By: Robert C. Hackney
There are various approaches to valuation in dealing with a merger or acquisition. The purpose of this blog post is not to teach you formulas or to go through the mechanics of spreadsheet analysis, but to give you an overview of the various ways of looking at valuation and to discuss why some methods of valuation are used more frequently than others.
The first warning that I have for you is that a seller of a business will initially have an over inflated opinion of the value of his business. This is simply because it is such an emotional issue for a seller who has created or grown the business from sometimes absolutely nothing to where it is today. The seller, having gone through the hard times and the periods when he didn’t know whether or not he was going to make it, places a very high value on his business that the marketplace really doesn’t take into account. So, the first hurdle you have to get over as a seller or a buyer is to get past the emotionalism in this issue and get down to the cold hard facts of what the marketplace is willing to pay for a business based upon a number of standard factors.
Since valuation is nothing more than an opinion of what a company is worth, it is equivalent to an appraisal of real estate, which again is nothing more than some professional’s opinion of what the real estate would bring in the marketplace. A seller should be leery of an intermediary who wants to help him place a value on his business, because in some circumstances, the intermediary is doing nothing more than looking for a listing and is more likely to tell the seller what he wants to hear about the opinion of the value of the business. It’s somewhat similar to the management consultants that I have hired in connection with analysis of law firms. They go around and interview all of the partners and ask them for the good news and the bad news and then regurgitate all that information in a pretty brochure that is attached to a $25,000 bill for services rendered. A frank discussion between the parties would be cheaper, faster and more efficient.
My advice to a seller is that he needs to employ a professional valuation expert who has nothing to gain by what he views as a favorable opinion of value because his opinion is not tied to a commission on the sale of the business. Secondly, I would suggest that when a seller is shopping for a valuation expert, that the seller realize that there are specialists that deal only with certain industries. Some valuation experts deal only with professional firms such as accounting firms and law practices. Some deal with just retailing or pharmaceuticals or the manufacturing industry generally or within some subspecialty of manufacturing. You really should shop around for a good valuation expert in your field and watch out for the “jack of all trades” valuation expert that will place a value on your steel mill, your flower shop and also your pharmaceutical company.
Valuation Methods
Next, let me outline for you some of the traditional valuation methods as well as what appears to be now the most accepted method of valuation. Let me first say that you need to distinguish the difference in the terms “valuation” and “price”. The buyer and the seller will each come up with what they believe to be the value of a company. They’ll then sit down together and discuss and negotiate regarding what the price of that company should be and obviously each party is going to have a range within which they will accept a price offered by the other party. Of course, price goes hand in hand with the terms of the purchase. Note that financing and structuring the transaction from a tax standpoint are not addressed in this blog post, and you will have to take some of the tax considerations into play when you talk about what the price should be.
Book Value
The first approach to value that I want to discuss is book value. Unless you are talking about a business that consists of totally liquid assets such as an investment company or in some cases a bank, the concept of book value is of little significance. Book value, as you know, is simply the net value as shown on the seller’s balance sheet once you subtract all of the liabilities from all of the assets.
Even in a situation involving a company that consists mainly of highly liquid assets, there will need to be adjustments made to the balance sheet if you are ever going to consider giving book value any significance whatsoever. Within the generally accepted accounting principles, there are provisions under certain circumstances for accelerated depreciation and variations on the way inventory is treated, whether it is booked as “last in first out” (LIFO) or “first in first out” (FIFO). There are also various methods for treating reserves that have the effect of inflating or deflating the company’s book value. In the vast majority of cases, however, the book value of the company will have little or no impact or significance when viewed in relation to the company’s earnings and consequently, most of the earnings based methods of valuation are generally viewed as more reliable and acceptable, and in today’s marketplace, the emphasis is less on hard assets and more upon the ability of the company to generate cash flow and earnings. Book value is really based on a liquidation value and takes no earnings capacity into consideration at all.
Delaware Block Method
Hardly worth mentioning is the Delaware Block Method. This method is not even used in Delaware anymore. I only mention it because someone might bring it up as a viable method of valuation. It is an old method that takes three valuation measures, net asset value, capitalized earnings and market value, and takes their weighted average to come up with a value. This method was used in the past simply because it was somewhat easy to calculate, but it has gone out of favor due to its obvious inadequacy.
Earnings Based Calculations
Even many of the earnings based calculations can be viewed as flawed because those methods are generally also measured by accounting standards. Variations in earnings calculations occur depending on which deprecation method is used by the accountants and whether they have used a LIFO or FIFO approach computing cost of sales. Consequently, in today’s marketplace some form of a discounted cash flow analysis is most commonly used.
Let me mention a few of the other methods before we go into the discounted cash flow technique. Two of the earnings based methods that are popular are “return on investment” and “return on equity.” The first of these, return on investment is computed by taking the net income divided by total assets. Return on equity is calculated or computed by net income divided by book value of shareholder’s equity. The difference in the two calculations is that total assets is used as the denominator in the return on investment calculations and shareholder’s equity is used as the denominator in the return on equity calculation.
The return on equity calculation is a calculation that is quite sensitive if leverage is involved in your transaction. The results can be somewhat misleading because return on equity will increase as the amount of leverage increases. The problem there is one of risk. If you leverage up your company so much that the debt is overly burdensome, the true value of the company should really decrease because you have substantially increased the risk of failure of the company, but the calculations will show that return on equity will be increased and consequently, I think that the results of that calculation are misleading and can tempt an investor to take risks that are unwarranted.
Price Earnings Ratio
A price earnings ratio is simply the number that is derived by dividing the purchase price of a company’s stock by one year’s after tax earnings. You can see the price earnings ratio or as it’s referred to its short form- the PE ratio, every day in the newspaper when you read about various public companies. For example, if you know the stock market has recently valued certain types of manufacturing companies at a price earnings ratio of 12 and you are looking at the same kind of manufacturing company, you would take the company’s earnings per share and multiply it by 12 to come up with a price for the company’s stock.
Once I dealt with a private acquisition where the buyer was originally taking that valuation method into consideration before we talked. He had studied the PE ratio for companies in the same industry as the company he wanted to buy and felt that a reasonable price could be computed simplistically by using the PE ratio. The first problem with that analysis was that my client was looking at a private company and not a public company. There is a substantial premium that can and should be paid on the stock of a public company due to that substantial liquidity provided by the public marketplace. Another problem is that no two businesses are alike, even if they are in the same industry and consequently I don’t think a PE ratio has any relationship to the future profitability or potential for a company, and of course that is what you are paying for. Again, the element of risk comes into play because no matter what price earnings ratio you think is appropriate, in your judgment as a buyer or a seller, the general rule is that the riskier the business, the lower the PE ratio.
I would advise a buyer to look at what the projected return on his investment into the company will be, and then compare that to other types of investments, such as government bonds and other safe liquid investments. Then interject the risk that is involved in the business that he will be acquiring. What you may find after taking this PE ratio approach and comparing an investment in the company to other types of investments, is that the risk may substantially outweigh the reward in that the same or similar reward may be available at a substantially lower risk.
The other problem with PE ratios is that it depends on which historical time period is used in evaluating the appropriate PE ratio for the type of company in which you are interested. During the 1980s, we experienced purchases of companies that when looked at on a price earnings ratio showed incredibly high PE ratios. During difficult economic times, such as the early 1990s, and the Great Recession in 2008, obviously, PE ratios are substantially depressed. Remember that you have to consider market conditions, as well as other situations such as the method of payment that will be used in the transaction, when considering PE ratios as a guideline to evaluation.
Discounted Cash Flow Method
The method that is popular and seems to reflect many of the important variables is commonly referred to as the discounted cash flow analysis method. The theory behind this method holds that a company is worth the present value of all of its future cash flow discounted back to the present as a specified rate and that rate is one that is proportional to the risk of the actual realization of the cash flow. The problem with discounting cash flow analysis is that like any other valuation process there are certain underlying assumptions and estimates that have to be made about future performance. While earnings based valuation methods can be viewed as flawed because of the variations that relate to generally accepted accounting principles, discounted cash flow analysis valuation can also be flawed if the underlying assumptions that are being made are not valid and if the estimates of future performance are inaccurate.
In the past, buyers of companies were willing to take those calculated risks, by trying to do their homework as best they could to make some determinations and assumptions about future performance. The discounted cash flow analysis method became popular based on the theory that the breakup value of companies was greater than the market value of such companies when viewed in their entirety. In other words, the sum of the parts exceeded the value of the whole.
On the positive side, the discounted cash flow analysis method does take risk into account, as opposed to the methods based earnings which actually excluded risk from their calculation. Since risk is usually viewed as a part of the economic value of an asset, then discounted cash flow analysis can be more accurate because a discount rate is selected that reflects the element of risk. Of course, variations on that discount rate may not reflect the appropriate amount of risk.
Discounted cash flow analysis also takes into account how leverage or debt affects the risk level. The discounted cash flow analysis method tries to determine an economic value by taking into consideration the fact that debt not only increases net income as long as the earnings generated by debt financing exceed interest expense, but also that debt increases risk and the increase in earnings will increase the discount rate and may not necessarily lead to an increased economic value calculated using the discounted cash flow analysis method.
In using an earnings based valuation method, the risk and the higher potentiality of insolvency due to the introduction of debt is not addressed, therefore an earnings based calculation will show that increased net income and will appear to show a substantial return without taking into consideration that the risk is greatly increased.
Another problem with earnings based calculations is that generally no consideration is given to the time value of money. Discounted cash flow analysis does specifically incorporate the idea that if you received cash today that such cash is worth more than the same amount which would be received a year from today, because that cash you received today can be invested and over the next year, will earn a return.
Discounted cash flow analysis is generally involved in forecasting what the cash flow will be for a certain period of time. That period of time may be a ten year period or a five year period, it’s generally is not beyond ten years. Of course, this doesn’t give the entire picture, because the value of a company may be greater than the amount of value that can be attributed to the cash flow over that time period. You have to take into consideration also that there is some residual value that is calculated and added to the valuation process.
Does the target company own unique technology? Is that technology something that could be categorized as a disruptive technology? Does the company’s intellectual property hold such a potential high value that it will affect your valuation? These are critical questions that you must take into consideration, and in some situations the anticipated cash flow may not accurately reflect the value of the company with its intellectual property. In such a case, the intellectual property should be valued separately by specialists in the particular industry.
Let me mention here that there are also numerous publications that you can obtain on your own that can be of great value to you. One of those, for example, is called The Handbook of Small Business Valuation Formulas and Rules of Thumb which was written by Glenn Desmond and John A. Marcell. Other helpful books are Handbook of Business Valuation by Thomas L. West and Valuing a Business by Alina V. Niculita. There are a number of other valuation handbooks that are available on websites like amazon.com.
Types of Buyers
There are different types of buyers and those buyers relate in different manners to the valuation process. What a seller obviously has to realize is that there are in essence two basic types of buyers, the operating buyer sees the target as a company that will fit with his existing operations and consequently he’d be willing to pay one price for the company. The other type of buyer is the investor buyer or the investor group that is generally a leveraged buyout type buyer and typically this is a group that wants to use a small amount of equity and intends to finance most of the purchase price with funds that are borrowed using the assets and the cash flow of the target as collateral.
While these investor groups generally buy a number of companies, for the most part they do not like to look towards the combination of any of their investments because they want to be able to dispose of each company separately and they don’t want to have to unwind or untangle the management or operations of any of their entities. If you are dealing with a “leveraged buyout” type buyer and you are a seller, what generally will happen will be that the investor group will do their analysis, then they will quickly try to get to the bottom line as to what the seller will accept. In the process, they will be analyzing how much debt the company can carry.
The bottom line is that if the investor group really wants the target, then they will find some creative way to justify the price that they will have to pay and they will, through various layers of debt, try to convince all of their lenders that the deal is worth the risk.
A substantial leveraged buyout usually includes at least two or three different types of debt and equity investors, each of which has somewhat different goals and objectives. Senior debt lenders generally are given the right to buy equity as part of their loan agreement. These are the most secured lenders and sometimes receive some type of equity as a kicker which generally tends to increase or boost their return. Subordinated debt is usually obtained from insurance companies or junk bond buyers who generally get equity kickers which boost their return into somewhere in the mid 20 percent area and then the management team of the company is usually an equity investor.
In most situations, the management team does not have a substantial amount of equity to contribute and consequently receives a smaller equity stake in the transaction. There are some variations on this theme depending upon whether or not the investor group is part of the management team.
Now let’s summarize. Remember the following:
Valuation firms specialize, use a specialist.
Valuation is phase one, which culminates in phase two, which is price.
The discounted cash flow analysis method of valuation has become the standard in the industry and seems to have the best chance of using all the variables that yield the most accurate valuation in today’s marketplace.
Investor buyers in LBOs will fit the maximum debt to the valuation process to see if they can buy your company with a small amount of equity.