What is a reasonable price for a target company, so that an acquisition will be profitable enough to reward financing?
Enterprise and Equity
A company is a business (capital employed) financed by invested capital (received from either debt or share holders). Buying a business is about buying capital employed. Buying a percentage of a business is about buying a share of the business equity.
Market Value of Equity = Market Value of Capital Employed – Market Value of Debt
However, this is not enough as ‘enterprise value’ is not the same as ‘equity value’, as there are often additional hidden elements of value. For example, what if a we pay a premium to buy a company and what if the company has not been listed on a stock exchange and therefore has no clear ‘market value’?
How to value a Company ?
We can base the valuation of a company on its equity value (the share price). This is done by asessing the enterprise value (the total capital employed) and then deducting net debt.
Equity Value = Enterprise Value – Net debt
We can value a business through the use of the following assumptions;
- Future expected returns
- The selling price of the company’s assets
1) Use Future Expected Returns
This approach adjusts any valuation to take into account future earnings or ‘cash flows’. For example the value of a building would depend on the amount of potential rent, less liabilities such as maintenance.
Discounted Cash Flow: “A Bird in the Hand is Worth Two in the Bush”
Like any project based on ‘Net Present Value’ (NPV), enterprise value can be estimated using cash flows. However, as per the saying ‘a bird in the hand is worth two in the bush’ the value of earnings or cash is not the same in the future as it would be if it was immediately available. Such a company valuation approach is similar to the method used when assessing the expected net present value (NPV) of an investment project.
It requires the following values to be known;
The sum of all future yearly cash flows expected from the company (the capital employed). Including;
a) Earnings Before Interest, Taxes and Amortisation (EBITA) – Related Tax ≈ Net Operating Profit After Tax (NOPAT) + Depreciation
b) +/- Changes in Working Capital Requirements (WCR)
c) – Sustaining Capital Expenditure (CAPEX)
These cash flows should then be discounted back to ‘year zero’ in order to provide a discounted period of yearly cashflows for analysis.
The Terminal Value is used to generate very long (if not unlimited) forecasts when we have no intention of simply closing a company after it is purchased. This is done by assuming that the growth rate will be constant into the future. This requires the following formula at the end of year zero;
Cashflow for year 1 divided by the discount rate minus the expected percentage growth rate
F(1+g) / (t-g)
Note; F = cashflow, t = the discount rate and g = the percentage growth rate of this perpetual cashflow
This then provides the terminal value for the last explicit year which can then be discounted back to year zero as per the diagram below.
A discount rate applicable to all the cash flows in the valuation.
This discounted cash flow (DCF) method is typically based on a Weighted Average Cost of Capital (WACC) rate for a normal risk free financing structure. For example that offered by US government bonds or the difference betwen equity vs debt.
If the finanncing structure changes significantly over the first few years a variable WACC maybe used, but if the terminal value ‘short cut’ is to be used then the WACC and the growth rate must be constant values.
For non-listed companies and small companies the cost of equity is often higher due to their lower levels of liquidity (they can not be quickly sold on the stock markets) and higher levels of inherent risk (smaller capital reserves leave them less robust in the face of adversity). This should be reflected in the discount rate with a ‘risk premium’.
Once these have been calculated various scenarios should be tested to understand the impact of changes within key parameters, for example;
- Events impacting the cashflow such as; sales evolution, time to market, the evolution of margins (as affected by changes in the cost of raw materials, labour or energy), and exchange rates.
- Events impacting the discount rate such as: changes in the interest rate
Finally to cluculate the equity value we need to;
- Use the DCF to get a an enterprise value for the business
- Deduct the value of net debt
- Add the value of any available cash
2) Value a Company based on it’s ‘Market Price’
A second approach to company vluation is to assess the ‘market price’ for the company and it’s assets. This is typically done by comparing similar assets. For example, a building would be assessed based upon the price / m2 of other similar types of real estate in the area.
Valuations with Comparables and Multiples
The main idea when using comparables and multiples is irrespective of the cash flows a valuation should be based upon the ‘current market price’. We can summarize the process in the following three steps:
Step 1: Identify Reference Company Data
To calculate the ‘current market price’ we need to identify indicative reference data from comparable companies. Such data typically falls into two categories;
- Comparable companies for which the value of equity is known (For example listed companies)
- Recent transactions involving comparable companies
Comparable companies can be referred to as ‘Reference Companies’, the company being valued can be referred to as ‘Target Companies’.
The difficulty with both types of reference data is;
- Access to accurate data
- Relevance of the data. (Can conglomerates be compared with non-conglomerates?)
Step 2: Identify Items Common to Both the Reference and Target
Often these will include items such as sales, EBITA, EBIT and non-financial data such as production volumes, facility sizes, and number of rooms, or visitors. However, such items need to be
- Relevant related to the known value of both companies
- Related to a known value (enterprise value or equity value)
Step 3: Apply the Reference Multiples
Next we identify, calculate and apply relevant multiples to each of the reference items identified in the earlier step.
a) Utilise Enterprise or Equity Value
For example by using;
- Enterprise value / sales, EBITA or EBIT
- Enterprise value / non financial data (e.g. volumes, m2, clicks per visitor)
- Equity value / NET result (Price to Earnings Ratio)
The multiples are often industry / sector specific, and should where possible exclude ‘synthetic’ figures such as net results which could be impacted by different financing policies or taxation schemes.
b) Apply the Price to Book Ratio
Alternatvely we can apply reference the Price to Book (P/B) ratio (book value / market value) to the target data.
- P/B Ratio / Enterprise Value
- P/B Ratio on Equity Value
A reference company has a market value of 100 (market value of equity). But in it’s financial statement it has a book value of 80 (book value of equity). Therefore its P/B ratio will be 100/80 = 125%
Applying this 125% figure to the target company book value as a multiple will then provide the target equity market value.
c) Use Other Methods
There are a number of other methods that can also be used. These include;
- The patrimonial method. Evaluating each asset line seperately (though some, such as goodwill, may require some kind of profitability approach)
- Mixed or hybrid methods. Mixing the book value of equity with certain profitability asumptions.
Some Risks …
1) Overvalued Reference Companies
The use of comparables and multiples based on reference companies can result in a valuation premium that is above the target company’s intrinsic value; especially when market activity and speculation is at a peak. This leaves potential buyers with a dilemma. Should they;
a) Buy at an inflated price? or
b) Miss the opportunity?
However, we should coinsider whether an expensive or over priced acquisition is really an opportunity. Any premium paid for a perceived competitive advantage must eventually be visible in the DCF, and if we over paid…
2) The Irrelevance of Historical Data
Another risk is that all methods based on multiples (e.g EBITA, EBIT, Net result) irrespective of the period of time sampled implicitly assumes that the future will be like the past. This can be an issue when a an industry is undergoing dramatic transformations or when a specific business model is being made redundant.
Some key terms used in this post…
- DCF = Discounted Cash Flow
- EBITA = Earnings Before Interest, Taxation and Amortisation
- EBIT = Earnings Before Interest, Taxation (can be susceptible to financial manipulation through excessive discounting)
- Market Value of Equity = Market Value of Capital Employed – Market Value of Debt
- Equity Value = Enterprise Value – Net debt
- P/E = Price to Earnings ratios
- WACC = Weighted Average Cost of Capital