Key Valuation Techniques for M&A

Accurate valuation of a business, assessing how much a company is worth at a particular moment in time, can be challenging but is necessary if you are to negotiate mergers and acquisitions (M&A). Reliable valuation methods are essential if we are to arrive at a mutually agreed price that is based on logic and not emotion – and when people are selling their businesses, there is often a lot of emotion involved.

The Importance of Valuation in M&A Transactions

Accurate determination of the value of a company is a critical element of M&A deals. It underpins the entire process, facilitating informed negotiations, ensuring fairness to all stakeholders, and helping to secure finance.

Accepted valuation methods aim to establish fair market value for a target company. Different methods may be used, some looking at potential future earnings and others at the value of existing assets, for example. Arguably a mix of methods gets best results.

Combining Multiple Valuation Techniques for M&A

If you rely on just one company valuation method, you only look at the target company from one angle. Using a number of valuation models allows you to get a more rounded view and avoid either overpaying, or losing a deal because undervaluation resulted in making too-small offer, which insulted the seller and caused them to walk away.

3 main valuation techniques for M&A

The types of valuation methods typically used fall under three main umbrellas: market driven; earnings driven; and resource based.

Market-Driven Valuation Techniques

Market-driven methods arrive at a valuation as a result of comparing a target company with other, similar companies operating in the same marketplace to establish a comparable market price. You effectively establish a benchmark against which value can be measured.

The most common methods used when taking a market approach are comparable company analysis, which operates on the presumption that comparable, or similar, companies will have similar valuation multiples, and precedent transaction analysis, which assumes that historical M&A transactions can be used to value a company in the present day.

Other widely used valuation methods include price-to-earnings ratio (P/E ratio), which compares share price of public companies to the profit a buyer can expect to make, generally using figures realised over the previous twelve months, and EBITDA (earnings before interest, taxes, depreciation, and amortization), the profitability of the company before items the owner has control over, such as interest on loans, are introduced.

Earnings-Driven Valuation Techniques

Valuation methods include discounted cash flow, or the DCF method, which estimates the current value of a target company based on its expected future cash flows. Once cash flow has been analysed, a discount rate, which is a measure of inherent risk, is applied. The cash flows of a business deemed to include more risk will be discounted more than one deemed to be more stable.

Resource-Based Valuation Methods

Resource, or asset-based valuation methodologies, are generally more commonly used with businesses that have significant amounts of physical, tangible assets – plant and machinery, or real estate, for example. They are also useful for establishing liquidation value.

Methods include revised net asset valuation, which determines a company’s worth after subtracting its liabilities from its assets; liquidation worth, which estimates net cash if all assets were sold and liabilities settled; and replacement cost assessment, based on what it would cost to replace the company’s existing assets with equivalent new ones. (This method ignores both depreciation and appreciation, unlike adjusted book value, which starts with the balance sheet and adjusts for market value of assets and liabilities to determine the value of a business.)

Key Insights from Contemporary Valuation Practices

The biggest challenge a business buyer has is agreeing a price with the seller. For key insights into contemporary valuation approaches, watch this video.

Valuation Based on Current Performance

A business has to be valued on its present state and current performance. It’s great if it was doing much better five years ago – but the owner would have benefited financially from that at the time, they can’t be paid again for it now. They also can’t be paid for what they think it might do in the future.

Prior growth rate and potential future growth prospects are not relevant to the current business enterprise value. All that matters is the present performance and condition.

Similarly, if you are able to achieve financial benefit as a result of synergies achieved by integrating a business with the acquiring company, that’s your gain; the seller does not get paid for that.

Challenges with Seller Expectations

Sellers often have unrealistic expectations when it comes to the value of their business. They look at what they did in the past and put a value on it. However, they have benefited from any past investment over the years in that they have been paid from the profits made by the business.

They also put a value on potential, but they are wanting to be paid for potential they haven’t realised – they expect you to put the work in to do that.

All this can be charged with emotion – people can be very sensitive when it comes to talking about their own business –and so you have to bring them back down to earth using logic and facts.

Potential vs. Actual Value

The people who focus on potential are generally people with a business that’s not doing very well. However, when it comes to the valuation process, we have to focus on the here and now, not the past and what’s gone into it. We also can’t value it on the future because at that time it won’t be the seller’s business, you can’t pay them for something the business is not but might become, that doesn’t make sense.

People say, ‘You must be buying the business for a reason, you must see potential.’

My response is, ‘Yes, I do see potential, but I can’t pay you for the potential that I see that my team are going to maximise. I can only pay you for what it is right now and if what it is right now is of modest value, that is the value; it can’t be valued on the future.’

Earn-Out Structures

There is one solution to the problem that bridges the gap and that is using an earn-out structure where part of the payment, sometimes a considerable part, is linked to the future performance of the business.

An earn-out strategy is flexible deferred consideration.

Consideration is what we pay for the business. The initial consideration is paid on day one; deferred consideration is paid later, over time, in line with a pre-agreed schedule.

With flexible deferred consideration we take things a step further: both the amount and timing of payments can change. Instead of it being a fixed amount every quarter or every year, it’s a flexible amount that changes, depending on the performance of the business.

Say the seller has been telling you about the amount of work that has gone into negotiations for contracts with a sizeable organisation, and that signing them is on the horizon, it’s pretty much guaranteed, and so the value of that work should be included in the valuation of the business.

The fact is, you can’t include that value because it’s not real yet. It might happen, it might not, there are no guarantees. But what you can do with an earn-out is say, ‘Okay, if the business does win those contracts then you will get paid more, but if they don’t come in, then I don’t pay out.’

Three key advantages of an earn-out are that you never overpay, the seller can achieve more, so your deal looks better, and you share the risk with the seller. It’s a great way of de-risking an acquisition.

Impact of Due Diligence

Due diligence will reveal the true state of a business. Your deal team will look at the business from a number of angles, examining the financials, checking the balance sheet, profit and loss and cash flow statements to establish financial performance, verifying legal status and contracts, confirming the value of a company’s assets, including intangible assets such as intellectual property, and more. All this will feed into the market value established.

Conclusion

M&A valuation methods are the key to establishing the present value of a business based on its performance in the prevailing market conditions.

Business valuation can be based on metrics including asset value, DCF analysis, comparable transactions, EBITDA, or P/E ratio. It’s best to use a mix of methods to get a clearer view. No matter whether you are aiming to buy just one business or building a group with a view to perhaps selling it to private equity, paying the right price for acquisitions is vital.

Having someone with years of experience in business mergers and acquisitions on your side can be a huge advantage. Jonathan Jay has helped more than 3,000 people buy successful existing businesses and become acquisition entrepreneurs, and he has put together the most comprehensive FREE package of business buying resources available today. To get started on your acquisitions journey, download your FREE Business Buying Toolkit now.