Company valuation methods for mergers and acquisitions

Valuation

Acquiring a company is a complicated affair that involves a great deal of analysis to arrive at a purchase price that works for all parties. The sellers' reasons for putting their businesses on the market will vary, as will the goals of the parties making the acquisitions. For example, a company being sold may be a car wash that has been closed for a year, where all the seller is really purchasing is the land, building and equipment. Conversely, a company being sold could be a solid performer with tremendous upside, and perhaps that company is going to be worth much more in 10 years than it is today. Clearly, we can not appraise these companies in the same way.

Similarly, investors purchasing companies may look for different things. A shoe manufacturer buying another shoe manufacturer may not be particularly interested in the company's assets (after all, the purchasing company can make the shoes itself), but may be more interested in the brand and long-term market-share issues (How to Buy 2007). This contrasts significantly with a situation where an investor will simply look to cash out in five years.

Because of the variety of circumstances that can exist on both the buyers' and sellers' sides, there are several different methods for appraising the value of a company. When Company a purchases Company B, the sides can use methods such as net-asset valuation; price-to-earnings ratio; or discounted cash flows, depending on Company a's goals and the conditions surrounding Company B's business. A look at each of these methods shows that they provide practical solutions to the many scenarios that can play out during the sale of a company.

Net-asset valuation

Net-asset valuation takes a "bricks and mortar" approach to establishing the value of a business. In essence, net-asset valuation estimates the total value of a company's assets and subtracts its liabilities, which may include taxes, debts, or other expenses (Judy No date). So, if a company owns $3 million worth of assets (such as buildings and equipment), but has liabilities (such as debt) of $2 million, the net asset value of the company is $1 million. Net-asset valuation is a preferred method for valuating businesses when assets are the primary staple of the business (such as a real estate company), or if a company is not profitable and may not have any tangible good will (Net asset 2000). If you were to buy a car wash that had been closed for a year, for example, all you would really be buying is the land, building and equipment, so net-asset valuation makes sense.

In practice, net-asset valuation is not as straightforward as it seems. When purchasing a business, both the buyer and seller will have to agree on answers to tough questions, such as what a building that was built five years ago for $5 million is worth today (Net Asset 2000). On one hand, it would likely cost more to build the structure today, and on the other hand, perhaps some damage or wear-and-tear has occurred. On such points, there is bound to be a level of disagreement. To help navigate the many problems inherent to net-asset valuation, there are different strategies that can be used.

In arriving at the net-asset value of a company, the replacement cost method is commonly used. The replacement cost method seeks to determine how much a buyer would have to pay if he or she needed to build or acquire the assets himself or herself from scratch (Bizquest No date). So, if the buyer was looking to purchase a self-storage business that consists of 100 storage units, and each one of those units would cost $10,000 to build, the value of the storage units is $1 million, excluding land. When using the replacement cost method to assess the value of a company, naturally it behooves both sides to get their own estimates of replacement costs and then search for common ground. An agreement of what the company's actual assets are should be reached before any appraisals occur. For example, a seller may hold a 25-year lease on a piece of property and may want to valuate that land as an asset, similar to if he or she owned it. The buyer is likely to see that scenario much differently, perhaps even viewing the land as a liability, as continual payments will still have to be made (Suits 2004). Also, will the seller offer continued assistance, and is that an asset with a price attached (Wexler 2003)?

Another common method for arriving at a company's net-asset value involves a determination using future cash flows. The future-cash-flows method tries to answer the question of whether a building built 5, 10 or 20 years ago is really worth the value of the replacement cost (Net Asset 2000). If a building being considered for purchase is only going to be standing, or practically functional for that matter, for another 10 years, perhaps it's not worth as much as the replacement value, which essentially envisions a new building.

The future-cash-flows method can become hazy and theoretical, but here is an attempt at a very simplified explanation. Perhaps a new car factory can be expected to operate and generate cash flows for 50 years and the replacement cost is $500 million. But the car factory Company a is looking to purchase from Company B. is only going to be functional and generating cash flow for another 10 years. Because Company a would not get 50 years of cash flow from that asset, it is not worth $500 million - it is worth one-fifth of that amount, or $100 million. It is easy to see why future-cash-flows is complicated and is typically not preferred to replacement cost valuation. There is bound to be some disagreement on how long a building will continue to be functional, or how much longer a machine can operate before replacement is necessary. Depreciation ratios can be a help - if the equipment is being depreciated over 10 years and is already eight years old, it has arguably lost 80% of its value. but, of course, this is not a hard-and-fast rule, as the equipment may function for 20 years. Future cash flows can be very complex, but it is a method worth considering, particularly in cases where both sides agree there has been some depreciation of the assets.

Discounted cash flow

The discounted-cash-flow method is arguably the most complex valuation model discussed in this paper, but it is often considered reliable because it considers a company's post-sale prospects (Calculating Discounted 2005). In the case of the previously discussed over-valued dot.com, it is easy to see where a potential buyer would eventually develop a cash-flow problem. The company is barely profitable, and it's going to take $5 million to purchase the company, likely creating some debt to be serviced. Perhaps a company with multiple business units would be capable of servicing that debt through the performance of the other units, but clearly the business being acquired could not service such debt through its own cash flow.

The discounted-cash-flow method works well because one of the things it does is help provide a correcting influence on these types of scenarios. The discounted-cash-flows method evaluates what a company's cash flow situation will look like into the future, with the obvious effect of debt service added into the equation (Bizquest No date). That future cash flow is multiplied by a "beta," which is essentially a multiplier that takes the business' level of risk into account (Bizquest No date). A company like Procter & Gamble, which is well established and sells products that people will always need, like soap and toothpaste, may not see its beta devalue the company much, as it is low-risk. On the other hand, when the personal transport vehicle, the Segway, was introduced, the parent company would have been valued as high-risk, because it remained to be seen whether there would be wide consumer acceptance. The risk of that business would create a beta that would have a more negative effect on the company's value.

Let's review a simple example that demonstrates how discounted-cash-flows works in practice. The company being purchased may be generating $10,000 a month in net income and the industry multiplier could be 10. So, the company is worth $120,000 x 10, or $1.2 million (Calculating Discounted 2005). Now, let's imagine that the investors want to cash out in five years. The post-acquisition company is immediately generating just $8,000 a month, primarily because of debt service, but cash flow is expected to increase regularly each year, until it reaches $15,000 a month in Year 5. At that point, the company will be worth $180,000 x 10, or $1.8 million, for a profit for the investor of $600,000 (Calculating Discounted 2005). But how confident is the investor that these Year 5 numbers can be reached, based on factors such as risk and historical performance (Berry 2004)? This is where the beta comes in. If the business is high risk, and that $600,000 is far from a certainty, the eventual valuation of the company could suffer. Maybe the investor discounts a third, assuming the profit to be $400,000, to play it safe, which obviously hurts how the company's value is perceived.

From the investors' perspective, assuming there is not an overly high rate of risk, the company represents $600,000 in potential profit, based on the value of future cash flow and net income. If the investor's goal is to clear at least $500,000 on the sale of the company, he or she can afford to overpay by $100,000 to purchase the company. If the goal was to clear $1 million, the investor will need to either get a deal on the purchase, find ways to further increase profit after the acquisition, or simply look for a different deal (Brooks, No date).

At any rate, the discounted-cash-flow method works well for investors, because it takes their goals into account, and it also realizes that a company may fundamentally change financially after the acquisition. A company that had cash flow of $10,000 before an acquisition may only have $5,000 after it, and this presents some concerns for the investor. Can that gap be overcome in a period of time that is acceptable to the investor, and what sort of risk does that entail? Discounted cash flow provides a solid approach for beginning to answer those questions.