Buy Side M&A Blog Series - Vol 7 - Valuing The Target
As investment bankers, RKJ Partners possesses a breadth of knowledge and experience in advising buyers on business acquisitions. In our latest blog installment, we define and outline the key elements involved in valuing a target company.
What is Valuation?
Valuation can be simply defined as the process of assigning an estimated dollar amount or range to the worth of an item, good, or service. To be more specific, business valuation is a process involving a set of procedures and approaches used to gauge the economic value of an ownership interest in a business as a going concern. Valuing a company is not a precise exercise, and best described as an art not a science. Business valuations are both formal and informal and serve multiple purposes, major categories include: taxes (gift/estate taxes, charitable contributions), financial reporting requirements (tangible/intangible assets, goodwill), litigation (shareholder disputes, divorce), and transactions (mergers and acquisitions, financings, employee stock ownership plans). For the purposes of this article, we will focus on valuation from the perspective of a merger and acquisition transaction, and specifically from the viewpoint of a buyer evaluating a business for sale.
As a part of the buy-side M&A process, once a buyer selects and decides to pursue an acquisition target, it is essential to reach a level of comfort that the business for sale has a reasonable chance of being successfully acquired. Confirmation that a buyer’s initial/preliminary view of what the target company is worth goes a long way towards establishing this level of comfort. It is important that the buyer’s deal team includes an experienced investment banking professional that can effectively and efficiently facilitate the appropriate business, financial, and valuation-related analyses during due diligence, and ultimately the completion of a business valuation. As a buy-side advisor, in addition to analytical support, the investment banker shields the buyer during the diligence and negotiation processes by working directly with seller to establish a framework and basis for assigning a value to the business. This valuation framework and basis is incorporated into the letter of intent (LOI) and purchase agreement, two legal documents signed by both the buyer and seller that layout the basic and detail terms of the business acquisitions.
How valuing a target works
An integral part of valuing a target company involves crunching the numbers. During preliminary due diligence, the view of valuation is often heavily contingent on the financial information provided by the seller. Sellers are often hesitant to provide in-depth, detailed financial statements without first feeling comfortable that the buyer can successfully close a transaction. As a result, a buyer’s view of the valuation may need to be refined multiple times as additional seller information is provided. Upon reaching the formal due diligence phase of the buy-side M&A process, the buyer hasthe opportunity to investigate the target company in a detailed, in-depth manner and his/her team is given access to financial statements, operating reports, and other private and confidential company documents (financial and non-financial). This financial information is used in various forms to conduct and complete analyses recognized as fundamental methodologies to arriving at a value for a business. Some methodologies are inappropriate for early stage businesses or those engaged in certain enterprises such as software development or financial services, where fixed assets are not usually important enough to use for purposes of valuation. Below are the six recognized methodologies with short explanations of each:
- Discounted Cash Flow (DCF) Analysis: This analysis derives an ‘intrinsic’ value of a company. This means that the method evaluates the future cash flow of the company and then discounts those cash flows to the present day. The advantage of this method is that it takes into account the development of the company, rather than simply the historical financials.
- Comparable Company Analysis: This analysis provides “relative” valuation. Essentially, comparable company analysis looks at the value of publicly traded companies. For an effective comparable company analysis, one should look at as many possible comparable companies. Averaging the multiples of the companies will also provide beneficial information. This is an easy method for a buyer to gain a strong baseline for potential transaction multiples.
- Precedent Transaction Analysis: Similar to the comparable company methodology, it also provides “relative” valuation. This method evaluates executed deals of both private and public companies. For a smaller sized target, this method can be beneficial due to the inclusion of private companies.
- Break-Up Analysis: In some cases, there is no comparable company to arrive at a possible transaction multiple. An example of this is a conglomerate, which might be involved in consumer products, financial services, and manufacturing. The valuation process entails the company being broken down by breaking up each business separately, valuing each one accordingly, and then adding them together.
- Book Value of Assets: This approach is particularly useful for companies such as manufacturers and warehouses, where the business is heavily dependent on its assets. This method looks towards the value of the company, if its assets were to be put together from ‘the ground up’.
- Leverage Buyout (LBO) Analysis: LBO analysis focuses on a company’s ability to generate cash flow. The method assumes leveraging, whereby the cash flow of the company is used to pay-off the debt—ultimately building equity. As a result, the value of the company lies in its ability to repay the debt.