Recently we have seen a significant increase in merger and acquisition interest in our client base. That activity prompted me to review business valuations for businesses sold several years ago. The first lesson from this review was the need to lose the emotional attachment to businesses and accept the agnostic reality of how businesses are valued. The second lesson from successfully closed deals was the need for clarity of objectives in buying or selling companies.
As background, we are talking about privately held companies with no empirical market value. That said, valuation is as much art as science. For private companies on both sides of the buy – sell transaction these are emotional events. Thus, knowing this and understanding in crystal clear detail the objectives of a deal allow shrewd buyers or sellers to effect trades that maximize the probability of realizing a successful deal beyond the transaction itself.
Published research suggests that 80% of all M&A transactions fail to meet their stated objectives. Consideration of any transaction, which also impacts valuation, must include post closing integration. To see our approach on maximizing probability of success, see our M&A Basic Check List. (This MAP is read clockwise from 1 AM to Noon.)
Owners need to be aware there are many valuation models but all fall under broad families: a) Asset Driven b) Income Based and c) Market Comparison. Each model offers ranges of valuation metrics, which means company owners not experienced in corporate finance retain suitable counsel. Each merchant bank, PE capital or M&A specialist focuses on different industries, deal sizes even buy or sell side of transactions.
For example, a family valuing a company for an estate may want to obtain an independent valuation on a low end for estate tax purposes. Remember that a low base now may translate to significantly higher capital gains in a following sale transaction or may reduce the ability to collateralize future transactions. But we will settle on the low valuation objective for this discussion. A special note on this example: All states have different regulations that apply so local counsel is critical.
Here is an actual range of trading ratios for a consumer products company based on publicly traded like-company values a year ago:
|Trading Ratios||Guideline Company Range||Selected Multiple|
|Bus. Enterprise / EBIT||5.7 – 11.5||5.7|
|Bus. Enterprise / EBIDA||5.1 – 10.0||5.5|
|Equity / EBT||5.5 – 13.2||9.0|
|Equity / Net Income||7.6 – 21.6||15.0|
The various metrics relate to income statement entries; EBIT = earnings before income taxes, EBITDA = earnings before income taxes and depreciation, EBT = earnings before taxes and net income is revenue minus returns and product costs. The use of any of these ratios as benchmarks again depends upon the nature of the industry and objective of the business deal.
In fair value determination, premium or discount salaries to family members paid are normalized to industry standard, as are premium rent payments and other idiosyncratic expenses that benefit a family. This normalization may either inflate or deflate valuation depending upon the objectives of the parties to the transaction. Examples of other variables influencing valuation are:
- Market or business category in terms of size, volatility, growth / decline
- Competitive concentration and market share of target company
- Nature and quality of inventory
- Revenue composition i.e. few large customers with constant order streams or many small accounts with few repeat orders
- Patents, trademarks or factors that give unique, sustainable competitive advantage.
Awareness of different fair market value methodologies is important for owners using their companies as a means of wealth creation versus current income production. All readers can understand that the range of ratios applied to whatever valuation metric is wide and the attending company value dramatically changes from the low to high end of the relevant range.
The key for me lies beyond the historic performance of a company. As a general rule, sellers are selling the past and buyers are buying the future. It is the potential a business has for future growth, a view I hold whether buying or selling companies. This gets back to the intangible but real value of brand strength and how to package a sale or conversely see extraordinary value in a purchase. Due diligence for both parties as outlined in this excellent checklist is critical.
Regardless of turnaround or high growth going concern, I personally focus on the nature and strength of a company’s perception in the collective minds of customers. Financial experts are essential in identifying and appraising fair monetary value and deal structure, yet real wealth is derived from grasping how to translate historic performance into ongoing profitable revenue while serving customers extraordinarily well.