In my previous article I touched on some of the issues one needs to consider if you are thinking about selling your Company or considering raising finance and/or introducing new business partners.
A critical question underpinning such decisions centers around the Company’s valuation. In this article I will look at some of the widely adopted valuation approaches used by investors in the region in evaluating M&A deals.
Fundamentally the 3 most common valuation approaches used in business valuations are the Cost approach, Market approach and Income approach.
The Cost approach as the name implies looks at the valuation of a business based upon the value of its net assets. The analysis more often than not is used in evaluating distressed companies and by buyers that are looking at businesses with a heavy asset base or large land banks. Conservative accounting policies can mean assets have been written off way before their expected useful economic lives. Many companies I have come across tend not to professionally revalue their assets on a regular basis and when assets are marked to market one can often be surprised at how much value can flow out.
The Market approach which I touched on last time looks at actual transactions in the market place for businesses that are broadly similar to the one you are evaluating, from an industry, market exposure and trading perspective. Benchmarks for such transactions can be found where publicly listed companies have made disclosures or announcements on acquisitions as well as trading statistics based upon their market capitalization. Although as with any statistic or data point a degree of caution needs to be exercised to ensure for example the data selected represents “normalized’ numbers and not those distorted by events such as profit warnings or one off events. I often hear some clients say if one or more company in the sector is trading at a particular multiple then surely they should be valued at least the same! There are many pitfalls to avoid when using such data, including the recognition that these data points are just that. When assessing where your private business may be valued, you need to run the full analysis of understanding why the companies are trading where they are. For example have the companies released any news or data which has impacted their market valuation? How have the companies been performing and are they earning returns which justifiably places them at a premium or discount to their peers?
Another word of caution when using such an approach, often data gleaned from transactional data will not give the full picture. Companies will target others sometimes for competitive reasons, and the full rational for doing so may not be disclosed in the public domain and will only be known to Management. These reasons could be to capitalize on synergies the acquirer feels they can instantly generate or it could be that the target enables them an immediate entry into a lucrative market they have been considering breaking into, thereby bypassing potential barriers and delays. These factors will have been instrumental in determining the final price at which the trade was done, so this should be borne in mind before any comparisons are made. It’s also imperative that data is not mixed and applied incorrectly. I have too often seen examples where enterprise and equity multiples have been incorrectly interpreted, rendering the analysis and resultant comparisons meaningless.
Other adjustments that may be required include:
Liquidity discount: A private company should normally be valued at a lower valuation than a publicly listed company as the investors in the public company can easily trade in and out of their stocks
Size discount: A larger company attracts more investors than a smaller one and as a consequence with larger size comes higher valuations
Additionally, where considering non-minority interests, a premium should be taken into consideration to reflect the additional rights and benefits a controlling interest brings to the acquirer.
The Income approach is one that many clients insist is included when evaluating their company. The reasons come as no surprise as often this approach is the one that tends to provide the highest value! I am talking about the discounted cash flow model. As the name suggests, this approach involves estimating the future cash flows the business is expected to generate, often over a period of 5-10 years and then discounting these back at an appropriate cost of capital. Unsurprisingly, I have seen resulting valuations based on this approach that that can seem truly astronomical.
On countless occasions, I have often found myself in a position explaining that an astronomical valuation that exceeds any bound of reasonableness that would otherwise be inferred by other valuation techniques, usually suggests a problem and not a windfall. In M&A, a multitude of valuation approaches are considered, but when advising clients either on the Buy-side or Sell-side, numbers that appear unreasonably high can highlight areas of concern on a deal. Fundamentally it can call into question the credibility of Management and their rational for wanting to sell the business. Questions that often arise include that if the numbers are truly as high as they appear then why haven’t you managed to achieve this in the past? If the business is that great then why are you even looking to sell? Basic questions but ones that are critical in getting into the mindset of target Management.
My advice in such situations is, yes the DCF will normally provide the highest valuation based on a broad application of different valuation techniques, but in applying such a methodology, all of the underlying assumptions and figures need to be rationalized and where doubts appear, better to err on the side of caution than present something that is undefendable and which will risk you losing face with investors. After all, if the analysis is on paper telling you that the deal is to good to be true, then more often than not, it probably is.
In conclusion, there is no one single methodology that can be considered as the best way to value a business. Valuations by their very nature are subjective and the only way one can bring any real sense of objectivity in assessing the worth of a company is by applying a multitude of techniques. Where differences arise, these should be sense checked and rationalized –only by going through this detailed analysis can the true worth of a company be fully understood.
May 18, 2015
Jagdeep Singh Kang
Head of Corporate Finance