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Mergers and acquisitions (M&A) play a significant role in the business landscape. Many consider M&A to be a mechanism that increases efficiency and effectiveness in a market economy. Typical M&A deals are complicated and time-consuming and can involve many parties, each with their own interests and motivations. Therefore, a proper valuation is one of the critical keys to success in every transaction. With accurate numbers on the table, the deal is more likely to end in a win for all parties involved.
In this article, we'll look at eight essential valuation methods. So, which one is right for your transaction?
General merger and acquisition valuation methods
Before we look at eight specific valuation methods, let's go over the three general approaches: cost, market and discounted cashflow.
1. The cost approach
A company's balance sheet is a logical starting point when it comes to estimating value. But many items might require adjustments to bring them in line with the current market value. Also, some items like intangible assets won't appear on the balance sheet and must be added.
2. The market approach
Another approach compares actual sales of similar businesses within a meaningful timeframe. While private companies aren't required to publish M&A transactions, you can often access proprietary private databases for a fee.
3. The discounted cashflow approach
The discounted cashflow (DCF) approach estimates a company's value on its expected future cashflows. With a DCF analysis, cashflow projections form the basis for the organisation's valuation.
Eight essential merger and acquisition methods
With these three approaches in mind, let's look at the specific valuation methodologies used within mergers and acquisitions.
1. Net Assets
In its simplest form, a net assets valuation involves adding up all of the company's assets and subtracting its liabilities. It's most applicable for stable, asset-rich organisations, such as property or manufacturing companies. Note that this method doesn't factor future earnings potential into its formula.
Example
A small machine shop chooses the net assets method because it has significant tangible assets and a volatile earnings history.
Use cases
The net assets method works well for companies with abundant assets, depend heavily on competitive contract bids or haven't yet emerged from the startup phase.
2. EBITDA
EBITDA (Earnings Before Interest, Tax, Depreciation & Amortisation) measures a company's financial performance as it can be compared with similar companies, whilst excluding the potentially distortionary effects of corporate taxation, capital expenditure, and financing working capital.
Example
A tech startup fills a void in the market and is worth more than its balance sheet indicates.
Use cases
EBITDA can work well as a valuation method for companies that need to capture a measure of their cash flow generation.
3. P/E Ratio (Price Earnings)
The price/earnings ratio (P/E ratio) is the company's value divided by its tax after profits. To establish the company's value based on price earnings, the valuator must multiply its after-tax profit by an appropriate multiple. Note that any debt should be subtracted and any surplus cash added to calculate the company's equity value.
Example
A company listed on the stock exchange chooses to use the price-earnings valuation method to highlight the marketability of its shares.
Use cases
This price/earnings ratio is applicable primarily in comparing companies in the same industry. Any such comparisons amongst organisations in different sectors would provide an apples-to-oranges result.
4. Revenue Multiple
A revenue multiple valuation is the most common methodology used in determining the value of a company. It provides a helpful metric when comparing companies with differing profit levels but similar margins, products, markets and competition.
Example
A software company chooses the revenue multiple method because they expect it to be years before turning a profit.
Use cases
Tech companies often use a revenue-based valuation approach because a lot of technology companies are not profit-generative. However, the lack of profits doesn't represent the true profit-earning potential of the organisation.
5. Comparable Analysis
A comparable analysis valuation takes two companies with similar metrics and calculates the valuation multiples to compare them. The methodology often includes the creation of benchmarks.
Example
A company uses the comparable analysis to determine the relative value of a smaller company it's considering acquiring.
Use cases
A comparable analysis provides valuable information in industries with many players.
6. "Football Field" Chart
A football field valuation chart allows you to quickly see a company's valuation across different methodologies, such as Comparable Analysis, Precedent Analysis, and DCF.
The overall results provide a broader view than any single method; it's helpful to see everything at once.
Example
A landscaping company provides both project services and supplies to the local community. Its two-pronged approach doesn't seem to fit well with a single valuation method, but the football field chart provides a deeper analysis.
Use cases
The football field chart works well to capture the valuation of unique, multifaceted companies.
7. Precedent Analysis
The precedent analysis method may incorporate the EBITA and revenue multipliers or any other multiple that the evaluator prefers. As its name suggests, this valuation method is derived from comparable transactions in the industry.
Example
If construction companies have been trading at multiples of somewhere between 5 and 6 times EBITA (or net income or another indicator), Johnson's Construction would establish its value by completing the same iterative process.
Use cases
The precedent analysis method serves well when you need more of a market barometer than a valuation method per se.
8. Dividend Yield
The dividend valuation (or dividend growth) model suggests that a company's market value is supported by the current value of its future dividends. This method is similar to the concept on which the DCF method is based.
Example
An enterprise corporation is considering selling off its distribution sector. It uses the dividend yield method to determine its value.
Use cases
The dividend yield methodology is best suited to valuing minority stakes in a company rather than a company in its entirety. Limitations of this approach include the assumption of steady growth in dividends over time, a reasonable cost of capital and a reliance on the company having a history of paying dividends.
Ulton's M&A Services
If you're preparing for a merger or acquisition, we can help in many ways. The experienced, ethical and committed Ulton Business Valuation team analyses and interprets companies' financial data in minute detail, ensuring the resulting reports are accurate. Presented in accessible and easy-to-interpret form, your valuation is essential for getting what you deserve out of the transaction.
Reach out to us at Ulton to set up a consultation. Whatever your concern or question, we'd love to help. And if you’d like a quick snapshot of how your business is currently performing, try our interactive Business Health Check by clicking the image below.
