Effectively valuing a business, whether a buyer or seller, involves multiple steps and requires both art and science. Getting it wrong results in widely disparate estimates of value, irrational analyses of risk and/or a cost of capital not reasonably related to the underlying value of the business. Getting it wrong means buyer and seller can’t come together.
One method of valuing a company, asset valuation, subtracts the company’s liabilities from the company’s assets. The resulting difference represents a most conservative view of the overall value in that it fails to incorporate any downstream earnings. This approach becomes particularly important when evaluating a liquidation strategy, a capital-intensive business or a worst-case scenario.
Another approach to valuation, market or multiples valuation, relies on available market information such as price-earnings ratios. This type of valuation assumes that the company being valued operates in a known market where buyers and sellers already exist. For example, if valuing a building products company where one can easily obtain industry price-earnings (PE) data, one might apply an average industry PE multiple to the company’s earnings to estimate a company value in the same way that one might apply that same multiple to per-share earnings to estimate the per-share market price of a company’s stock.
Ideally, one finds a similar company in the same industry that has recently sold – loosely called a “twin” – for comparison much as one would review real-estate comparables when buying or selling a house. Revenue and/or earnings multiples for this twin would of course prove highly relevant to the valuation process. Companies in new or emerging “Blue Ocean” markets, however, seldom find twins or meaningful reference data and must therefore rely on other methods.
In addition to earnings multiples, business owners often become enthralled with dreamy valuations based on revenue multiples which reveal nothing about the real value of the business. For the most part, such valuations prove meaningless – fool’s gold in this writer’s opinion.
A free-cash-flow valuation, in contrast with the above, begins with the company’s projected annual earnings before interest, taxes, deprecation and amortization, i.e., before EBITDA, and adds the net changes in assets and working capital needed to support the projected year-over-year growth. This process yields an estimate of the nominal free cash flows that the company will generate over time. These, in turn, are discounted and summed to create a present-value estimate – a preliminary free-cash-flow valuation – of the company. At this point in the valuation process, one adjusts the present-value estimate to reflect additional value for the acquiring company, e.g., increased market reach, new customers for its products, intellectual property and, in general, any synergies likely to result from the acquisition. Similarly, one would incorporate downward adjustments for business risk associated with expiring contracts and patents, loss of key personnel, customer defections or changes in the competitive landscape.
Unlike a market or multiples approach based on revenues and/or earnings, EBITDA more clearly reveals the cash generated by operations by removing non-cash expenses as well as those expenses subject to wide variations such as:
- Interest expense which will vary for the acquiring company since it will have its own financing and cost of capital;
- Taxes which may also vary widely based on past financial performance and previous acquisitions;
- Depreciation, a non-cash expense that may reflect an overly conservative or aggressive attitude about the useful life and/or residual value of a tangible asset; and
- Amortization, also a non-cash expense that may similarly reflect a conservative or aggressive attitude about the useful life of an intangible asset (intangible assets typically have no residual value).
Importantly, valuations based on EBITDA must also concern themselves with the quality of earnings or, put differently, the cowboy antics of rogue accountants. For example, EBITDA may be exaggerated if the company has: (i) delayed writing off obsolete inventories or bad debt; (ii) been overly aggressive in recognizing revenue; and/or (iii) minimized reserves. In other words, handle EBITDA with care.
The above paragraphs notwithstanding, in the end, a company’s value is precisely the amount a buyer will pay for it. Hence, the more buyer and seller reason their valuation estimates, the more likely they are to come together and consummate a transaction.