By Jonas N Olsen, Novell Corporate Development
There could be several reasons to perform a valuation of a business. The business might be for sale, it might be raising money or preparing an IPO, or it could be attempting to restructure debt. The business could also be in litigation and requiring an assessment of the case impact on the value of the business.
Environment
Before performing a valuation, it is important to first look at the environment in which the company is operating. Looking at the following fundamentals will form a solid base for starting valuation considerations:
What is the current economic environment? Where is the economy in terms of the growth cycle?
Is company’s industry cyclical and secular? How effected is it by the current environment?
What do the current economic forecasts tell us? There are no guarantees, of course, but it is important to get a sense of what underlying growth can be expected.
Global and industry specific M&A activity and evolution of multiples. Which way is the momentum pointing?
Credit market conditions and access to funding. Can companies readily access funds?
Is there a major global pandemic? Geo-political tensions?
This forms the foundation from which to start the valuation process. The next step is to choose a valuation method, or perhaps, a combination of them. Let’s look at the more common approaches to valuing a business or an asset.
Valuation Methods
One way to get started is to ask, “what would it cost to build or replace this asset?”. This can be useful in some cases where there is a build vs. buy option, such as in expansion of a retail franchise, or in building a plant. But in many situations, the reasons a business is a target for acquisition, is exactly that it can’t be easily build or replaced, in which case this method falls flat.
Second, we can look at relative value options for pricing a business. In this scenario, we will look at comparable business valuation or precedent M&A transactions. Comparable valuations are most commonly available in the public markets, where the actual value of the company can be derived based on the published equity value. This method is typically only relevant for larger companies. If a company is in the same market as a public company, but is much small, a direct comparison to the public company value does not hold much benefit. Smaller companies are typically valued at lower multiples, just by nature of having smaller market share and less rigorous auditing of financials. The smaller company, ceteris paribus, will also be more volatile in a crisis or down market. Another relative value option is to look at precedent M&A transactions. We would look for other, similar M&A transaction in the same marketspace, for the same size of company, and, generally, in the same geography. If such example(s) is available, it can be a good guide, but, again, care should be taken to make sure we are comparing apples to apples.
Finally, we can look at the intrinsic value option for establishing the worth of a business or asset. Here we look at the historical performance of the business, we make assumptions (carefully and well defined) about the future performance, which will lead us to an estimate of future cash flows. These future cash flows to the firm (FCFF) are then discounted back to a present value of the company today. This is an excellent and reliable way to estimate a value of a business, but it is often compromised by the lack of availability of clear data. Perhaps the target company is itself a newly formed entity from a merger or spin-out. Perhaps it is growing very fast, which makes predicting future performance less reliable. Or perhaps you simply don’t trust the available accounting data.
Reality
Putting a value on a business is part science – part art. In most situations, we do not have the full picture; we do not have all the data, we would like. Instead, we piece together a picture of the business, though financials, presentations, documents, IP filings, conversations with the acquirer’s and target organization’s staff and executives, which leads to an overall sense of the target company. Once we arrive at a number or a range, we can sanity check it against common multiples. Most businesses will know what it’s key multiple will be, should it be put up for sale. It could be a multiple of revenue, or of EBITDA, or it could be a multiple of capital employed. The target company’s contribution, once acquired, will live under this valuation assumption, and as such, should be evaluated in the same way. Let’s say a private company considers that it could be sold for 12x EBITDA. If it acquires a stable business at less than that multiple, it will automatically create value, assuming it can continue or improve the business plan. If, however, it decides to acquire a business at a higher multiple, it will need to be convinced that the target will grow significantly, to make up for the (hopefully short term) value destruction the transaction would result in.
Ideally, unless we are convinced of a significant growth scenario for the target company, we will want to acquire businesses at a lower multiple than what the acquiring business assumes it is able to garner. This is the key source of value creation in the M&A process.
Takeaway
M&A valuations are part science/part art. We often operate with imperfect information and will have to piece together a picture of the target business. Ultimately, we make a number of assumptions about how the business will perform, and how the acquiring entity can accelerate value creation. The intent is to strike the right balance between being careful and taking a measured risk. It is hard to go back on a bad deal – but it is equally hard to watch a good deal slip away.