How Much Is the Company Worth

How Much Is the Company Worth One of the most important questions turned over and over by investors or acquirers during a deal involving a merger or an acquisition is on whether the purchase or investment will be beneficial to them or not. Is the company worth buying? Will the benefits of taking it over or merging with it be more than the cost that was incurred in the takeover or merger process? How long will it take for the buyers to recoup the costs they incurred in the deal? Shareholders are more concerned with the premium or return they will get out of the deal.These questions will never be answered unless the acquiring companies or investors are able to determine how much the target company is really worth. © Shutterstock.com | garagestockThis guide covers 1) an introduction to company valuation and 2) most commonly used  approaches to company valuation.COMPANY VALUATIONThe valuation, or the price that one party in an MA deal will pay for a company or a business, is, by nature, subjective. There are two parties involved in an MA deal: the acquiring company and the company being targeted for acquisition. Thus, it comes as no surprise that the value of a company will be seen from two perspectives.Seller’s point of view â€" The seller, or the shareholders of the target company, would want to value the company at the highest possible price, so they can get a higher premium.Buyer’s point of view â€" The buyer, or the investors or shareholders of the acquiring company, would want to get the target company for the lowest possible price, so they can maximize their returns later on.But what is the importance of determining what the target company is worth?As mentioned earlier, the main reas on why a company valuation should be done is that the investors or the acquiring company will know if the purchase will be beneficial to them, and eventually decide how much to offer for the target company.Complexity of ValuationYou may think that valuation is straightforward, as long as you have all the numbers and the source data. As it turns out, it is a far more complex exercise than that. What does it involve?Valuing the target company: This is the technical part, where you will have to choose a method to calculate or estimate the company’s worth. It also often involves looking into the target company’s financials.Synergy: Synergy is the potential and additional value that will result from the combination of two firms, or the acquisition of one firm by another. It could stem from the operations of the combined companies, or from financial sources, such as savings from tax and increased capacity to incur and handle debt. In this instance, the investor may opt to prepare valu ation while taking into account the built-in synergies, or the synergies that come with the target company.Control: This pertains to the management of the company. Control will also affect valuation because it is possible that the investor is motivated by control when valuing the company. Thus, they will pay more attention to the investment, dividend and financing policies at work. The extent to which they would look into the financials of the target company will also be influenced.Contributing Factors to MA ValuationIn company valuations, there are several factors that come into play. While there are some who are of the belief that valuation is purely a financial or mathematical exercise â€" where only equations and numbers matter â€" it is important to note that there are other, non-mathematical factors that affect it. Although the numbers resulting from a computation provide a starting point for the determination of the valuation, there are other items that should also be taken i nto account.The meeting point of cash flow and time. How long is the period needed in order for the acquiring company to get back its cost of investment, or the price that it paid for the purchase of the target company?The inherent risks that come with the target company. The business being acquired is sure to carry with it some associated risks. What are these risks, and how will they figure in the valuation? Will the risks be high enough that it would affect the value that the buyer would be willing to pay for the company?Economic risks faced by the target company. This is looking at the bigger picture, specifically the industry and the economy that the business operates under. Economic downturns are sure to have negative effects on all businesses, and these risks are to be considered when valuing a company’s worth.Potentials of the business. We are talking about the target company’s future prospects. Is it looking good? Are the numbers showing rapid growth and profitability i n the future?Negotiating skills. At the end of the day, valuation will largely depend on how good the parties are at negotiating. This is the reason why many businesses bring in the “big guns”, or the expert negotiators, in order to talk about company valuation.The last item will now bring to light one crucial question: who prepares the valuation?There are two options available: the first one would be for valuation to be prepared internally, (by the acquiring company) and the second option is to have independent professionals do it.Now, which is better? For purposes of objectivity, it would appear that the better option would be to have an independent professional do it. He is likely to be more objective and impartial, thanks to his independent nature. However, there is also nothing wrong with having your own people do it, especially if you are confident that they are knowledgeable, experienced, and more than competent when it comes to MA transactions.The recommendation of most experts in MA would be to do both, meaning that investor should prepare its own valuation, and have another valuation prepared by an independent professional. The two valuations may then be compared, and it will be easier to identify gaps or differences that can be easily bridged between the two perspectives.The 4X to 6X Valuation RangeSpeaking in general terms, there is a simple valuation range that is used in valuation:                                                                                             4x to 6x EBITDAIn the above range, EBITDA is the net earnings left over when you deduct expenses from revenue, excluding interest, taxes, depreciation and amortization expenses.Say, for example, that a target company has EBITDA of $5 million. This would lead to a valuation of $20 million to $30 million.Take note that 4x to 6x is just the range, with the average, 5x, seen as the generally accepted industry standard. The 6x multiple is not the ceiling, however, because there a re instances where it can go above 6x. This is in the case of businesses that are highly profitable or show very rapid growth potential in an industry that is equally dynamic and promising when it comes to growth and profitability. Of course, we also cannot rule out the possibility that the negotiators may be so good at their jobs that they can raise the valuation â€" and negotiate it â€" at multiples higher than 6x.APPROACHES FOR PREPARING VALUATIONThere are more than several procedures used by companies to prepare valuations that are later used in various business transactions, not just MA. However, we can categorize these procedures into three valuation approaches.ASSET-BASED ApproachIn this approach, the attention is mostly on the assets of the target company. It is the approach that is chosen when the target company has a very low, sometimes even negative, value, particularly in terms of its status as a going concern. It could be that the company is not really making profits at all, or have sustained operating losses in recent years, so it shows no strength when it comes to profitability. Thus, the acquiring company would value it based on its assets instead of income. In short, it is the target company’s assets that will be valued separately.Many say that this approach provides the minimum benchmark when it comes to valuation in MA, and that is true. The method of purely basing the value on the assets of the company often results in the lowest valuation, even in the case of a target company that is doing relatively all right in making profits.Some of the most common procedures are:Net Asset Value Method: Net Asset refers to the remaining equity of the target company after its assets and liabilities have been adjusted to reflect the fair market value. That net value is the value of the business. In accounting, Net Asset is equal to Assets less Liabilities.Liquidation Value Method: The valuation of the company is equal to its liquidation value, or the pr esent value of the estimated proceeds from liquidating all its assets, after paying off its liabilities and other mandatory expenses.INCOME-BASED ApproachThis approach holds that the value of the company is equal to the present value of all the future benefits (income), after considering the inherent risks to these benefits, to the acquiring company. A discount rate will be applied in order to arrive at the net present value (NPV) of the company’s future income. It essentially answers the question: “how much should the investor pay today in order to receive a certain amount in n years?” Or “how much should the investor pay today in order to receive periodic, regular income amounting to x over a period of n years?”The most common procedures are:Capitalization of Earnings: This procedure requires looking into the historical earnings of the target company, and normalizing them in consideration with inherent risks that affect the growth of the company’s future income.Discoun ted Future Earnings: The projected future earnings of the target company is not really considered much in this method, since the acquiring company will discount that amount back to its present value.MARKET-BASED ApproachThis is a broader approach, since the valuation is with respect to the value of other, similar companies within the same industry and economy. In most cases, the comparison is made on several similar aspects of the companies, not necessarily the overall value. Compared to the Asset- and Income-based approaches, this is the one that is more commonly used in MA transactions.There are two variables that come into play:The companies to be compared. For companies to be comparable, they have to have similarities or parallelism. One way would be to narrow things down by comparing companies that belong to the same industry as the target company. Of course, it would not make sense to compare, for MA valuation purposes, an international airline carrier company to a fast-food c hain, even if it also operates internationally. In the same vein, it would also be more prudent to compare a publicly traded target company with other publicly traded companies. This also applies to size, since it does not seem fair to compare aspects of a multinational company to a domestic one.Aspects of the companies to be compared. Not all aspects of the companies will be relevant in valuation preparation. You have to choose those aspects that actually have an impact on the value or worth of the company. For example, the aspects to be compared may be their annual earnings, the total gross revenue, or even the book value of their capital assets.METHODS OF VALUATIONAlthough the 4x to 6x multiples are widely used by many businesses and even some of the tools mentioned in the three approaches, there are other methods or tools that are commonly used to assess the value of target companies.1. Price-Earnings Ratio (P/E Ratio) MethodComparative ratios have proven to be very useful in va rious financial analysis, and they also come in handy when it comes to MA valuation.In this method, all the stocks of companies in the same industry are analyzed in order to get a good picture of the P/E ratio of the target company. The acquiring company will value the target company, and make an offer that is a multiple of the latter’s earnings.2. Enterprise-Value-to-Sales Ratio MethodThe buyer will make an offer using a multiple based on the sales of the target company. Usually, the multiple is arrived at after conducting a study on the prevailing price-to-sales ratio of other companies within the same industry.3. Replacement Cost MethodIn this method, the target company will be valued at its replacement cost. Replacement cost is defined as the “cost to replace the assets of a company”. In this context, it means the “cost to replace the target company itself”. A simple example would be when the investor makes an offer that is equal to the value of the capital assets and equipment, as well as the staffing and personnel costs of the target company.The downside for this method is that it is limited to companies whose assets and operations are purely quantifiable. Service providers are much harder to quantify in terms of their replacement costs.4. Discounted Cash Flow MethodThis method will have the preparers of the valuation taking a closer look at the target company’s estimated future cash flows, specifically the free cash flows. It will basically predict the free cash flows, based on historical cash flow data, and the estimated amount will be discounted to its present value, using the target company WACC, or weighted average cost of capital.Watch this video to learn more about the discounted cash flow method. For purposes of computation, free cash flows is computed:Operating Profit100Add back:Depreciation Expense10Goodwill Amortization515Total115Deduct:Capital Expenditures(12)Taxes (paid in cash)(4)Change in working capital(4)(20)Free Cash Flows                95Having so many methods available, with each of them having their own pros and cons, can be quite confusing for companies involved in MA, and there is a chance that that choose the wrong method and subsequently come up with a valuation that is not truly representative of the company’s worth. That is why there is a need for everyone to work together in choosing which method is most applicable.Ultimately, it is important to know that the value or worth of a company in any MA transaction is that amount which a buyer and a seller willingly agree on, leading them to conclude the transaction and close the deal. There are two elements that must be present: the buyer is willing to pay for it, and the seller is willing to accept that payment at that amount.So you have the numbers and the figures, backed up by the recommendation of MA experts and independent professionals. Due diligence investigation has been conducted thoroughly, and you were finally able to come up with a v aluation. Will this be enough to green light the deal?For some, perhaps the answer is yes. However, there is one other ingredient that should never be left out, and that is Common Sense. The investor should always exercise common sense and professional judgment, in combination with the cold and hard facts and numbers, in order to decide whether the valuation truly reflects the target company’s worth.