At the core of mergers and acquisitions (M&A), including the sale of a business, is the concept of valuation—a process that determines the business’s value.
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.
We won’t delve too deeply into the technicalities but these are a few key valuation principles:
1. The Basics of Valuations – It’s A Story
Valuation refers to the process of determining the economic value of a company. This is not just a numerical exercise; it is also an art involving applying a high-level of judgement on key assumptions, future performance, and market conditions.
In essence, a valuation is a story about the future built using key assumptions, which are expressed in figures which form the basis for the valuation. The process of valuation, 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 Specific Point In Time
There is no single correct market value for your business. A valuation is just someone’s opinion based on current circumstances.
The user’s perception of an opinion’s accuracy is influenced by the independence and expertise of the person providing it. 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 specific assumptions, so any major shift in business forecasts or market conditions will alter the valuation.
3. You Are Buying The Future
Buyers usually want to buy a business based on past results, whereas sellers have future results in mind.
However, when someone buys a business, they can only buy the future earnings’ ability of the business, so valuations are in essence future looking. The only reason that past results have such a bearing on the valuations is that they are usually a strong proxy of what can be achieved in the future.
4. It’s A Comparison
Valuations are based on comparisons, much like how estate agents value homes by looking at nearby sale prices. In business, service providers offer global data on business sale prices to determine value.
Valuation of businesses is made more difficult due to the market being less active than the housing market, which results in less data points to build a comparison. 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, 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.
- The Market Approach (Market multiples approach) uses market multiples from comparable businesses sold to value the business. This 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
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 represent the extra value from combining two companies, such as cost savings, increased revenue, enhanced market power or acquisition of new capabilities.
While synergies generally benefit the buyer, a clever seller who understands the potential synergies can push for the buyer to pay a premium above the company’s standalone value.
Valuations in M&A are complex but essential. They require a balance of analytical rigour and strategic insight which considers 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.
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