M&A Valuation: The truth

Posted on Monday, 9 November 2009. Filed under: Commentary, Mergers |

M&A valuation is simple. Yet it often appears to be, in the words of Winston Churchill, ‘a riddle wrapped in a mystery inside an enigma…’

For the maths, all you need to be able to do is add, subtract, multiple and divide.  Oh, and to punch in some numbers to a relatively simple financial calculator that can do net present value (and therefore, if you were to do this the old fashion way, you would need to know how to take numbers to the power of).

But in most deals, this isn’t even needed.  What you do need is some research about recent deals, just as you would do if you were to sell your house.  If another house or two have sold recently on your street, then you should know a general price to sell your house – adjusted, if you can, for the number of bedrooms and bathrooms that your house has versus those other houses that sold.  And asking prices don’t matter:  what is critical is the actual price that was agreed.

You do need to know if there are also any significant changes in the market since those sales, or if you will be offering anything different (such as seller financing).  The deal terms will affect the price:  will you swap houses with the seller (similar in business to a stock offer) or will it be a cash transaction.

Your real estate agent will help you to do this pricing.  You probably buy and sell a house just a handful of times in a lifetime, but the estate agent will (in a good market) sell many houses in a month.  They will have a sixth sense about the market that no amateur could have.  Likewise the investment banker advising on a deal where the managing director will have done hundreds of deals by the time they reach the level where they are the trusted advisor to a company doing a merger or acquisition.  They will know best which other deals do look most similar to yours.

It therefore is somewhat a ‘mystery’, even if not complex.  ‘Art more than science’ as I explain in the chapter on valuation in the book Intelligent M&A:  Navigating the mergers and acquisitions minefield.

Aside from the aforementioned need to look at comparable deals and to consider the ‘art’ aspect of pricing, what else is important when pricing a public deal:

  1. Looking at the valuation from several different perspectives.  Although recent deals successfully conducted by similar companies in the same industry as yours will set the general level for your deal, usually boards of directors and shareholders require more than this to feel confident approving the deal.  Therefore, once the price has been agreed, it will be justified with other valuations (as many as possible) using other methods such as net present value (usually based on cash flows).  Of course, these other methods require a large number of assumptions (which cost of capital to use, which discount rate, etc), so again is actually more art than science.
  2. No two valuations will ever be the same if done by different firms, even if they are using the same base information.  This is because they will use different assumptions (see above) and weight the answers differently.
  3. There are two sides to every deal.  Each side will have created their own valuation, and you can be certain the seller will have a figure in mind which is higher than the buyer.  This leads to the next point.
  4. The final figure agreed is a result of the negotiation between the two (or more) parties.  The level of negotiating experience and the negotiating strength of each party (e.g., is either one being forced into the deal, or can they walk away if they wish).
  5. There will be several anchor points to the valuation.  The most important is the actual market capitalisation of the target company on the day the negotiations begins (sometimes this is structured as a price which is the average closing value of, say, the previous five or ten trading days).    The second is the 52-week high for the target company, as this is an easier sell for the target if the offer price is at a premium to any price in the previous year.  Both figures are anchor points only, and will have differing levels of importance if the market is declining or advancing during the negotiations.

Leave the very complex maths to the equity derivative traders and the designers of structured products — and for the back-up and support once the number’s been agreed (and you WILL need to justify the number for the board, shareholders and others).  M&A valuation is much more fun than that and can be done on a simple Excel spreadsheet.

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