When performing their due diligence, buyers in an M&A or private equity transaction must perform a valuation of the entire assets of the target company. Often, this means employing one or more business appraisal techniques.
The most common methods that analysts use to evaluate assets include discounted cash flow analysis, comparable company analysis and precedent transactions. These three methods are used across all areas of finance, and sometimes in due diligence analysts will use multiple methods in order to get the clearest picture possible of the company’s assets.
Discounted Cash Flow Analysis
Using discounted cash flow (DCF) analysis, an analyst forecasts the business’ free cash flow into the future and discounts it back to today at the firm’s Weighted Average Cost of Capital (WACC).
Requiring an extensive amount of detail and analysis, and taking into consideration dozens of assumptions and conditions about the business, a DCF analysis is performed by building a financial model in Excel. Because of its detail, a DCF model is often considered the most accurate valuation of a company. A DCF model allows the analyst to forecast value based on different scenarios and even perform a sensitivity analysis.
The DCF value can even be performed for different divisions or units of a company, and then combined for an entire DCF analysis of the entire company.
Comparable Company Analysis
A comparable company analysis, also known as a “comps,” is less extensive than DCF and simply compares the current value of a business to other similar businesses in its market or industry by looking at trading multiples, like a price-to-earnings ratio, enterprise-value-to-EBITDA ratio or other ratios. Multiples of EBITDA are the most common valuation method.
The “comparable” part makes sense, as the business under valuation is simply compared to the worth of companies considered its peers. Because it’s easy to calculate and always current — thanks to available market data — the comparable company analysis valuation approach is, not surprisingly, the most widely used approach.
The logic follows that if company X trades at a 10-times P/E ratio, and company Y has earnings of $3.00 per share, company Y’s stock must be worth $30.00 per share (assuming the companies have similar attributes).
The downside of this valuation method, of course, is that if the securities of the peer companies are mispriced, or over- or undervalued, then the comparable company analysis of the company in the transaction will not be accurate.
Precedent transactions analysis is another form of relative valuation, and as its name implies, looks at previous companies that have recently been in play.
In this valuation type, analysts compare the company under consideration to other businesses that have recently been sold or acquired in the same industry. These transaction values include the take-over premium — the difference between the market price or estimated value of a company and the actual price paid to acquire it — included in the acquisition price.
The downside of this valuation method is that current market conditions for M&A may differ from those when the previous transaction for that other company occurred. As time passes, the precedent transactions may no longer be useful or valid, and no longer reflect the current market interest in such transactions. As a result, the precedent transaction method is less utilized than the DCF of comparable company analysis methods.
Additional Valuation Methods
The cost approach is less utilized, and considers what it actually costs or would cost to rebuild the business. This approach does not consider value creation, such as that of IP developed by a company over time, or cash flow generation.
Another valuation method for a company is called the ability to pay analysis. This approach looks at the maximum price an acquirer can pay for a business while still being able to hit some target. For example, if a private equity firm needs to hit a hurdle rate (or minimum acceptable rate of return) of 30 percent, the firm may want to pay the maximum price for the business.
For companies that have been dissolved, a liquidation value can be estimated based on dividing up and selling all of the company’s assets. The liquidation value is usually extremely discounted, and can continue to decline as time goes on because it assumes that the assets will be sold as quickly as possible to any buyer at any price.
Financial Documents and the Need for a Virtual Data Room
All financial documents should be made available securely for all parties to evaluate them, in order to speed the valuation process of the target company in play in an M&A or private equity transaction.
Companies should consider using a virtual data room to host these documents in the cloud in order to assure speedy due diligence. With rights management, permissioning, tracking and other advanced features, companies could delay their decision without using the virtual data room for proper document evaluation.
Organizations should consider an enterprise document security solution like Caplinked that has years of experience working with corporate, financial and legal teams and providing data rooms for transactions and ventures of all sizes.
Jake Wengroff writes about technology and financial services. A former technology reporter for CBS Radio, Jake covers such topics as security, mobility, e-commerce, and IoT.
Corporate Finance Institute – Valuation Methods