We will continue the Financial Advisory Series by talking about valuation in mergers and acquisitions.
Overview
When a business considers buying another business, it must first determine the maximum amount it is willing to pay. This is a combination of financial science and an art form in terms of assessing data and making the correct assumptions.
Valuation is a crucial aspect of mergers and acquisitions (M&A) since it helps the buyer and seller arrive on an agreement on the ultimate transaction price. If difficulties are discovered after analysing all of the financial and related information, the buyer might ask for answers. This might lead to the whole agreement being called off or changed at times.If the buyer is impressed and satisfied after the assessment, they can sign a purchase contract.
The valuation process
The acquirer and the target both conduct the valuation process in an M&A transaction. The acquirer will seek to secure the lowest price for the target, while the target will want the highest price.
Valuation methods
The three primary valuation methodologies used by industry practitioners to value the target firms or organisations are listed below.
1 - Discounted cash flow (DCF) method: This is an intrinsic valuation that takes the most exact and thorough approach to value modeling. It is a popular M&A valuation technique that determines a company's current value based on predicted future cash flows. Here, an analyst estimates the company' unlevered free cash flow into the future and discounts it back to today’s present value at the firm's Weighted Average Cost of Capital (WACC). The company's Weighted Average Cost of Capital (WACC) = Net Income + Depreciation/Amortisation – Capital Expenditures – Change in working capital. Although DCF is tough to grasp, few valuation tools can compete with it.
2 - Comparable company analysis: This is also known as trading multiples, peer group analysis, equity comps or public market multiples. Here, relative valuation metrics for public companies are used to determine the value of the target. It is a relative valuation method in which the current value of a company is compared to the current value of other similar companies using ratios like P/E ratio (price-to-earnings ratio), EV/Sales (enterprise value to sales ratio) or EV/EBITDA (enterprise value to earnings before interest, taxes, depreciation, and amortisation). Enterprise Value (EV), also known as firm value, is the sum of a company's equity, net debt, and any minority stake.
Price-to-earnings ratio - A price-to-earnings ratio (P/E ratio) is used by an acquiring firm to make an offer that is a multiple of the target company's earnings. By comparing the P/E multiples of all the firms in the same industry group, the acquiring company may get a good indication of what the target's P/E multiple should be.
Enterprise value to sales ratio - The purchasing company uses an enterprise-value-to-sales ratio (EV/sales) to make an offer based on a multiple of revenues while keeping the industry's price-to-sales (P/S) ratio in mind.
Enterprise value to earnings before interest, taxes, depreciation, and amortisation) is a ratio that compares a company's enterprise value (EV) or firm value to its earnings before interest, taxes, depreciation and amortisation (EBITDA).
3 - Comparable transaction analysis: The worth of the target firm is determined using valuation parameters from previous similar deals in the industry. This is when you compare the firm in issue to other businesses in the same sector that have recently been sold or bought. These transaction prices include the take-over premium that was included in the purchase price. The numbers indicate a company's total value. They are useful for M&A deals, but they can quickly become out-of-date and no longer reflect the current market. The other methods are more regularly used.
More valuation methods
The Cost Approach Strategy - Here, the cost of rebuilding or replacing an asset is considered. Commercial Real Estate, New construction, and Special Use Assets all benefit from this strategy. The cost of replacing the target company is sometimes included in Mergers and Acquisitions. For the purpose of simplicity, consider a company's value to be the sum of its equipment and staff expenses. The acquiring company might order the target to sell at that price or construct a competitor at the same price. Naturally, putting together a competent management team, securing property, and procuring the essential equipment takes time. This method of setting a pricing makes little sense in a service firm when the key assets (people and ideas) are difficult to evaluate and increase.
The ability to pay analysis is another way to value a firm that is still operating. It considers the highest price a buyer may pay for a company while still meeting a set of criteria.
If the firm does not continue to exist, its assets will be broken up and sold to determine a liquidation value. This value is frequently greatly reduced since it anticipates that the assets will be sold as soon as possible to any buyer.
In summary, it is critical to determine the proper value of companies in M&A with the rightmethodologies to avoid financial downfalls as inaccurate valuation of the firms involved in mergers and acquisitions frequently have a detrimental impact on the entities involved.
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