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.


a.     Advantages:

                                          i.    The key advantage of this approach is that there is easily available data on assets. The valuation therefore can be pretty straightforward.

                                        ii.    This approach is most useful when evaluating businesses which have large tangible investments in land, property and machinery etc.

                                       iii.    It allows for adjustments in fair market value- either up and down.

                                       iv.    It is particularly helpful when there is only a brief record of a company’s or firm’s earnings.

b.    Disadvantages:

                                          i.    It may understate the value of intangibles like intellectual property or business good will.

                                        ii.    It does not track the future of earnings either up or down.

                                       iii.    A balance 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.


a.     Advantages:

                                          i.    The biggest 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.

b.    Disadvantages:

                                          i.    It relies on projections which are largely hypothetical and based on predictions.

                                        ii.    Too many 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.


a.     `Advantages:

                                          i.    It is 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.

b.    Disadvantages:

                                          i.    It is usually only beneficial when the target is publicly traded.

                                        ii.    It is usually not a good indicator when the target’s stock is thinly traded.

                                       iii.    It may 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.


a.     Advantages:

                                          i.    This 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.

b.    Disadvantages:

                                          i.    It is not always easy to determine what companies are comparable.

                                        ii.    It is extremely hard to obtain data of transactions with respect to private companies.

                                       iii.    Requires considerable adjustment of prices etc when considering comparable data over a longer period of time.

                                       iv.    It is not flexible.

                                         v.    It does not take into account – on its own – other factors such as future benefits etc.

                                       vi.    Finally the veracity of the data is always a question mark.



It is 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.

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