Deal valuation is something that many executives struggle with, and I probably get more questions on this topic than any other. This is understandable. Acquisitions are big decisions that can make or break an executive’s career. They are often competitive, with multiple bidders. Investment bankers, with their deal experience and complex models, can be somewhat intimidating for many, making it a scary proposition to start questioning their numbers.
It is nevertheless critical to make sure the valuation is calculated properly, thoroughly vetted by management, and well-articulated to the board. The best place to start is to return to the foundational basics we’ve discussed in earlier posts:
While it may seem tedious to keep returning to these B-school basics, it is extremely useful to do so as it helps inoculate against the “deal fever” that so often leads to overpricing and poor investment decisions. Buying a company should be like buying anything else for your business, a new photocopier or another delivery truck. “Will the purchase accomplish our objectives better than another approach or investment” is what you are seeking to answer, and the bias should be towards skepticism and objective logic. And you can tell those scary bankers that I said that!
Re-grounded in the strategic basics, with our “deal fever” booster shot, we can get down to the business of some calculations. Two common methods used to calculate acquisition valuations are comparable multiples and discounted unlevered cash flows. We will discuss multiples here, and cash flow valuation in a future post.
Regardless of what other valuation methods you employ, you will likely need some comparable multiples for your board and/or investors to consider. Multiples are calculated thus:
This gives us an average valuation of 10.6 EBITDA, and a median valuation of 10.0 EBITDA, which when applied to our target’s financial results yields the comparable value.
Real-World Example: Nothing Can Compare
Several years ago a CFO asked me if I could take a look at the valuation model for a proposed deal. I agreed, but immediately ran into some noticeable resistance when I contacted the bankers and requested a copy of the model. When I finally got my hands on a copy, the reason for their hesitation became clear. Their figures showed sales revenue for the proposed target increasing at 6% per annum in perpetuity! Nice, but hardly likely.
I immediately set a meeting with the bankers, and asked them to provide the business operations and market research rationale that indicated the business would grow forever. Not surprisingly, they were unable to provide such analysis. Eventually they admitted that the 6% perpetual growth was simply “the formula we had to put in to get to the multiple a competitor recently sold for”. To make matters even stickier, the same bank was representing a party that would benefit from the higher sales price, so definitely a cagey situation.
Luckily, in the example above we were able to calculate a more realistic projection of the company’s prospects, and narrowly avoided overpaying for a terrible investment. Remember to always check the deal models, and to validate all assumptions!
The problem with multiples is the underlying assumption that all parties were rational actors, and that the amount paid for the company was highly correlated with EBITDA. This is not always the case- in fact many tech and pharma acquisitions are done before there is any profit, and sometimes even before there is revenue! This is also exactly how asset bubbles develop, and I would strongly caution against evaluating deal value based solely on what others have paid. Also, the 10.6x above is not what the deal is worth to us, it is just what we might expect to have to pay. What it is worth is another matter altogether, but we know that because we’ve reviewed our strategy fundamentals. Right?
That said, multiple comparisons do have their uses. First, due to different strategic priorities and deal rationales, it would be reasonable to expect an acquisition to be worth more to certain parties than to others. Considering the median/average values of multiple transactions can help predict the range of values that your competitors might be willing to pay, and (perhaps more importantly) what your investors might be willing to fund. So multiples are a reasonable starting point, but don’t get stuck there.
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