Central to Mergers and acquisitions (M&A), including selling a business, is the concept of valuation, a process that determines the value of the business.
Understanding the valuation is crucial for both buyers and sellers as it forms the foundations from which negotiations start and affects the overall success of the deal. Overvalue the business and you can chase away good potential buyers; undervalue the business and you could leave money on the table when selling the business.
This Blog explains the principles behind valuations, without delving too deep into the technicalities of how to value.
1. A valuation is a story expressed in numbers
Valuing a business isn’t just about crunching numbers. A good valuation is backed by a believable story of what the business could achieve in the future. This story is based on things like how the business has done in the past, its current strengths, and where the market is heading. Numbers are part of it, but it’s the thinking behind the numbers that really matters.
In essence, a valuation is a story about the future, built using key assumptions, which are expressed in figures. The process of valuing and selling your business includes understanding whether the story is believable and can be backed up by current capabilities and a history.
2. Market value is only an opinion at a point in time
There is no one correct market value for your business; a valuation is someone’s opinion of the market value of your business based on current circumstances.
The user’s perception of the accuracy of the opinion is affected by the independence and expertise of the person giving the opinion. If the buyer and seller both believe in the correctness of the valuation it makes a massive difference to the speed with which a deal can be consummated.
In addition, the opinion is based on a particular set of assumptions and if the businesses forecast changes, due to changes in the business or market conditions, the valuation will change.
3. You Are Buying The Future
Buyers usually want to buy a business based on past results and sellers want to sell their business on future results.
However, when someone buys a business, they can only buy the future earnings ability of the business, so valuations are in essence future looking and the only reason past results have such a bearing on the valuations is they are usually a strong proxy of what can be achieved in the future.
4. It’s A Comparison
Valuations are built on comparisons.
Houses prices are a good example of this. When an estate agent values your house, they look at sale prices for other houses in your area and determine a value at which they expect your house will sell. Valuing a business is based on the same principle and there are a lot of service providers making data available on prices fetched for the sale of businesses around the world.
What makes the valuation of a business more difficult is that the market is not as active as the housing market which results in less data points to build a comparison, and there are a lot more variables driving the value of a business. A house price is driven by size, location, and the condition whereas a business has numerous variables driving its value from the strength of a management team to expected growth and risk and many variables in between.
5. Approaches To Valuation
There are several approaches to valuations each with their own strengths and weaknesses. The most popular methods include the Income approach (Discounted Cash Flow Approach), which is the most technically correct approach, and which values the business based on expected future cash flows that the business will generate, and the Market Approach (Market multiples approach) which uses market multiples from comparable businesses sold to value the business. The Market approach is more popular, easier to use and in my opinion has greater shortcomings.
Each method however offers a different perspective on value, and it’s often beneficial to use a combination to gain a comprehensive view.
6. Market Considerations
Market conditions have a direct impact on the valuations. Economic trends, industry health, and investor sentiment can all impact how a company is valued.
For instance, a booming market will lead to higher valuations due to optimistic growth forecasts, while a downturn could result in more conservative estimates.
Value is driven by perceived risk and if interest rates go up, risk goes up and values come down, there is a direct correlation.
7. Non-Financial Factors
Valuations are not solely based on financials. Non-financial factors such as brand value, intellectual property, customer relationships, and market position can also significantly influence a company’s worth. These intangible assets can be challenging to quantify but are crucial in valuing a business.
8. The Role of Synergies
In M&A, synergies refer to the potential additional value created by combining two companies. Synergies can arise from cost savings, increased revenue opportunities, enhanced market power or acquisition of new capabilities.
Strictly speaking synergies belong to the buyer but a clever seller who has a good grip on the synergies the buyer will get will try get the buyer to pay a premium over the company’s standalone value.
Conclusion
Valuations in M&A are complex but essential. They require a balance of analytical rigor and strategic insight, considering both the tangible and intangible aspects of a company’s worth. Understanding the principles of valuations can help parties involved in M&A transactions make informed decisions, negotiate effectively, and ultimately, achieve their strategic objectives. If you’re involved in M&A, how do you approach valuations? Share your experiences and thoughts in the comments below.