Mergers and Acquisitions: Valuation Matters

In a merger or acquisition transaction, valuation is essentially the price that one party will pay for the other, or the value that one side will give up to make the transaction work. Valuations can be made via appraisals or the price of the firm’s stock if it is a public company, but at the end of the day valuation is often a negotiated number.

Valuation is often a combination of cash flow and the time value of money. A business’s worth is in part a function of the profits and cash flow it can generate. As with many financial transactions, the time value of money is also a factor. How much is the buyer willing to pay and at what rate of interest should they discount the other firm’s future cash flows?

Both sides in an M&A deal will have different ideas about the worth of a target company: its seller will tend to value the company at as high of a price as possible, while the buyer will try to get the lowest price that he can.

There are, however, many legitimate ways to value companies. The most common method is to look at comparable companies in an industry, but deal makers employ a variety of other methods and tools when assessing a target company. Here are just a few of them:

1. Discounted Cash Flow (DCF) - A key valuation tool in M&A, discounted cash flow analysis determines a company's current value according to its estimated future cash flows. Forecasted free cash flows (net income + depreciation/amortization - capital expenditures - change in working capital) are discounted to a present value using the company's weighted average costs of capital (WACC). Admittedly, DCF is tricky to get right, but few tools can rival this valuation method.

2. Comparative Ratios - The following are two examples of the many comparative metrics on which acquiring companies may base their offers:

• Price-Earnings Ratio (P/E Ratio) - With the use of this ratio, an acquiring company makes an offer that is a multiple of the earnings of the target company. Looking at the P/E for all the stocks within the same industry group will give the acquiring company good guidance for what the target's P/E multiple should be.
• Enterprise-Value-to-Sales Ratio (EV/Sales) - With this ratio, the acquiring company makes an offer as a multiple of the revenues, again, while being aware of the price-to-sales ratio of other companies in the industry.

3. ​Replacement Cost - In a few cases, acquisitions are based on the cost of replacing the target company. For simplicity's sake, suppose the value of a company is simply the sum of all its equipment and staffing costs. The acquiring company can literally order the target to sell at that price, or it will create a competitor for the same cost. Naturally, it takes a long time to assemble good management, acquire property and get the right equipment. This method of establishing a price certainly wouldn't make much sense in a service industry where the key assets - people and ideas - are hard to value and develop.

Some factors to consider in any analysis include:

• Future prospects of the business. Does the target company have solid growth prospects or at least generate solid profits and cash flow?
• The risk of the other company? Are they in an industry that will add too much risk to the combined entity? Operationally is the business well-run, is there a solid employee base?
• The cost of capital in terms of this transaction providing the best return on the acquiring party’s capital.

What to Look For

It's hard for investors to know when a deal is worthwhile. The burden of proof should fall on the acquiring company. To find mergers that have a chance of success, investors should start by looking for some of these simple criteria:

• Price-Earnings Ratio (P/E Ratio) - With the use of this ratio, an acquiring company makes an offer that is a multiple of the earnings of the target company. Looking at the P/E for all the stocks within the same industry group will give the acquiring company good guidance for what the target's P/E multiple should be.

• Enterprise-Value-to-Sales Ratio (EV/Sales) - With this ratio, the acquiring company makes an offer as a multiple of the revenues, again, while being aware of the price-to-sales ratio of other companies in the industry.

Mergers are awfully hard to get right, so investors should look for acquiring companies with a healthy grasp of reality.