This article is written by Janhavi Shringarpure, pursuing Diploma in M&A, Institutional Finance and Investment Laws (PE and VC transactions) from Lawsikho.
Business owners design and implement their operational, financial, legal plans so as to align their practices with the strategic objectives of the organization. These plans are designed to maximize the value of the company over time and to provide an impetus to its corporate growth. In order to negotiate a suitable deal amongst the investors and the target firms, one of the most indispensable parts is valuing the business using appropriate methodology. An accurate valuation is necessary for assessing both opportunities and opportunity costs as they plan for future growth and eventual transition. Valuation for M&A helps to estimate how long will the buyer take to recoup the cost of investment and how many years’ worth of profits is the seller willing to take today in exchange for diluting his entire stake.
This article encapsulates the most common methods used to value companies in a mergers and acquisitions setting.
Common methods of business valuation: An outlook
The prominent methods used for valuing a company are:
1. Discounted cash flow approach (DCF Analysis)
The discounted cash flow approach is an intrinsic value approach that determines the value of the company by computing the present value of cash flows over the life of the company. This analysis primarily seeks to forecast the cash flows into the future and discount it back to the present day at the Weighted average cost of capital. The DCF analysis is based on the assumption of infinite life of the company and hence the analysis is broken into two parts:
A forecast period
Typically the forecast period used ranges between 5 years or 10 years. In this period, the forecasts of cash flow must be developed in a way that incorporates the costs and benefits of such a transaction.
The value of the company derived from free cash flows arising after the forecast period is captured by a terminal value. The terminal value is determined in the last year of the forecast period and capitalizes the present value of all the future cash flows beyond the forecast period. The terminal region cash flows are projected under the assumption that the firm enjoys no opportunities for abnormal growth or that expected returns equal required returns in this interval.
Once the forecasts are developed, the free cash flows are then discounted to the present value using WACC.
A DCF valuation aims to derive the value of a company in the most direct manner and thus can be vouched for being the most precise method. However, this level of preciseness can jinx at times. DCFs involve predicting and forecasting future cash flows and hence can often be difficult to get right in practice though theoretically, they may be seemingly accurate. Any assumption made in a DCF valuation could swing the value of the company significantly. Therefore this method is feasible and convenient only for companies with a stable and predictable cash flow generation.
2. Comparable company analysis
Comparable company analysis is a method that determines the value of a company using the metrics of other peer businesses of a similar size in the given industry segment. Analysts use a list of available statistics and trading multiples such as P/E ratio, EV/EBIDTA or other financial ratios. It is a relatively straightforward process that provides an observable value that is easy to calculate and always current.
The logic follows that, if company A trades at a 5-times P/E ratio, and company B has earnings of $6.00 per share, company B’s stock must be worth $30.00 per share (assuming the companies have similar attributes).
The process begins with establishing the sample peer group consisting of similar entities and groups in the same industrial vertical. The data gathered is then further used to establish the enterprise value and to calculate other ratios including enterprise value to sales (EV/S) ratio, price to earnings (P/E) ratio, price to book (P/B), and price to sales (P/S) ratio etc.
3. Precedent transactions
As evidently the name suggests, this method uses the “precedents’ that is the past performance of the comparable companies as a tool for determining the present value of the entity The valuation multiples can be derived by dividing the transaction value by the target’s financials. Precedent transaction analysis considers the price paid for the acquisition of similar companies in the past to estimate the worth of stock for the proposed transaction.
The recent acquisitions in the relevant sectors which entail similar industrial classification, geographic factors, company size including its employees, revenue, product mix, deal size etc. are intricately analysed and the data gathered thereof is then used to estimate the enterprise value.
The stepwise process to perform a precedent transaction analysis:
- Ascertaining the relevant transactions in the history within the same industry segment.
- Sort and filter the available transactions and scrub out the transactions that do not fit the current situation.
- The average or selected range of valuation multiples shall be calculated.
- Applying the valuation multiples to the company in question.
- Graphing the results.
Precedent transaction analysis has proven to be a reliable valuation method however, certain downsides associated with it cannot be overlooked. The data and quantum of information available in the public domain might be limited which could hinder the process of drawing conclusions. Further, this difficulty can be compounded while accounting for differences in the market conditions during previous transactions as compared to the current market scenario.
While this type of analysis benefits from using publicly available information, the amount and quality of the information relating to transactions can sometimes be limited. This can make drawing conclusions difficult. This difficulty can be elevated when trying to account for differences in the market conditions during previous transactions compared to the current market. For example, the number of competitors may have changed or the previous market could have been in a different part of the business cycle.
4. Leveraged buyout analysis
Leveraged buyouts are typically used by private equity firms that acquire huge stakes in companies inexpensively with an intention to control such companies, in the hopes that they could be sold at a profitable rate in the future. Such leveraged buyouts are generally highly leveraged as they use debt financing in large proportions to fund the acquisition of such companies. This is based on the assumption that since the investment would make profits, the debt leverage would maximize the returns for the sponsor investors.
Given below is a primer of the approaches to consider in running an LBO analysis for the target company:
- Impute a company value by assuming a normal minimum return for the sponsor investor plus the debt/ equity ratio.
- Impute the required debt/ equity ratio by assuming a minimum rate of return for the sponsor and adding to it the appropriate company value.
- Compute the investment’s expected return by assuming the appropriate debt/equity ratio and company value.
Although LBO analysis provides structured valuation criteria, performing the analysis could involve complex headwinds, especially as the model gets bristled with details. For instance, different assumptions about the capital structure can be made, with increased refinement layers, so as to ensure that the individual component of capital structure is modelled over time with a number of tranche specific assumptions and features. That being said, a simple, standard LBO model with high-level and generic assumptions can be structured fairly easily. However, LBO valuations are fairly dependent on the market forces and any periods of low capital markets activity or higher interest rate, fluctuating yield issuances etc. might have a significant bearing on the valuation.
Parameters for determining the appropriate valuation methodology
The appropriate valuation method to be adopted depends upon the surrounding circumstances and nature of the entity and the stage at which the company is in its corporate cycle, for instance, a going concern, distress sale or winding up situation may require a valuation. Furthermore, there are several other parameters that help in determining the suitable valuation methodology:
- The stage at which the company is in its corporate life cycle (For instance during the infancy stage, although the company may incur losses, the investors would be keen to infuse capital if it has prospects for future profitability and generation of sustainable returns in the long run).
- How much would it cost for the acquirer to build a similar business?
- How long will the buyer take to recoup the cost of investment?
- Growth history and track record.
- Percentage of recurring revenue.
- Retention rate.
- Gross margin.
- Customer acquisition costs.
All the aforesaid considerations are imperative while selecting an appropriate valuation methodology for an entity.
Although M&A transactions can be complex and involve some unique considerations, merger and acquisition valuation methods are the same as the approaches used for other business valuation purposes. Ultimately, what is most important is to seek the services of valuation experts to establish a fair and reasonable value for the purchase of the company being acquired.
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