Business valuation as part of the M&A process
The process of Business Valuation is integral to the “due diligence” process for the acquisition or sale of a business. The valuation determines an entity’s value and underpins the decision to buy or sell. Regardless of whether you are buying or selling, an objective and accurate Appraised Value is critical to any transaction.
A business valuation is the process of determining a value for a business that does not trade publicly or is privately held. Fintalent’s Business Valuation Consultants admit that Valuing a business can be challenging if there are no or little comparables to compare it to. For example, if you want to value an antique shop, where most of their inventory is unique and can’t be easily compared to similar businesses in the marketplace, you’ll need to use more subjective factors in your analysis.
Overview of business valuation methods
When valuing a privately held business, you can compare the company to public companies that have gone through a similar business transition. The process involves collecting information about the comparable company, which is then used to estimate the value of your private company. Keep in mind that this method doesn’t take into account the unique aspects of your private company.
Comparable company analysis is a valuation technique used to determine the value of a privately held company by comparing its financial performance against other companies similar in size and industry within its peer group. This technique considers both the common aspects of these companies as well as those that are specific to your firm.
An important note: when performing comparable company analysis it is critical to remember that taking into account one or two external factors can have a large effect on the resulting value of your private company. For example, benchmarking a private company against publicly traded companies is not necessarily a good idea because it will take into account situations that have nothing to do with your company. In such cases, you need to perform more sophisticated analyses such as discounted cash flow to determine the value of your firm.
In addition to the method of valuing your business, there is also some general information that you should consider as you prepare for your valuation. Keep in mind that there are many similarities between private and public companies and that it’s not necessary or recommended that you perform an industry type analysis when valuing a company. This will depend on the unique situation of your firm and its products/services.
Regardless of the type of analysis that you perform, you will inevitably discover some weaknesses in your business. You should take the necessary steps to remedy these issues before moving forward with the valuation process. This is especially important if you are planning to raise capital for your business.
If you want to understand the value of a business, there are two general approaches to take. One is to use a discounted cash flow analysis, which estimates the expected future profits and then discounts them back to present value; this approach will be less accurate if there’s uncertainty in the projections. The other is to look at comparable transactions that have taken place in the marketplace, which is often called an acquisition price multiple method or “APM” and which will be more accurate for companies with stable cash flows.
The vast majority of mergers & acquisitions involve an APM since calculating future cash flows can be complex in most cases. Applying the appropriate valuation multiple is sometimes a subjective process and there may be more than one way to build the relevant comparable set. The key point is that certain companies within a sector or industry group may be more complex to value than others, and their multiples will differ accordingly. If two companies are relatively similar, except one is much more profitable than the other, the less profitable company will typically be sold at a lower multiple.
In cases where there is little to no comparable market for an asset (usually real estate or construction), the valuation can become very subjective. There are generally two approaches to valuing these types of assets. The first is where an expert will determine what they believe the asset is worth based on their own experience or knowledge in the relevant area. The second is a ratio analysis that compares a particular property to one or more properties with known values. This can include looking at sales prices of comparable buildings in a similar area, or comparing renovation costs for comparable buildings with known costs, etc..
Example of an APM Calculation
Here is an APM calculation for a company in the auto industry. It is taken from a valuation of Xerox Corporation, which was completed by GMAC in 2002 but many of the assumptions are still relevant today.
To begin, Xerox’s estimated future annual revenues are $8,422 and its future annual expenses are $6,540; then it is discounted to today’s value with a 10% discount rate. The resulting free cash flow is $1,721 per year. Let’s assume the firm is sold in five years for $18,000, which is a 2.6 multiple of free cash flow; this would provide an estimated value of $12,000. At twice free cash flow would result in a value at least four times as high, and so on; this ratio analysis indicates that investors might expect a multiple of four times free cash flow to be reasonable.
To quickly review:
1) The total market capitalization is $5 billion. The GMAC analysts believe that the firm’s stock price should be not higher than 55% of total market cap (the analysts calculated this based on the company’s profitability and growth prospects).
2) The business has revenues of $842 million and expenses of $642 million.
3) The firm is expected to generate free cash flow in the future of $1,721.
4) A good multiple for this company would be a multiple of 2.6 times free cash flow, or a multiple of 2.6 times 10% of total market cap. So, if a buyer is willing to pay $18 billion for the business, then it would account for 2.6 times Xerox’s free cash flow of $1.721 billion, or $4.437 billion. That would be a reasonable purchase price for the company; it is not likely that Xerox could sell for more than that at this point in time without its business suffering.
The valuation of hedge funds and private equity firms is more complex because there are many different types of fees structure as well as multiple LPs with differing rights and withdrawal delays.
First we must state that the value we place on a private equity investment is based on our view of future performance. Therefore, if bond yields are going up and we expect the bond market to become more sticky and thus favor buybacks as much as new equity issues, we would be looking at a situation where values need to converge. The same happens when valuations do not converge.
Types of PE funds
The Value of an investment in a private equity fund depends on its four main components: Investment Multiple, Time Horizon, Future Cash Flows & Risk. Investment multiples vary from 6x to 15x. Up to a point, a 6x multiple is reasonable because the funds have a high degree of leverage and therefore can deliver a lot of excess returns. However, if an investor expects less than 20% returns after 5 years, then that investor is probably better off with a longer time horizon. Some investors seek 3-5 year time horizons for true value creation and longer periods of “busts” whereby cash flows may be negative but can recover in the future. Therefore, value can maintain a positive trend for years.
The liquidity of the investor also has an impact on PE investments. Historically, U.S.-based investors have been average to poor in terms of liquidity, but overseas investors are now beginning to buy more actively and sit atop portfolios. In theory, these buyers are able to take advantage of longer time horizons, but also take a risk that they cannot find close substitutes for their investments in future years. The question then arises, do they feel that they can get out before the 5-year mark? The answer will be yes if these new investors have access to secondary markets or future liquidity puts. It is our view that most U.S.-based investors will want to get out after 5 years and will welcome these additional liquidity options.