Michael’s M&A Playbook: Company Valuation
Company valuation is a fundamental business topic. Boards, executives, and employees focus their planning and actions on increasing the company's value. But how do you calculate it? In this article, we dig into the details of intrinsic and market value and show you the most common valuation techniques. You need those methods during the whole M&A process: For the term sheet (where you include a purchase price), during the negotiations (to finalize the purchase price), and for the valuation topics in accounting and financing after the closing.
Valuing a company in M&A deals can be challenging. First, you have to choose which method you use, which is already difficult because there are many different approaches. Secondly, each of those valuation techniques has its difficulties and subtleties. With each method offering its advantages and disadvantages, finding the one that best suits your unique situation is essential but can be complicated.
This section explores the main valuation methods used in M&A deals, including their advantages and disadvantages. From asset to income valuation, we'll break down each approach and provide you with a roadmap of what to expect. Whether you're a buyer or a seller, understanding these methods is critical to making informed decisions and negotiating a successful deal. Let’s start with the difference between intrinsic and market company values.
Intrinsic Value vs. Market Value
Intrinsic value and market value are two different concepts used to assess the value of companies. Let’s look at them closer.
Intrinsic value refers to the underlying value of a company based on its fundamental characteristics, financial performance, and potential future cash flows. It is an estimate independent of investor sentiment. The market value, however, represents the current price at which a company can be bought or sold in the market. It results from supply and demand forces and reflects investors' perceptions, expectations, and sentiments. Various factors, including market conditions, investor behavior, economic trends, news, and other external influences, affect the market value, which can fluctuate significantly.
To summarize, the intrinsic value is what you calculate as the value; the market value is what buyers are willing to pay. Those two numbers can be very different. For example, when senior executives talk about the undervaluation of their companies, then they believe that the intrinsic value is significantly higher than the market value and vice versa.
Next, let’s take a look at some of the valuation techniques.
Asset Valuation
Asset valuation is an easy and commonly used method in M&A deals; however, it has its limitations. This approach looks at the company's value based on its tangible and intangible assets, such as equipment, buildings, patents, trademarks, and copyrights. People use the asset valuation method predominantly when a company has significant tangible assets, such as real estate or manufacturing companies. The valuation approach is less appropriate for companies with significant intangible assets, such as technology firms, as it tends to undervalue the potential value of these assets.
You can use asset valuation in several ways, including the book value, adjusted book value, replacement cost, and liquidation value. The book value approach takes the value from the balance sheet. In contrast, adjusted book value incorporates the current market value of assets by adjusting their value to reflect their fair market value. Replacement cost valuation estimates the cost of replacing assets in the event of loss or damage. Liquidation value assumes that you close the company and sell them on the market.
Asset valuation is a straightforward method that does not rely on future projections. Additionally, it provides a clear picture of a company's tangible assets and can help identify opportunities for cost-cutting or asset optimization. However, this method does not consider a company's future growth potential or intangible assets that are not on the balance sheet, which can lead to the company's undervaluation.
Market Valuation
Let’s move on to market valuation. This method assesses a company's value based on current market conditions using metrics such as the price-to-earnings ratio, price-to-sales ratio, and price-to-book ratio. The price-to-earnings ratio compares a company's stock price with its earnings per share, while the price-to-sales ratio compares its stock price with its revenue per share. The price-to-book ratio measures a company's stock price with its book value per share. You can also use these ratios to benchmark similar companies in the same industry.
Market valuation has advantages as it is a widely accepted method that can provide a basis for negotiations between buyers and sellers. However, market valuation can be affected by market conditions that can change rapidly, leading to significant swings and over- or undervaluation of a company.
Income Valuation
Income valuation is one of the methods that I often use in M&A transactions. It is a method that considers a company's future cash flows to determine its value. By evaluating a company's potential to generate future revenue, earnings, and cash flow, income valuation can provide a more accurate assessment of a company’s intrinsic value.
When people talk about NPV (Net Present Value) and DCF (Discounted Cash Flow) methods, they use the income valuation approach and apply the concept of the time value of money. The EVA (Economic Value Added) is calculated by using the NOPAT (Net Operating Profit After Taxes) and reducing it by a finance charge (i.e., multiplying the invested capital with the weighted average cost of capital). It looks initially different, but the DCF is mathematically equivalent to the discounting of the EVAs.
Let’s discuss the idea of the time value of money and WACC (Weighted Average Cost of Capital) more.
Time Value of Money
The time value of money is a fundamental concept in valuation. Investopedia explains it the following way:
“The time value of money (TVM) is the concept that a sum of money is worth more now than the same sum will be at a future date due to its earnings potential in the interim.”
Let me give you an example: You take $1 now, invest it, and get a yearly return. Let’s assume you get a 5% annual return, meaning you will have $1.05 in one year, $1.10 in two years, and you will have doubled your money in year 15. Taking this approach, when you forecast to get $1 in the future, it is now worth less than that amount considering the interest. It is why methods such as the DCF method apply this concept and discount future cash flows to the current value.
What is the discount rate that you should use? It is the weighted average cost of capital (WACC) that I mentioned before. It is, in essence, the combined discount rates of equity and debt instruments.
Not every valuation method uses the time value of money. For example, if you take an asset-value approach, you look at current and not future values. Therefore, there is no need to discount the amounts. The same applies to the comparable transaction analysis, which we will discuss next.
Comparable Transaction Analysis
Another popular valuation method used in M&A deals is comparative transaction analysis. This method compares the company's sale price, i.e., the price that an M&A transaction achieves, with similar recently sold businesses. Comparable transaction analysis is always helpful and especially useful when a company has a short history of generating cash flows, such as a startup or a company in a rapidly evolving industry.
One common metric is the EBITDA multiple, which takes the sales price of a comparable M&A transaction and divides it by the EBITDA of the company that was sold. You will find this metric in many M&A discussions and articles. It is a simple but helpful approach, and I often use this method in my M&A deals.
One of the challenges is that comparable transactions may not always be available for analysis. In such cases, other valuation methods may need to be used to determine the company's worth.
Factors that Affect the Valuation
Each valuation method has its strengths and weaknesses. Because of that, it's necessary to factor in other critical elements that could impact the valuation process of a company.
Industry trends and current market conditions are two such factors. The value of a company is inherently tied to the larger economic environment and the current market trends. A company in a growing industry may be worth more than a company in a stagnant or declining industry, even with similar financials. Current market conditions during the acquisition can also significantly influence the valuation because they often affect the planning assumptions for the following years. Those two factors make forecasting difficult and sometimes create quite different valuation outcomes depending on which studies you use for the economy, industry, and specific market. It is also the reason for calculating different scenarios and valuations.
Another critical element to consider is the company's intangible assets, such as brand value, intellectual property, customer base, and employee knowledge. These intangible assets can be challenging to quantify.
Lastly, regulatory and legal factors can also impact the valuation during an M&A deal. Legal issues such as pending lawsuits or regulatory changes may affect the company's valuation and influence the selected valuation method. The acquirer must understand the potential risks and liabilities associated with the target company, which may, in turn, affect the deal's final value.
Which Method Should You Use?
While many methods exist to value a company in an M&A deal, other critical factors, such as industry trends, intangible assets, and legal issues, must be considered to accurately determine a company's worth.
One important tip is to use methods that people understand. I have used many approaches over the years, some of which are complex. For example, I calculated company values with the CFROI (Cash Flow Return of Investment) and used the Monte Carlo Simulation in the past. The Monte Carlo Simulation calculates thousands of scenarios instead of only three (e.g., a pessimistic, realistic, and optimistic case). The valuation techniques were helpful to me, but it was very difficult to present them to non-finance people. The CFROI includes a long list of potential adjustments, and the Monte Carlo Simulation is, in principle, easy, but it is challenging to go through the specific assumptions.
Most people who work with M&A know asset-valuation methods, understand discounted cash flows, and apply comparable transactions such as the EBITDA multiple. I propose to use them and add other techniques if needed.
Valuing a company in M&A deals is not easy, but by understanding the various methods available, you can make an informed decision that best suits your unique circumstances. Whether you opt for the asset, market, income valuation, or comparable transaction analysis, take the time to weigh the pros and cons of each. Since each method has advantages and disadvantages, I suggest using different techniques for each target and comparing the results.
