Business Valuation: Market Multiples in the Age of WallStreetBets and Redditt
There are three main approaches that professionals use to determine the economic value of a business. These are the asset-based valuation approach, the income-based approach that includes methods such as using discounted cash flows, and the market-based approach. The market-based approach uses either past comparable transactions for business similar to the one being valued or involves the use of stock market multiples such price to sales(P/S) or price to earnings (P/E) that are derived from publicly traded peers. The market-based approach is known to produce reliable results because value is derived from real transactions between willing parties, that being either merger and acquisition transactions that involve the purchase or sale of whole companies or transactions in common stock that trades on regulated stock exchanges accessible to the public. Using the notion that companies are worth what some is willing to pay for them, stock prices of publicly traded proxies are used as reliable method to estimate value. But does this notion still hold in today’s markets that can exhibit extreme volatility in certain stocks, sectors, or asset classes? Can a stock price driven by coordinated buying or selling from hordes of social media users be deemed reliable enough to be used for business valuation?
The efficient market hypothesis (EMH) states that stock prices reflect all currently available information and that all stocks are fairly valued at any given time. That implies that even if some stock market participants act irrationally, collectively the stock market is always right. That makes a strong case for using stock market multiples and ignoring all the volatility in the market, all the tweets, all the Redditt boards, and all the media noise. However, the efficient market hypothesis relies on the markets being fair, with no large-scale insider trader and market manipulation. Without taking a side on the legality of the issue, the coordinated buying of stocks initiated by retail investors on the Redditt forum WallStreetBets is in fact market manipulation for the purposes of market efficiency. The coordinated pumping of certain stock prices with the sole aim to force a short squeeze, forcing investors to buy the heavily shorted stocks at elevated prices just to be able to close their positions, fits the definition of market manipulation. According to the SEC market manipulation is the act of artificially affecting the supply or demand for a security. It would be different if some investors disagreed on the value of Gamestop, Nokia or Koss Corp with other investors, thus buying stock because they believed the companies in question would perform better in the future, beating market expectations and deserving higher stock prices.
So why market manipulation matters for valuing businesses using stock market multiples? It matters because artificially inflated or deflated stock prices, based on manipulative transactions, cannot be used as the basis for future transactions. In other words, after the market manipulation has run its course one cannot expect to transact on the basis of irrational past transactions. For example, Gamestop was not able to issue new stock and bring much needed fresh capital into the company when its market cap reached the staggering $21 billion on January 27th because no institutional investor would have bought shares anywhere near the stock price at the time. Now that rises another question: what can business valuation professionals do to avoid the effects of market manipulation when estimating a company’s value derived from stock market multiples?
By its nature, market manipulations are short lived and often prices revert back to equilibrium once the manipulation has run its course. One solution would be to wait for prices to stabilize and delay the company valuation until that happens. However, that is not always possible due to external circumstances that demand the valuation be performed in a timely manner. Probably the best solution is to exclude stocks from the valuation peer group that are subject to extreme volatility due to market manipulation. In some cases, even that might not be possible because there are too few publicly traded peers and the companies whose stock is exhibiting the extreme volatility are important benchmarks for the sector they operate in. In this case, the volatile period can be excluded from the historic averages. But that creates the risk that important market developments might not be reflected in the valuation.
To avoid the trap of using stock market multiples derived from manipulated stock prices, a valuation professional needs to make a judgment regarding the following:
- Was there market manipulation in the first place or the volatility is driven by rational factors such as the COVID-19 pandemic, technology developments or regulatory changes?
- Has the market manipulation taken its course and how long it will continue?
- Is it prudent to exclude the stocks whose price is subject to manipulation from the industry peer group?
- Can the volatile period be excluded from the calculation of market multiples?
To makes all these professional judgments requires a great deal of professionalism. Therefore, it is important to hire an experienced and certified business valuation professional to produce a reliable estimate of your company’s value.
Contact us today to hire an experienced and competent business valuation professional.