The past 18 months have been difficult for business owners and financing markets as the economic recession curtailed growth prospects and tightened credit markets. While improving economic indicators are motivating strategic buyers to take advantage of their cash-heavy balance sheets, there remains a great deal of uncertainty as to what fair market value of companies truly are in the 2010 economy. Rumors and anecdotes surrounding M&A activity often conflict, indicating rebounding, flat, or falling valuations. The uncertainty over the reliability of valuations seems to have discouraged many sellers from considering their exit option, though the prospect for advantageous deals remains interesting going into the rest of 2010.
Despite an improving environment for M&A activity, sellers must be aware that buyers, though interested, are unlikely to pay a premium price during a transaction and will offer a low valuation, citing the uncertainty over the current definition of fair market value. In order to obtain a market premium, sellers must prove their company’s worth.
In order to prove worth, sellers will have to understand the details of the valuation process in an uncertain economy. We developed a valuation tool for those sellers interested in determining if their company is worth a premium.
Valuation Process
While the most valuation processes utilizes quantitative techniques to estimate market value for a business, there is a substantial element of subjectivity. Valuations are also influenced by institutional, economic, and personal perceptions of attributes and detriments. The qualitative factors utilized in valuations include the discounted cash flow method and the market approach.
Discounted Cash Flow (DCF)
DCF is a relatively simple premise that measures the worth of a company based on the total amount of after-tax cash it generates for the shareholders’ benefit. The value is indicated by an estimation of the company’s future economic capabilities, calculated as the present value of projected cash flows for a predetermined period in addition to the present value of residual value at the end of the projection period. DCF is typically computed as a range of values, including best- and worst-case scenarios in addition to the expected value. While the premise is simple, there are multiple components that can be disputed, argued and/or negotiated when using a DCF and it is not often used when a seller is receiving offers from multiple buyers.
Market Approach
The market approach uses either comparable companies or comparable transactions as the basis for preparing a valuation. The comparable companies approach uses the values of public companies similar to the company looking to be acquired as a benchmark for determining fair market value. The theory with the comparable companies approach is that the market is an efficient evaluator of a company’s worth, since price of exchanged securities is a reflection of available information in addition to the supply and demand created by rational buyers and sellers. Therefore, a company’s worth on the marketplace is an expression of the market’s valuation of that company. When buyers and sellers utilize this approach, a peer-group of publicly traded companies are compiled, multiples are applied, and a valuation is calculated based on a variety of factors.
The comparable transactions approach is similar to the comparablecompanies method, except that the benchmark is recently acquired companies. A portfolio of recently acquired or divested companies similar to the subject company is compiled and the multiples that were implied in these companies’ purchase prices are used to determine the subject company’s value. The most widely used quantitative analysis is EBITDA times market multiplier.
Challenges of Valuations in an Economic Recession
While a sound valuation is always a complex and nuanced undertaking, there are particular challenges to completing an appropriate valuation in the current economic environment.
First, choosing the companies to form the basis of a comparable transactions analysis is very difficult. The companies that have been acquired or divested over the preceding 18-month period have most likely been in distress or similar unfavorable fiscal situations. Therefore, these purchase prices are likely to be low, misleading a valuation analysis to place a company’s value below fair market value. However, reaching beyond the preceding 18 months into the time period prior to the recession for transaction history is likely to yield valuations that were too high, yielding an above-market valuation that buyers will be reluctant to accept on the basis of the transaction history analyzed.
Compounding the challenges of finding the appropriate transactions for benchmarking, buyers are typically very reluctant to discuss the types of attributes that would induce a selling price that is a market premium. Multipliers are typically discussed in a wide range to garner interest among sellers, but determining the exact circumstances that would lead a buyer to pay above this range are difficult to gauge in the absence of an expert who works with both buyers and sellers on a regular basis. Additionally, determining if a company is worth a market premium requires in-depth analysis of each component that goes into a valuation.
Our Valuation Matrix and Expert Guidance
We developed a valuation matrix that serves as guidance for a business owner to determine the valuation price of his or her company. When formulating the variables for this matrix, we formulated and weighted the variables that buyers usually look for when deciding to place a valuation on a company. While the matrix is a helpful standalone tool for determining the general baseline of a company’s standing in the market, we also provides the expert guidance throughout the valuation process that will always be a seller’s best option if he is seriously considering strategic alternatives for his business.
The Matrix
To use the matrix, one must first identify comparable transactions, typically between 5 and 10 transactions that are similar in revenue size to the subject company. Once identified, the price/EBITDA mean of those transactions should serve as a benchmark range for the subject company’s valuation. The valuation matrix will serve as the tool for determining whether the subject company is worth above or below the mean range.
The matrix is divided into three separate general sectors that a seller must take note of when deciphering the value of his company:
• Individual Company Inputs
• Industry Inputs
• General Economic Inputs
Each of these general inputs contain metrics that affect the valuation of a company, and each metric’s weight has been appropriated based upon the importance of the variable from a buyer’s perspective. By using a ranking system based on a scale of -3 to 3, one can determine a number which can tell whether a company will sell below market value (negative), at market value (0), or for a premium (above market value), after weighting and summing. Once completed for all categories, the sum should be a number anywhere from -3 to 3 depending on the grading.
Designating rankings to a business in itself requires market knowledge, however we provide a description of each variable and what is considered to be a “-3” and a “3” for each metric, outlined in detail in an appendix accompanying the valuation matrix.
The valuation matrix is also a powerful tool for determining strategic plans. For example, once an owner calculates a final number, a number that is below 0 indicates that it may not necessarily be the right time to sell a business, and if considering retirement soon, owners should develop value enhancing strategic initiatives for the business in order to ensure an accretive exit as quickly as possible. Numbers closer to 1-3 are a good sign, and these owners should consider taking the next step by having an official valuation performed and most likely have multiple strategic options open to them.
We developed this matrix after several years of transactional experience where we were asked to prove or defend a client’s valuation premium. Our expertise in business valuations and our ability to understand how the market will perceive a company’s strategic initiatives from a valuation perspective allows us to assist our clients identifying all the options available to them in today’s market.
To receive a copy of the Valuation Matrix Excel Worksheet, email research@wyattmatas.com.
Tags: Business Valuations, Chip Measells, Discounted Cash Flow, Ed Manthey, Market Approach, Market Valuation, Mergers and Acquisitions, selling a business, Valuing a Business, Wyatt Matas & Associates