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Tuesday, February 16, 2016
Valuation methods - for Mergers and Acquisitions
Valuation approaches are the basic methodology
of evaluating a target business for acquisition. The four basic approaches to
valuation are as under:
1.Asset based approach
2.Balance sheet or income based approach
3.Market value based approach
4.Comparable transaction approach.
1.Asset based approach: Essentially this approach considers the fair
value of a company’s (or firm’s) assets minus the liabilities that have
accrued. This approach commonly uses either the asset accumulation method or
the capitalized excess earnings method. The first method establishes the fair
market value of tangible and intangible assets (including intellectual property
rights, key customer contracts and strategic partnerships) and subtracts from
this value, the value of recorded and contingent liabilities (including legal
court cases, tax exposure and environmental compliance costs). The resulting
value is the value of the business. The second method uses net tangible value
of assets and adds them up with excess earnings and good will.
advantage of this approach is that there is easily available data on assets.
The valuation therefore can be pretty straightforward.
approach is most useful when evaluating businesses which have large tangible
investments in land, property and machinery etc.
for adjustments in fair market value- either up and down.
particularly helpful when there is only a brief record of a company’s or firm’s
understate the value of intangibles like intellectual property or business good
ii.It does not
track the future of earnings either up or down.
sheet can be misleading in terms of exhibiting all assets.
2.Balance Sheet or Income based approach: This method
attempts to put a value on the target business by analysing its ability to
generate the requisite economic benefits for its owners. It takes estimated
future earnings of an equity interest and quantifies its net present value. It
looks at the target company’s net cash flow and capitalizes, multiplies or
discounts the same. The most famous method deployed by this approach is the
Discounted Cash Flow Method. This method establishes a discount rate i.e. a
rate of return which would make an acquisition economically beneficial. Another
method deployed by this approach is the Capitalization of Earnings Method which
takes a target’s discretionary cash flow and divides it by the capitalization
rate i.e. the rate of risk associated with the said benefit. Capitalization
rate is arrived at by subtracting long term growth rate in business earnings
from the discount rate. A third method is the Multiple Method and uses seller’s
discretionary cash flow. Here seller’s discretionary cash flow is multiplied
with a composite valuation multiple based on industry/business comparison.
advantage is that it is a widely recognized and credible method of valuation.
ii.It is useful
in analysing companies at various stages and of various natures and is based on
in certain cases a comparison.
iii.It comes to
a valuation even without there being a market.
i.It relies on
projections which are largely hypothetical and based on predictions.
variables are in play when determining a composite multiple or a discount rate.
3.Market value based approach: This
approach looks current market price per share of a company if it is publicly
traded or if an IPO is filed. This price is then multiplied with the number of
shares outstanding. The actual price paid by the buyer in this case turns out
to be higher because the buyer usually has to account for a premium. Another
variant of this approach is to look at historic similar sales.
reasonably straightforward in terms of calculation.
ii.It is based
on real data i.e. share price.
iii.It is not
based on hypotheticals.
iv.It can help
the target establish a substantial market value.
usually only beneficial when the target is publicly traded.
usually not a good indicator when the target’s stock is thinly traded.
overstate the value of the stock.
4.Comparable transaction approach: Comparable transaction
approach compares previous transactions of companies which are similarly placed
in the market i.e. the valuators look at similar acquisitions of companies with
similar industry, earnings and business models. Under this approach, the revenue
multiple or EBIDTA multiple is utilized. EBIDTA is Earnings before Interest,
Taxes, Depreciation and Amortization. The buyer usually organizes a multiples
table which lists a selection of previous valuations in the said industry. These
are usually similar or comparable companies with similar market capitalization.
This table is then used to arrive at a value that the buyer will be willing to
pay for the target.
approach deploys simple straight forward calculations based on real public data
and empirical evidence.
ii.It does not
depend on subjective data or future forecasts.
i.It is not
always easy to determine what companies are comparable.
extremely hard to obtain data of transactions with respect to private
considerable adjustment of prices etc when considering comparable data over a
longer period of time.
iv.It is not
v.It does not
take into account – on its own – other factors such as future benefits etc.
veracity of the data is always a question mark.
important to note that these approaches are seldom used as stand-alone but
rather a hybrid approach is adopted in valuation. Of the above, the income
approach especially vis a vis
Discounted Cash Flow Method is used in conjunction with comparable transaction
approach, especially the use of EBIDTA multiple as well as the revenue multiple
often together to determine the business health of the target.