There are a number of ways to value a target company. While the most common is discounted cash flow, it is best to evaluate a number of alternative methods, and compare their results to see if several approaches arrive at approximately the same general valuation. This gives the buyer solid grounds for making its offer.
Using a variety of methods is especially important for valuing newer target companies with minimal historical results, and especially for those growing quickly – all of their cash is being used for growth, so cash flow is an inadequate basis for valuation.
If the target company is publicly held, then the buyer can simply base its valuation on the current market price per share, multiplied by the number of shares outstanding. The actual price paid is usually higher, since the buyer must also account for the control premium. The current trading price of a company’s stock is not a good valuation tool if the stock is thinly traded. In this case, a small number of trades can alter the market price to a substantial extent, so that the buyer’s estimate is far off from the value it would normally assign to the target. Most target companies do not issue publicly traded stock, so other methods must be used to derive their valuation.
When a private company wants to be valued using a market price, it can adopt the unusual ploy of filing for an initial public offering while also being courted by the buyer. By doing so, the buyer is forced to make an offer that is near the market valuation at which the target expects its stock to be traded. If the buyer declines to bid that high, then the target still has the option of going public and realizing value by selling shares to the general public. However, given the expensive control measures mandated by the Sarbanes-Oxley Act and the stock lockup periods required for many new public companies, a target’s shareholders are usually more than willing to accept a buyout offer if the price is reasonably close to the target’s expected market value.
Another option is to use a revenue multiple or EBITDA multiple. It is quite easy to look up the market capitalizations and financial information for thousands of publicly held companies. The buyer then converts this information into a multiples table, which itemizes a selection of valuations within the consulting industry. The table should be restricted to comparable companies in the same industry as that of the seller, and of roughly the same market capitalization. If some of the information for other companies is unusually high or low, then eliminate these outlying values in order to obtain a median value for the company’s size range. Also, it is better to use a multi-day average of market prices, since these figures are subject to significant daily fluctuation.
The buyer can then use this table to derive an approximation of the price to be paid for a target company. For example, if a target has sales of $100 million, and the market capitalization for several public companies in the same revenue range is 1.4 times revenue, then the buyer could value the target at $140 million. This method is most useful for a turn-around situation or a fast growth company, where there are few profits (if any). However, the revenue multiple method only pays attention to the first line of the income statement and completely ignores profitability. To avoid the risk of paying too much based on a revenue multiple, it is also possible to compile an EBITDA (i.e., earnings before interest, taxes, depreciation, and amortization) multiple for the same group of comparable public companies, and use that information to value the target.
Better yet, use both the revenue multiple and the EBITDA multiple in concert. If the revenue multiple reveals a high valuation and the EBITDA multiple a low one, then it is entirely possible that the target is essentially buying revenues with low-margin products or services, or extending credit to financially weak customers. Conversely, if the revenue multiple yields a lower valuation than the EBITDA multiple, this is more indicative of a late-stage company that is essentially a cash cow, or one where management is cutting costs to increase profits, but possibly at the expense of harming revenue growth.
If the comparable company provides one-year projections, then the revenue multiple can be re-named a trailing multiple (for historical 12-month revenue), and the forecast can be used as the basis for a forward multiple (for projected 12-month revenue). The forward multiple gives a better estimate of value, because it incorporates expectations about the future. The forward multiple should only be used if the forecast comes from guidance that is issued by a public company. The company knows that its stock price will drop if it does not achieve its forecast, so the forecast is unlikely to be aggressive.
Revenue multiples are the best technique for valuing high-growth companies, since these entities are usually pouring resources into their growth, and have minimal profits to report. Such companies clearly have a great deal of value, but it is not revealed through their profitability numbers.
However, multiples can be misleading. When acquisitions occur within an industry, the best financial performers with the fewest underlying problems are the choicest acquisition targets, and therefore will be acquired first. When other companies in the same area later put themselves up for sale, they will use the earlier multiples to justify similarly high prices. However, because they may have lower market shares, higher cost structures, older products, and so on, the multiples may not be valid. Thus, it is useful to know some of the underlying characteristics of the companies that were previously sold, to see if the comparable multiple should be applied to the current target company.
Another possibility is to replace the market capitalization figure in the table with enterprise value. The enterprise value is a company’s market capitalization, plus its total debt outstanding, minus any cash on hand. In essence, it is a company’s theoretical takeover price, because the buyer would have to buy all of the stock and pay off existing debt, while pocketing any remaining cash.
Another way to value an acquisition is to use a database of comparable transactions to determine what was paid for other recent acquisitions. Investment bankers have access to this information through a variety of private databases, while a great deal of information can be collected on-line through public filings or press releases.
The buyer can also derive a valuation based on a target’s underlying real estate values. This method only works in those isolated cases where the target has a substantial real estate portfolio. For example, in the retailing industry, where some chains own the property on which their stores are situated, the value of the real estate is greater than the cash flow generated by the stores themselves. In cases where the business is financially troubled, it is entirely possible that the purchase price is based entirely on the underlying real estate, with the operations of the business itself being valued at essentially zero. The buyer then uses the value of the real estate as the primary reason for completing the deal. In some situations, the prospective buyer has no real estate experience, and so is more likely to heavily discount the potential value of any real estate when making an offer. If the seller wishes to increase its price, it could consider selling the real estate prior to the sale transaction. By doing so, it converts a potential real estate sale price (which might otherwise be discounted by the buyer) into an achieved sale with cash in the bank, and may also record a one-time gain on its books based on the asset sale, which may have a positive impact on its sale price.
If a target has products that the buyer could develop in-house, then an alternative valuation method is to compare the cost of in-house development to the cost of acquiring the completed product through the target. This type of valuation is especially important if the market is expanding rapidly right now, and the buyer will otherwise forego sales if it takes the time to pursue an in-house development path. In this case, the proper valuation technique is to combine the cost of an in-house development effort with the present value of profits foregone by waiting to complete the in-house project. Interestingly, this is the only valuation technique where most of the source material comes from the buyer’s financial statements, rather than those of the seller.
The most conservative valuation method of all is the liquidation value method. This is an analysis of what the selling entity would be worth if all of its assets were to be sold off. This method assumes that the ongoing value of the company as a business entity is eliminated, leaving the individual auction prices at which its fixed assets, properties, and other assets can be sold off, less any outstanding liabilities. It is useful for the buyer to at least estimate this number, so that it can determine its downside risk in case it completes the acquisition, but the acquired business then fails utterly.
The replacement value method yields a somewhat higher valuation than the liquidation value method. Under this approach, the buyer calculates what it would cost to duplicate the target company. The analysis addresses the replacement of the seller’s key infrastructure. This can yield surprising results if the seller owns infrastructure that originally required lengthy regulatory approval. For example, if the seller owns a chain of mountain huts that are located on government property, it is essentially impossible to replace them at all, or only at vast expense. An additional factor in this analysis is the time required to replace the target. If the time period for replacement is considerable, the buyer may be forced to pay a premium in order to gain quick access to a key market.
While all of the above methods can be used for valuation, they usually supplement the primary method, which is the discounted cash flow method.