Explaining Guideline Public Company Method for ESOP Participants (In an Easy Way)
Educating employees about the company’s financials can go a long way to maximize employee engagement. Going a step further, teaching participants the basic concepts of how valuation methods work can empower participants to drive company value. Unless your participants are financial experts, communicating any valuation method will be a challenge. It would be like teaching a finance person, like myself, how to make a good weld, which I know nothing. Luckily, the guideline public method can be related to a more broadly understood concept of determining what to pay for a house.
Sure, a seller lists a price they want for a house, but is that what you should actually pay? To find out, the most common approach is to look at what similar homes have sold for. First, you would look for houses that have recently sold nearby. Next, you would narrow the list by comparing these houses to the home you are considering buying. Once you have a group of houses, you then calculate the price per square foot of the group. Of course, no house is going to be exactly like the one you are buying, so you may need to adjust the price per square foot calculation. A newer construction or a house in a better neighborhood will bring a higher price per square foot. Once you find the appropriate ratio, you then apply that ratio to the home you are looking to buy to get an estimate of value.
The process is very similar when valuing a business using the guideline public company method. You start by narrowing the search to public companies operating in similar markets or related economic drivers. Those could be companies that are direct competitors or companies in the same value chain. Once a group of comparable companies is created, a valuation multiple is calculated based on the group. The valuation multiple can vary but generally consists of some ratio of cash flow to the price of the guideline public company. The multiple then needs to be adjusted for different characteristics. Companies that are growing faster, are larger, and are more efficient with invested assets will be worth more. The last step is to apply the adjusted multiple to your company’s earnings to come up with a suggested value.
Comparing the guideline public company method to buying a house can be a useful way of communicating this method. When the basics are understood, an ESOP participant can see that growing earnings and improving the characteristics of their company are critical components to driving value. Contact me today to discuss educating shareholders on key ESOP terminology.