This is the whole series of articles on Mergers and Acquisitions, make sure to check all other articles including:
Part 1: What Are Mergers And Acquisitions
Part 2: Synergies In M&A Deals
Part 3: Outline Of Business Valuation Techniques
Part 4: Quick Overview Of M&A Process
Part 5: Selling Business To Private Equity
Part 6: Selling Business To Venture Capital
Part 7: Letter Of Intent (or “LOI”) In Mergers And Acquisitions
Part 8: Due Diligence Process
Part 9: Principles Of Negotiating In Mergers And Acquisitions
Part 10: Sale And Purchase Agreement
Part 11: M&A Deal Closing
The topic of valuation in M&A transactions is a really difficult thing to get head round. It is really neither an art nor a science, and it is a bit like coming up with whole different guesses, if you like, different values for a business and then trying to narrow them down into a range where everybody is reasonably comfortable with the number. It really is something quite difficult to get your mind around. But as long as you are prepared to accept that you will get that sort of range, then there are very specific methods that you can use. Some are more rigorous than others to come up with effective valuations of businesses.
There are essentially three main ways to value a company and only some of these are relevant in merges and acquisitions, but we will provide an outline of all the main existing techniques. There are balance sheet methods, which include book value, adjusted book value and liquidation value. And there are profit and loss methods, which include profit multiples, price, earnings ratios, sales multiples, and EBITDA multiples. And there are discounted cash flow methods, which include cash flow to equity and free cash flow.
There are two other methods which we will not be discussing in too many details, but it is important you are aware of their existence. These are book value-based valuations, dividend valuation models, value creation methods such as economic value added (or EVA), and then methods using option pricing theory with Black Scholes being the most known one but which is very, very complicated, and I’m not entirely sure anybody really understands this method?
Let’s consider why we would want to value a company. It is important to make the distinction between the perspective of the buyer and the seller. And the value is also going to differ for different buyers because they will have different criteria and different strategies, and therefore the company will have different values for them depending on who they are.
For a buyer, the valuation process is going to establish the maximum price he is prepared to pay for the business. For the seller, the valuation will show him the minimum price he will be prepared to receive for his company. Whatever you do, do not confuse the value of a company with the price of a deal, or what a buyer may be prepared to pay for it. The two things are really very different.
So what purposes are there for having a valuation? It is useful in a whole range of different circumstances, and we will explain these in the context of an M&A transaction. It will help the buyer and to determine the value and then hopefully an agreement about the price.
When valuing listed companies, it will help establish whether the company is either overvalued or undervalued compared to their market value. When you are preparing a company for an initial public offering (or IPO) on a stock market, it will help you establish the right price for the shares.
When you’re evaluating the outcome of a financial performance of a business, and its senior management team in particular who are under an incentivization scheme, then valuation is very, very important.
And if you are trying to identify strategic value drivers in a business, then the valuation process can help you do that.
Finally, if you are trying to help management teams and their advisors with a strategic planning process, then obviously the assumptions that go into that strategic planning process can be tested in a valuation.
So remember, there is really no definitive answer to this whole problem of valuation. It depends on your deal perspective, whether you are on the buy side or the sell side. It depends on which methodology you want to use. And also it depends very heavily on the assumptions that you put into those methodologies, in order to then come up with the answers that you are going to derive from whichever approach you take.
So be prepared for a bit of a rollercoaster, but it is an important aspect to corporate finance, and it is something that one needs to be able to demonstrate you he can do as part of your role as a corporate finance advisor.
Valuation is a very contentious topic because the owner of the business will expect to have a very high value and any purchaser will try to attribute a low value. And if you are an advisor, you are sort of stuck in the middle because you will be trying to come up with an objective value and guide the two parties together.
Let’s explore now the different valuation methods.
The essence of this method is to look at the quoted companies, which are similar to the company you are trying to value, and trying to see how the market is valuing these for their revenues, their cash flow, maybe even possibly their balance sheets.
Depending on the nature of the business, you have to decide which is the most relevant, but normally you are looking at profit and loss account and earnings per share multiples possibly.
And what you need to do is create a matrix of these so that you can see the averages that come out. And this helps to even out at any market anomalies. And of course when you look at your comparables, you have to be sensitive to the fact that if there is a real outlier there, you need to go and investigate and see why the market’s particularly valuing a company either very highly or at a very low level.
But once you have got the valuation matrix, and you have those averages of these multiples, you can then go and apply them to the business that you are trying to value and see what sort of ranges for each of the different multiples you get from that valuation.
The next way to look at valuation is by looking at comparable mergers and acquisitions transactions. So these are the deals which have already been done, and you will find these in the press or just on Google. There are also deal databases which your advisors will have access to, but go and look at similar companies that have been sold and try to understand what multiples of revenue and profit and assets and cash flow have been applied to those businesses and apply them back to the business you are valuing.
What you will find will not get complete financial data on all these deals, but if you can get a multiple of profits or a multiple of revenues, and you can pick up these individual data points, and if you have enough of them, you can start to put together a meaningful range of multiples that you can apply back to the business of trying to value.
One last point to make is that when you are looking at both comparable market transactions, and you are looking at historic M&A transactions, then you do need to be sensitive to the market conditions both prevailing at the present and also that prevailed in the past because as the market goes up and down like a yo-yo, and you do get these boom and bust cycles, and you will get different levels of valuation depending on where you are in that cycle.
Discounted cash flow is a more complex, but also a more objective valuation method because what you are doing here is to build a model of the business, and it has to be an integrated profit and loss cash flow and balance sheet model so that any changes in one reflects all the way through the model. And your balance sheet must always balance, and the model must not be circular. But what you essentially do is take the free cash flow from the business, forecast it out five or ten years, and then you discount that value to the present. And the number you come up with gives you valuation for the business.
There are a number of issues here. One is obviously the assumptions you make in your forecast, such as the revenue growth rate. Secondly, it is the discount rate that makes DCF extremely sensitive, and thirdly, the terminal value you decide to use.
Do not worry too much about the technicalities of this, but just to say that the value of a DCF model is very much dependent on the assumptions you make going into it. So it is still subject to quite a high degree of subjectivity.
As mentioned before, it is really important that your DCF model is what is called an integrative model so that the balance sheet, the profit and loss account, and the cash flow all work together. And the real test of this is one that your model is not circular, and two, that your balance sheet always balances and if it doesn’t, there must be a problem with your model. But you need to set this model up with the correct inputs in order to get the outputs for your cash flow valuation. And the creation of the integrated profit and loss account, balance sheet, and cash flow model is an art in itself. However, you can estimate the cash flows from the business and use that, but it’s obviously not as robust.
Let’s look at some of the cash flow methods and the methodology itself is probably the one I like the most when you come to look at company valuation provided you have got your component parts calculated correctly.
The underlying basis of the valuation method is to discount the free cash flow forecast from the business back to the present. And this gives you a value of the business in today’s money. Now, the valuation is very sensitive to some key assumptions, the forecast earnings growth of the business into the future, the discount rate that you use to bring the forecasted cashflow back to the present. The number of years in the forecast, this is typically five to ten, and the assumptions you use when arriving at the terminal value of the business in its final year.
It is essential to note that the free cash flow that you are measuring is the unlevered (or unleveraged) cash flow. That is to say it does not include the costs of debt financing. This enables you to value the business irrespective of the financing structure being used. There are several steps in this process, and the first thing you have to do is to create an integrated profit and loss, balance sheet and cash flow model of the business. The model should ideally calculate the cash flows for at least 10 years, or you run the risk that the terminal value will end up being a disproportionately large part of the valuation, which the risk with short term models. You have to calculate correctly the terminal value in year 10, and then you have to come up with an appropriate discount rate to discount the cash flows back to the present. And the discount factor that you use is the weighted average cost of capital for the business.
The theory behind this is the capital asset pricing model, and if you want to investigate this in more detail, I suggest you Google it and go and investigate it. But for the moment, it is enough for us to consider that the method calculates a discount rate for the equity and the debt separately and then combines them into a weighted ratio depending on the mix of the debt and the equity financing in the company. This is referred to as weighted average cost of capital (or WACC).
When preparing a discounted cash flow method, you need to give the following factors some careful consideration. The future cash flows will be heavily dependent on the assumed returns on future investments and the assumed growth rate for the company’s sales. The return on equity represented by the equity portion of capital comprises a risk-free rate, a market risk premium (or beta), a further discount factor for the company’s specific operating risk and a discount factor for the company’s financial risks.
Putting these together, this can actually in its own right be a highly contentious process, but your result, the end valuation is very sensitive to the assumptions made in this part of the calculation.
Finally, one can look at the breakup value of the business, by valuing the sum of the parts of the business, still using the discounted cash flow valuation for each different part of the business and independently assessing those parts of the business, but also making the assumption that the separate businesses will be sold on a going concern basis.
When valuing a business it is really important that you bear these common errors, explained above, in mind before you start to use these numbers for the purpose of valuation. Usually, the numbers have been very carefully prepared by accountants for valuing a business. And here is what these numbers shared with you will look like.
When you’re looking at a balance sheet you are looking at accounting (or book) value of the assets in the business. Book value considers the net worth attributable to the holders of equity, and this is the net difference, hopefully positive between the assets and the liabilities of the business.
Adjusted book value attempts to take account of some of the potential pitfalls which may occur as a result of some of the accounting conventions. These can include adjusting or updating the value of land and property, adjusting for the impact of bad debts or indeed removing the overstatement of value caused by things obsolete stock. Now you can get a different perspective of a business’s value by looking at the liquidation value, and this assumes that the assets are sold potentially at short notice and at conservative values in order to pay back the liabilities of the business. When you are closing it down, this is one way of estimating the minimum value of a business.
It is essential to understand that the book value has very little actual correlation with market value of the business, and in my view, it is not a very robust way to value a business altogether.
Let’s take a look at some profit and loss account methods or (or what in US is called income statement methods). These methods focus on the sales and the profits of the business to establish a value for the company. One of the most common methods used in the public markets is the price earnings (or P/E) ratio. And this compares the market company’s market value as a ratio of its earnings per share (or EPS). And this shows as well how high the market values the company on a per-share basis and provides a very useful if simple comparative ratio when looking at one or more companies. You can of course reverse this to arrive at a value by multiplying the earnings per share of the company by a given ratio.
Dividend value is based on the fact that shareholders may receive a dividend from the company from time to time, and this cash flow and its future projections can be used to derive a value for the business. The dividend is considered as a cash perpetuity, and this is used with a terminal value to discount to the present the value of the business using the same discounting method that we will meet when considering discounted cash flow methods of valuation. The dilemma for a business is that the payment of dividend distributions of cash to shareholders might otherwise be used to grow the business, and therefore, you may get a higher value for dividend paying companies, whereas in fact, the growth of lower dividend paying businesses would in reality exceed that of the high dividend business. So you can get an inverted result on this because there is lots of cash coming out, and it is being paid in a dividend, which you then value, but you are assuming certain levels of growth. But, if there were fewer dividends paid, the levels of growth may well be higher which is why the dividend valuation method is deeply flawed in my view. For years Microsoft did not pay a dividend for exactly this reason, and used all cash it generated to grow its base business.
Now let’s take a look very briefly at technology valuations because there has been a real issue in the past when technology companies have been valued extremely highly, often at a very early stage, and this makes it very difficult to value them in conventional ways, particularly if you anticipate stellar growth in the future.
In these cases, it has often been necessary to resort to the rather simplistic approach of pure sales multiples on the basis that they’re seldom any earnings to value. Sales multiples are a somewhat crude method of company valuation and our common practice rule of thumb, ways to value a business with within certain industries. While this can be used informally when discussing comparative valuations for two business in the same sector, this method provides little more than an indicator of value. It is essentially a “back of the envelope” calculation if you like.
Profit multiples are much more reliable in performing business valuation. And the two most common that are used are the EBIT (or earnings before interest and tax) and the EBITDA (or earnings before interest tax depreciation and amortization). The EBITDA is particularly useful in M&A deals and private equity transactions because it values the business independent of its financing structure by removing the costs of interest which are being paid on debt, tax (which is obviously something you can shelter) and historical depreciation and amortization on your tangible and intangible assets (these are purely book entries that have no actual impact on cash flow)
Let’s take a look now at the common errors in calculating company valuation. These consider a number of different aspects of the weighted average cost of capital and the capital asset pricing model. And they include errors in the discount rate relating to the riskiness of the company using the incorrect beta for the valuation, using the incorrect market risk premium, using the incorrect calculation of the weighted average cost of capital itself and making incorrect country risk assumptions.
Let’s start with errors in the discount rate relating to the riskiness of the company. This may relate to using the incorrect risk-free rate for the valuation itself. This can arise when the historical average risk-free rate is selected rather than a rate whose time profile matches that of the cash flows. It is also a mistake to use the short term government rate rather than a longer term.
Mistakes can also be made when calculating the real rate using the incorrect beta for the valuation. When calculating the beta it is too easy to use a historical industry beat or an average beat for similar companies, despite the fact that the results appear out of line with the valuations of the comparable companies.
A similar mistake can be made when using the historical beta for the company. You should not assume that the beta that you calculate from historical data fully incorporates the country risk of the business you are valuing. This can lead to either over or under valuations of the company.
Another common mistake is using the wrong formula in your calculation. When de-leveraging your beta do not fall into the error of assuming that a beta for a company in an emerging market is comparable with one calculated on the companies of a major developed market index. This is to confuse apples and pairs.
It is also a common mistake when making a valuation in an acquisition scenario to use the beat of the company making the acquisition, in order to value the target company. It is a mistake to confuse the market risk premium with the equity premium. They are different and one should not impute one from the other. Equally, you should not assume that the market risk premium is zero.
Incorrect calculation of the weighted average cost of capital (or WACC) is another common valuation error. This can start with something as simple as an incorrect definition of the weighted average cost of capital. Make sure that you understand what it is you are calculating before you begin. Ensure that the debt to equity ratio you use is consistent with the balance sheet weightings of the company you are valuing has a reality check. Your calculated weightage average cost of capital should not be lower than the risk-free rate. If you are valuing different businesses in a diversified company, each business should have its own WACC calculated separately. You can also go wrong when the debt value in the business is impaired. If the debt’s market value is different to the book value of the debt, this will distort your debt equity ratio calculation.
Do not arrive at a WACC by assuming a capital structure and deducting the outstanding book value of the debt from the enterprise value of the business.
Incorrect country risk assumptions are also a common source of valuation mistakes. The most obvious mistake here is not to consider country risk at all. Do not assume that any major adverse change in an emerging market will necessarily result in an increase of the beta with respect to leading developed market indices. Equally, an agreement with a government agency does not eliminate country risk by implied underwriting of the prospects of the business with whom the agreement has been made. Do not assume that the beta provided to you include country risk, illiquidity premium and small cap premium. You should only include an illiquidity small cap or specific premium when it’s appropriate, but not automatically.
These additional premiums are not automatically relevant, and you should consider what is appropriate on a case by case basis. Equally, a small cap premium is not equal for all companies and should be evaluated on a separate basis for each company being valued.
So let’s summarize what we’ve covered. We have looked at some of the different ways in this section of valuing a company using the balance sheet, the profit and loss account, and the free cash flow from the business. And of the three, I hope you agree that the free cash flow is by far and away the best way of doing it, with EBITDA x multiplier the second best. As pointed out earlier, it is important to apply several valuation methods to come up with a range as this gives a much broader perspective on the value of a company and helps down the road of finalizing the deal. So that is it for the valuation.
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