VALUATION MATTERS: INVOLVED IN MERGERS AND ACQUISITIONS
Naturally, both sides of an M&A deal will have different ideas about the worth of a target company: Its seller will tend to value the company at as high of a price as possible, while the buyer will try to get the lowest price that he can.
There are, however, many legitimate ways to value companies. The most common method is to look at comparable companies in an industry, but deal makers employ a variety of other methods and tools when assessing a target company. Here are just a few of them:
- Comparative Ratios. The following are two examples of the many comparative metrics on which acquiring companies may base their offers:
- Price-Earnings Ratio (P/E Ratio) – With the use of this ratio, an acquiring company makes an offer that is a multiple of the earnings of the target company. Looking at the P/E for all the stocks within the same industry group will give the acquiring company good guidance for what the target’s P/E multiple should be.
- Enterprise-Value-to-Sales Ratio (EV/Sales) – With this ratio, the acquiring company makes an offer as a multiple of the revenues, again, while being aware of the price-to-sales ratio of other companies in the industry.
- Replacement Cost – In a few cases, acquisitions are based on the cost of replacing the target company. For simplicity’s sake, suppose the value of a company is simply the sum of all its equipment and staffing costs. The acquiring company can literally order the target to sell at that price, or it will create a competitor for the same cost. Naturally, it takes a long time to assemble good management, acquire property and get the right equipment. This method of establishing a price certainly wouldn’t make much sense in a service industry where the key assets – people and ideas – are hard to value and develop.
- Discounted Cash Flow (DCF) – A key valuation tool in M&A, discounted cash flow analysis determines a company’s current value according to its estimated future cash flows. Forecasted free cash flows (net income + depreciation/amortization – capital expenditures – change in working capital) are discounted to a present value using the company’s weighted average costs of capital (WACC). Admittedly, DCF is tricky to get right, but few tools can rival this valuation method.