of differences in accounting practices and regulations. When companies are in different countries, they also may have different currencies and tax rates which affect their earnings statements and balance sheets differently than similar companies located in other countries.
This method can only be used when companies are operating at full capacity and producing at maximum efficiency levels. If there are any problems within an organization or if there are unexpected delays or interruptions in production processes due to natural disasters or strikes by workers, then these will have an impact on company performance and therefore its stock price as well.
You can only use publicly traded companies as a benchmark
It fails to consider the underlying quality of the business. The company might be growing and profitable, but that doesn't mean it's a good investment.
Often used as an excuse for lowballing the price of an investment. If a company wants to sell a stock at $1 per share when its price has been rising steadily for years, then it may use its peer group’s average price as justification for that "low" price.
Conclusion
The Key deliverables in terms of benchmarking valuation include the effectiveness of usage for both internal & external factors including taxation, financial obligations, valuation, and transaction of companies.
The benchmarking valuation method will reveal the market value of your business based on comparable companies. It's recommended to use this tool once a year to track trends. This tool can aid in your exit plan by giving you a more specific number for the sale of your company.
Benchmarking is an excellent tool to help you move your business forward. It is essential in investing, and in not only ensuring you are on track but also looking for improvements.
Key Takeaways
Benchmarking Valuation is a technique that utilizes the subject company’s financial data and compares it to similar public companies that have already been valued.
The method is based on the public market multiples of these comparable companies.
The simple process is to identify similar companies, locate the market value of competitors, compare financial ratios, and determine the multiplier effect.
When using this method, you need to make sure that the financial statements of the subject firm are well prepared with meticulous attention to detail.