Valuations

One of the more important services that the investment banker provides, is to analyze and render an opinion of the value of the corporate enterprise. Most assignments that Grand Avenue Capital Partners undertakes involve the determination of value. A number of techniques are utilized to determine the value of the enterprise, and clients must understand that in the final analysis, the true value of the business is the market.

Valuation Methodology

No single methodology is universally applicable in determining the fair market value of a business. A complete and objective business valuation which looks at and compares a number of methods is generally the starting point for sellers and buyers of on-going businesses. Armed with a professional opinion of value using several different analyses will give the shareholders a better understanding of the merits of offers that may be received by buyers. In the final analysis, it is the market that will dictate the value; i.e. the price and terms that a business will transfer between a willing buyer and seller, when neither is under any compulsion to buy or sell, and both parties have access to all relevant facts and understanding of the business being sold.

The future prospects of the enterprise are critical in assessing its value. While historical financial performance is a valuable starting point, future performance will ultimately validate the value or price paid today for the entity. The valuation analyst must assess the operation and industry today and make a call regarding what the future revenues, costs, capital expenditures, working capital requirements, and what industry competitive threats, technology changes and other opportunities face the company. Acquiring companies who fail to risk-adjust each of these internal and external factors affecting company performance increase the likelihood of failure in their acquisition strategy.

Several valuation methodologies will be briefly discussed here:

  1. Present value of unlevered future cash flows and related analyses
  2. Various cost approaches
  3. Market values from closed transactions and data from publicly traded companies
  4. IRS Rev. Rul. 68-609/Rev. Rul 59-60, et al

It is important to note that business valuations have many purposes. The aim here is the true value from a financial prospective of the on-going business in a merger/acquisition transaction. Other valuation purposes may include legal proceedings, disputes between shareholders or partners, estate planning and resolution, ESOP regulations, and capital raising. Analysts calculating values in these latter areas may have different objectives in determining value.

Frequently promulgated are “rules of thumb” earnings or EBITDA multiples to determine value. These are proxies of value simplifying either a more rigorous analysis or summarizing what transactions have actually occurred in the market. It is our opinion that sole use of these proxies is dangerous; clearly, analysis of the internal (company specific) and external (industry specific) factors of valuations discussed below need to be understood to fully understand the value of a specific enterprise. The use of the multiples is pervasive, however.

Present Value of Unlevered Future Cash Flows

A rigorous analysis of the present value of the unlevered, after tax future cash flows, adjusted for capital requirements, discounted at the cost of capital is the financially accurate and correct estimate of business enterprise value. Such an analysis is performed twice: the first values the firm in the hands of the present shareholders, employing the cost of capital of the firm, with business as usual factors incorporated into the forecast of unlevered cash flows.

A second analysis starts with the first and overlays what, if any synergies (positive, but also negative) are brought to the firm by the acquirer, with the cost of capital of the acquirer estimated as an element of synergy. A range of values is therefore established which will bracket price negotiations between buyer and seller.

The financial analyst utilizing this present value formula for determining enterprise value takes into account:

  • Analysis of the existing business, margins, costs, revenues, capital needs to support the business and other operating factors.
  • Analysis of current financial condition of the company, balance sheet strengths or weaknesses, debt capacity, operations capacity utilization, marketing strengths or impediments to growth and capital needs.
  • An analysis of the exogenous factors in the industry, macro-economic factors, domestic and offshore competitive threats and opportunities, customer trends, technology obsolescence, etc.
  • The impact is assessed of these external trends on the forecast of future revenues, costs, after tax cash flows without existing leverage and after capital needs based on management’s best estimates of working capital and capital expenditures.
  • A determination is made of the weighted average cost of capital of the firm and the present value of these after-tax unlevered cash flows is calculated. An assumption is made regarding terminal value, and excess working capital (if present and not required in the business) is added to the present value. The present value calculation is made for the existing shareholder case and the case of the company owned by the acquirer.
  • Proforma, post-acquisition financials of the acquirer are prepared with assumed acquisition financing to pressure-test the valuation assumptions. If the acquirer is able to finance the acquisition with an acceptable blend of equity and debt as dictated by current market conditions, and on a proforma basis the acquired company indicates an acceptable return on the acquirer’s equity, the valuation has positive validation.

Cost Approaches to Valuation

Various cost-based methodologies are employed, and briefly discussed here. Because these methods generally ignore the earnings generating capabilities of the firm, these methods are discounted in terms of the value of the on-going concern value.

  • Replacement cost approach: Typically this method is important in a “make vs. buy” decision and focuses on assets only. Rather than acquiring a company, the acquirer determines that the replacement cost of the target’s assets are much lower than the target’s on-going business value. It ignores, for instance, the value of the target’s intangibles as position in the market or market share, value of a highly trained workforce and experienced management, unique relations with customers or vendors, value of intellectual property and trade secrets, etc.
  • Adjusted Asset cost approach: The balance sheet of the target can be adjusted to reflect current market values of assets and liabilities. This is an appropriate method for valuing a real estate holding company or limited partnership interest, but not helpful in determining the on-going value of a stream of cash flows from an operating company.
  • Book Value approach: The accounting book value of an enterprise determined from the accumulated retained earnings is generally used to compare acquisition values to a benchmark book value. This does not provide a true indication of the market value of the enterprise, nor does this take into account the free cash flow that can be generated by the enterprise.
  • Appraisal value: The difference between the appraised value of the assets and the historical cost liabilities gives a value that is useful in liquidation or bankruptcy scenarios. Again this value has little relevance to the on-going value of the business enterprise.

Market Valuation Data Applied to the Target Company

Obtaining actual market data on closed transactions and applying this data to a target company is an indispensable measure of market value agreed to by a willing buyer and seller. Information on transactions between public companies is readily available; however, data on typically private smaller firms are difficult to obtain, and even analysts who follow a particular industry have difficulty in making direct analogies between private company deals.

Not surprisingly, however, valuation data on private companies, when obtained, is a compelling metric when determining and negotiating the value of the target company. What is often not known, are data relative to comparisons of product mix, unique vendor relationships giving rise to differential costing, management impact on performance, market share, size, proprietary and differential technical capabilities, trade secrets and other intellectual property, etc. Unfortunately, market comparable data for operating companies are misused and overused, particularly when few data points are available. Market comps are better utilized in the real estate industry and used equipment markets.

Public markets are generally considered efficient in valuing companies. Daily stock prices reflect the value assessment of many buyers and sellers. Public company data is considered a valuable benchmark in valuing on-going entities. Each comparable company’s data (EBITDA % of sales, gross margin % of sales, etc.) is compared to the target company’s metrics and the target’s value is determined by relatively weighting the metrics of the number of public companies in the sample. Public company data and valuation metrics are generally discounted in using such data to value the private enterprise.

Market actual data, however, is another set of information available to the informed acquirer who relies principally on the present value techniques described above.

Cost Approaches to Valuation

The IRS has weighed in with methodology that it suggests being used only when no better basis is available for valuing the intangible assets of a business using a “formula” approach. Fortunately, the science of financial analysis has progressed to minimize the use of this methodology in conventional M & A transactions.

This formula approach suggests that the average annual return on the tangible assets is deducted from average total earnings of the company and the remainder, if any is considered to be the amount of the average annual earnings from the intangible assets. This latter amount is capitalized by a percentage of 15-20%, and the former capitalized at 8-10%. Lower factors are utilized for stable companies with low risk; higher factors are utilized for companies in which the hazards of business are relatively high.

The Revenue Rulings suggest that the past earnings to which the formula is applied should fairly reflect the probable future earnings.