My Philosophy on Valuations
Over the years I have had the benefit of watching the acquisitions process from many different perspectives. I have been a principal of a company being acquired as well as a principal of a company conducting acquisitions. I have also served as an executive working on both acquisitions and dispositions teams and as a professional advisor representing both the buy-side and the sell-side. Having sat on all sides of the acquisition table it has been my experience that regardless of approach, style, timing, culture, synergy, supply or demand drivers, or any other catalyzing factor the transaction will eventually boil down to valuation metrics.
When I’m on the buy-side of the table I’m looking to drive down valuations to make accretive purchases that provide a solid return on investment. When I’m on the sell-side of the table I attempt to secure the highest valuation possible in order to maximize my return on equity. It is easy to see and to understand the divergent interests in play between buyer and seller. Thus when both the buy-side and sell-side parties are in alignment on valuation metrics and philosophy the transaction in play will have a certainty of execution that does not exist when there is either a philosophical gap or a large pricing delta between the bid and the ask.
Regardless of which side of the table you sit on the best way to close a gap in valuation is not by continuing to hammer on the financial metrics in a vacuum, but to rather use non-financial metrics to justify movement in valuation pricing.
While I have always placed a strong emphasis on valuation, I perhaps place an even greater emphasis on the quality of the employees, the client base, the product and service mix, the reputation of the business within the market place, the character of management and the integrity of the management process, current trends and future forecasts of the competitive landscape etc. Acquiring a large revenue stream that is also a poorly run organization simply results in a much “larger” headache. Simply put, building critical mass is not the same thing as building an excellent organization.
However, equally important to me is the recognition that there must be an excellent cultural and organizational “fit” in order for any acquisition to succeed. By “fit”, I simply mean a similar set of values and practices regarding the actual running of an ongoing business: business ethics, work styles, work ethics, a vision for the future, perpetuation objectives, leadership styles, and so on. It is the valuation of the non-financial metrics described in the last two paragraphs that should be the major influencing factors in your decisioning behind the justification of the final valuation.
Now that we’ve discussed the major influencing factors behind how to negotiate movement in valuation I want to give you an overview of what I believe is the “right” way to arrive at the “right” number to begin with. There is an abundance of available data on common industry rules of thumb concerning “multiples” that can be used to estimate the value of a business. However, while multiples may be useful in providing an immediate ballpark of a business’s value, they do not substitute for a more comprehensive valuation approach. Multiples are shortcuts to value based upon the simplification of more in-depth valuation methodologies. The use of multiples as the primary valuation methodology is equivalent to the business plan that is written on the back of a napkin. This is primarily true because no understanding of the data underlying the multiples has been performed, and thus neither the data integrity nor comparability with the subject business can be evaluated.
Valuation multiples provide a rough guideline for the price of the average business in a particular industry, but without due consideration given to the unique attributes of an individual business, geographic location(s), current competitive landscape, current economic environment, etc.
I have always believed in providing open, honest, fair and full disclosure of how I value an organization. In order to insure that both buyer and seller model a transaction that is fair to all parties and economically viable going forward I developed a blended valuation approach that takes into account a variety of valuation methods that is weighted to the unique circumstances of a the particular business and the market timing of the transaction. I have successfully used this algorithmic valuation methodology to establish a fair price for a business. The following inputs are a representative sampling of some of the factors that we weight in our calculations:
Pre-tax Cost of Debt (PD) is the Company’s marginal cost of borrowing long-term funds.
After-tax Cost of Debt (AD) is the cost to the company of borrowing money after factoring in the benefits of the deductibility of interest.
Risk-free Rate of Return (RF) is the return an investor would require at the present time to invest in a long-term security with essentially no risk. The closest indicator to a risk-free long-term investment is a 30-year U.S. Treasury bond.
Equity Risk Premium (EP) is the historical premium that investors have required to invest in stocks over the returns that were available on risk-free treasury bonds at the time.
Integration Analysis (IA) is the estimation of both hard and soft costs projected for post integration activity as well as any projected cost savings due to enhanced leverage or economies of scale attributed to operating activities.
Beta (B) represents the volatility of an individual stock (as a result of the risk of the underlying business) relative to the volatility of the overall stock market. A beta of greater than 1.0 means the stock is more volatile than the market in general; less than 1.0 connotes a stock that fluctuates less than the overall market.
Small-Company Premium (SCP) is the incremental return historically required by investors in small stocks over the return required to invest in the market overall, after considering the impact of beta.
Company-Specific Premium (CSP) is the incremental return required on early stage companies and those with extraordinary risk characteristics over the premium required on equity securities in general.
Growth (G) is the estimated growth in the cash flows that can be sustained in perpetuity. It is important to understand that this number must be small, i.e., 0% to 3%, because of the underlying assumption that this growth occurs forever. As an example, many companies claim that they can grow at a rate of 10% per year indefinitely. However, if a company with revenues of $25 million today grew at 10% annually for 40 years, it would have revenues of over $1 billion. Very few companies with current revenues of $25 million will ever become $1 billion companies.
Capital Structure (CS) is the percentage of debt and equity that the company should operate with over time given the norms within its industry. This may differ from the existing capital structure of the company. The WACC is a function of the capital structure in that it is the after-tax cost of debt times the percentage of equity in the capital structure.
At the end of the day it is a combination of financial and non-financial metrics that will determine the valuation. Post valuation and post acquisition it is the solid operating skills and cohesiveness of management (of lack thereof) that will determine eventual success or failure of the acquisition.