This guide will give a cursory review of some of the popular valuation methods in M&A transactions.
Preliminary Considerations: Liquidation Value or Value as a Going Concern
Generally, when valuing a company, there are two different ways to approach the valuation of the company: the first is the liquidation value of the company, and the second is the value of the company as a going concern. Most often in a mergers and acquisitions transaction, the target business will be valued as a going concern, unless the target company is in distress and the acquiring company is purchasing it to strip it down and sell the assets, or to remove it from the market as a competitor. The liquidation value is most accurate for distressed companies, or companies that require restructuring. When a company is valued as a going concern, the assumption is made that the company will continue operating throughout the foreseeable future, adding to its value beyond just the sum of its assets. When undergoing valuations for companies that are being valued as a going concern, the acquiring company will be looking at the earning power of the business, as well the cash generation capability of all of the assets that make up the operations of the target company. When the target company is valued as a going concern, rather than through liquidation value, non-operating or intangible assets will be included in the valuation, including such items as: brands, trademarks, patents, interests in other companies, customer and supplier relations, skill of management and expertise, technology, industry know-how, infrastructure, etc.
Price Earnings Ratio
The P/E Ratio is the comparison of the company's current share price to its per-share earnings. The P/E Ratio is expressed as follows: Market Value per Share / Earnings per Share (EPS). Usually, the EPS is calculated from the last four quarters of the company's performance, but can also be calculated by estimating the company's earnings over the next four quarters, or a combination of the previous two quarters and the estimates for the next two quarters. A higher P/E ratio signals an expectation by investors for a high earnings growth in the future compared to those companies that have a lower P/E ratio. When valuing a company's P/E Ratio, it is most useful to compare to the ratios of companies in the same industry, or against the company's historical P/E Ratio. The P/E Ratio also signals how much investors are willing to pay per dollar of earnings. P/E Ratios can be easily manipulated via a company's accounting practices however, so it is important to not depend on this method alone.
Enterprise Value to Sales Ratio
This ratio is a valuation measure comparing a company's enterprise value to the sales of a company. This ratio is used by investors to get a base estimate of the price it would cost to buy the company's sales, and generally, the lower the EV to Sales ratio is the more attractive or undervalued the company is believed to be by possible acquiring parties. A company can essentially be bough by its own cash if the EV/Sales measure is negative - meaning that the cash in the company is greater than the market capitalization and debt structure. EV/Sales is often more accurate than the price-to-sales valuation method (which uses the market capitalization rather than the enterprise value of the company), due to the fact that market capitalization does not incorporate the level of debt a company has as well as the enterprise value of the company does. EV/Sales measurements are not always telling of the company's position, however, as a high ratio could mean that investors believe future sales could greatly increase, and a lower ratio may even signal unattractive future sales prospects. The EV/Sales Ratio equation is expressed as follows: (Market Capitalization + Debt + Preferred Shares - Cash and Cash Equivalents) / Annual Sales
Valuation based off of the book value method works best for those firms that do not have intangible assets, and important assets such as intellectual property, trade secrets, brand value, and the competency of the managers and officers are ignored in the valuation. The book value will also depend on which of the varying accounting practices the company uses. Liabilities are often in dispute when negotiating a valuation in a mergers and acquisitions transaction when using book value.
Liquidation value is the value of the sale of assets at a certain point in time via the use of an appraiser or appraisers. Usually this method will be utilized for firms in financial distress, or have an uncertain future. Often, it is difficult to get a consensus between the parties as liquidation values tend fluctuate with the appraiser, and such factors need to be taken into consideration such as the physical condition of the assets, or in some cases, the age of the assets. Furthermore, some appraisers may ignore the value of certain intangible assets.
Market Value of Securities
The market value of traded securities is most often used to assess the value of the company's equity by taking the stock price and multiplying it by the outstanding shares. Another way to value an enterprise is by further adding the market value of debt as the price per bond multiplied by the number of bonds outstanding. The book value is frequently close to the market price of a bond, and as such, the book value of debt can be used as a reasonable proxy for its market value. In the opposite, book value per share of equity is rarely close enough to its market price to be a reasonably good estimate. For this method to be used accurately, it is necessary for the stock to be publicly traded and analyzed by securities analysts, and is not available for privately held companies. This is further based on the efficient market hypothesis, and that all necessary materially important information is reflected in the price of the equity. When negotiating a mergers and acquisitions transaction, the company selling its equity (and the equity holders) will generally receive what is called a "control premium." A control premium is often around 30% to 50% more than the price of the equity one day before the merger or acquisition announcement. The control premiums are due to the equity holders of the target company not being willing to sell unless they benefit more from such a sale, such a control premium is a way of making it more beneficial to the selling equity holders than not selling the company. The control premium is further based on the rarity of assets, including the intangible assets, and the saturation of the company's assets within the market and owned by competing businesses, the financial resources of the company making the bid, or over-inflated market prices.
This method is based off of the cost of replacing the target company. This method is not used as often anymore, and as such the discussion on this method will not be as detailed. The replacement cost method works on a most basic level by the acquiring company forcing the target company to sell at the price of its equipment and staffing costs, or else the acquiring company will form a competitor for the same price and force the target company out of business. This method is least effective when merging or acquiring a service industry based business.
Discounted Cash Flow
The principle behind this type of valuation is that a business's value is based on that company's ability to generate and grow its cash flow for the providers of the capital. In mergers and acquisitions transactions, this method is used to determine the enterprise value by estimating future cash flows over the horizon period (explained later), calculating the terminal value at the end of that period, then the forecasted free cash flows and terminal value are discounted to the present value of the company's weighted average cost of capital. Free cash flow is the cash generated by the business available to be distributed to all providers of capital to the business. The terminal value is the value at the end of the free cash flow projection period (also known as the horizon period), and the discount rate is the rate used to discount the projected future cash flows and terminal value to their present values. If done correctly this method is one of the most valuable tools when valuing the enterprise value of a company, due to this method being: forward-looking and less dependent on historical results; inward-looking and less influenced by external factors; based on cash flow and less affected by accounting practices and assumptions; operating strategies able to be factored into the valuation; and allowing different components of a business to be valued separately. However, one must be wary when using this method as the quality of the assumptions made when calculating the free cash flow, terminal value, and discount rates are integral in assuring an accurate valuation.
This is only a basic and cursory review of some of the ways to value a business, and is by no means exhaustive. It is important to remember that your individual circumstances dictate what is best for you and your company, and it is highly recommended that you consult with an experienced business law attorney to ensure your transaction is handled correctly and effectively.
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