How to choose the best valuation techniques
Valuation in any merger is the amount a buyer is willing to pay the seller and if the latter is willing to accept the deal amount. There are different techniques to value a company and it depends on the industry or situation-specific.
For a buyer, valuing a company should not be seen as a routine exercise of applying one formula to one set of financial criteria. Before finalizing the purchase price, the buyer must evaluate the viability of the business, cash flows, future growth opportunities, employees cost, and liabilities. The buyer must fully investigate the financial health of the proposed business, including trends in its financial situation over time as well as overall industry and macroeconomic trends.
It is important to distinguish between an asset purchase transaction and stock purchase transaction. In an asset purchase transaction, a buyer will acquire all of the seller's assets but not the seller's liabilities. In a stock purchase transaction, a buyer will acquire all the stocks of the seller subject to its liabilities. An asset-based valuation approach is used when a business has a very low or negative value. In such a technique, it will result in the lowest valuation but may result in an appropriate value depending on the circumstances. On the other hand, the income-based approach to valuation calculates the net present value of future income by applying a particular discount rate.
Some of the common techniques are Comparable Company Analysis like evaluating similar companies’ current valuation metrics. There is Discounted Cash Flow Analysis (DCF), which values a company by projecting its future cash flows and then using the Net Present Value (NPV) method to value the firm. Then the third technique is Precedent Transaction Analysis, which looks at historical prices for completed M&A transactions involving similar companies. The other technique is called leverage buyout, which uses a significant amount of borrowed funds to fund the purchase.
In each of these valuation techniques, M&A bankers in most cases look at the transaction and comparable valuation for acquisitions. Equity markets bankers underwrite company shares in the stock markets in advance of an initial public offering (IPO) or secondary offering and rely heavily on comparable valuation. Leveraged finance groups will value a company based upon leveraged buyout transaction assumptions. The comparable company valuation is the easiest technique to follow. If the company is listed, then the value of the comparable companies can be estimated quite easily.
The valuation techniques discussed above will have its pros and cons. While some are more reliable and accurate, some of them are easier to perform and the outcome is usually positive. For instance, in the Comparables Company Analysis, the market efficiency ensures that trading values for comparables companies are a good indicator of value for the company being evaluated. One will have to select the comparables carefully reflecting industry trends, business risk and market growth so that the result is near to perfection. However, one needs to be cautious of the fact that no two companies are perfectly similar and the valuations may not be identical.
Similarly, discounted cash flow technique is not so much influenced by market conditions or non-economic factors. In fact, it is the most powerful method of valuation if one is confident in the projections and assumptions as DCF values the individual cash streams directly. The valuation obtained is very sensitive to modeling assumptions—particularly growth rate, profit margin, and discount rate assumptions. So, different DCF analyses can lead to various different valuations. In valuation done by the DCF technique, forecasting of future performance thus becomes the key.
The precedent transaction is often vouched as the best valuation as the previous transaction has validated the valuation. However, one has to keep in mind that the valuation multiples in prior transactions will include premium and synergy assumptions, which may not be public knowledge most of the time. So one must very carefully do the valuation in M&A and reap the best out of it.