Question

The average trailing PE ratio of publicly traded auto parts companies in the US is 20.0. You own a regional auto parts firm in the Northwest that is privately held and has no debt. In the last year, the firm earned $1.5 million.

You are looking to sell your firm to a private equity firm and are arguing the valuation of the firm should be 20 * $1.5 million = $30 million dollars.

• Why might this be a biased estimate of the value of the firm?
• What are one or two reasons why the estimate might be biased?

Answer 1

Reasons why the valuation of (20 * $1.5 million = $30 million) might be biased:

~ Size and Liquidity Adjustment: The subject firm is a regional auto parts firm in the Northwest and is privately held, while the average P/E ratio used for relative valuation belongs to publicly traded auto parts companies. Therefore, the valuation estimate is biased because the average P/E ratio is not comparable, because the subject firm is smaller in size, and less liquid than the publicly traded firms.

Hence, if an average P/E ratio of publicly traded companies is taken for valuing a small regional firm, then adjustments for size and liquidity difference should be made to the P/E Ratio to make it comparable, before multiplying it to the subject company's earnings.

~ Adjustment for Leverage: The subject firm has no debt, while the publicly traded companies whose average PE ratio is taken might be highly leveraged and therefore might be highly riskier than the regional auto parts firm. Therefore, without making the relevant adjustment to the average PE for the difference in leverage in the subject firm and publicly traded companies, the valuation estimate will be biased.