Pricing and Value perspectives in M&A valuations

Introduction

  1. Valuing a target company in a M&A transaction is the most complex part of the entire M&A process and involves extensive negotiations. This is because the valuation differs in the eyes of the beholder(The buyer and seller).The buyer would look at valuation conservatively and target at the same time would be optimistic about its future growth and hence want to max out its returns.
  2. Value and Pricing is generally used interchangeably in M&A deals, though different inputs are required to arrive at intrinsic value and price of a company.
  3. A value investor determines the value of a target company based on its future cash flows, growth in its cash flows and risk associated in generating those cash flows.Alternatively, a company can also be valued based on its assets and liabilities.In this case, the assets and liabilities are valued at Fair Market Value and then net equity values is calculated based on that. This would be the value available to the shareholders.
  4. Pricing a company is more to do with intersection of demand and supply for that company.Pricing is entirely market driven and is dependent on macroeconomic factors like GDP growth, optimism/buoyancy in the market as well as growth in the stock markets.These factors can increase/decrease the price of the target company at the same intrinsic value.This is the reason why some companies in some industries/sectors are valued more than others at the same intrinsic value.
  5. In a M&A transaction, the intrinsic value of a company and the price paid to the target company can be different.Once the buyer arrives at the enterprise value, then it negotiates with the target company based on the deal structure, considerations and how quickly the deal can be closed.Such negotiations can have a purchase price which is less/higher than the intrinsic value.

Valuation approaches

A company is generally valued using three approaches:

  1. Asset based approach
  2. Income based approach
  3. Market based approach

These approaches do not yield the same value for a company.This perhaps vindicates why valuation is not a science and why judgement is very important when valuing a company.
For instance in capital intensive industry which is matured and have an marginal profits, valuations done using a income approach will yield a lower value as the future cashflows of the company may not be as high as the fair market value of its assets.
In an early stage technology company which does not have historical track record of earnings and revenues, income based approach would not work correctly. The asset based approach will also not work as a technology company generally does not have upfront investments.In such a case, a market based approach by comparing the target with the available companies in the market that exhibit the same business model will value the company correctly.

How Public companies are valued?

  1. In case of public companies, the information available on the target is vast which can help in valuing the company better.In addition, public companies can be easily traded in the exchange and hence are more liquid.
  2. Any additional information available on the company, whether it is positive or negative will impact the stock price of the company.The quarterly earnings announced by the companies also helps the analysts to revalue the listed companies quarterly. This explains why valuations are not permanent and vulnerable to changes depending on the periodic results announced by the company.
  3. Even in public companies, the stock prices change more based on the market situation than the intrinsic value of a company.This partially explains the existence of value investors and traders in the market.The value investors base their valuation on target future cashflows where as traders use the pricing points and arrive at points where the stock can surge or decline based on demand and supply.
  4. The value investors also uses the EBITDA and revenue multiples approach to value the company.These multiples are again derived from the prices of the comparable companies.This is the reason why a target company that is stable will command a better valuation in the boom period than compared to a recession.

How Private Companies are valued

  1. Valuing a private company is more challenging. This is because of the lack of available information on the target.In addition, the private companies do not announce their earnings at a quarterly basis and are not transparent in updating their information.
  2. There are also other issues like quality of financials available, internal controls followed as well as the accounting standards followed. In addition, private companies need to be discounted due to the lack of marketability as these companies are illiquid and cannot be exited easily as against public companies.
  3. Some of the Private companies are also VC/PE owned.In these situations, a portfolio company can be owned by more than one PE/VC firm.
  4. The VC and PE funds are required to mark their portfolio valuations annually to inform the Limited partners on the realized and unrealized value of their investments.In this case, the approach used by the VC fund to value its holdings is price driven than value driven.
  5. The VC firms either look at the last valuation round of its portfolio company to arrive at its total valuation and then arrive at its holding value based on the stake owned by it.If a target company is valued at $3Bn in its latest valuation round and if a VC has 10% stake in it, then the valuation entered is $300Mn.
  6. Alternatively, the VC also values the company by comparing its portfolio company with comparable companies in the market.The challenge here is that there is less information available on comparable companies.For instance, for a company like Uber, there aren’t many companies present to compare its valuations with.For Uber, list of companies available for comparison is Lyft and a small set of ride sharing companies.
  7. For early stage VC owned companies, the valuations should not only include the future growth rate but also the probability of the survival rate of the companies as most early stage companies do not survive after certain period.Hence VC firms discount the early stage companies at a higher rate which is higher than the discounting rate.
  8. VC owned companies generally exhibit a higher growth rate than a public company.This is because VC firms can influence the performance of its portfolio company by acting as advisors or taking a board seat in the companies.In case of public companies, the investors generally can observe but do not have the power to influence the performance of the target.

Conclusion

  1. Almost all the companies, be it public/private companies use a pricing game than intrinsic value to arrive at target valuations.
  2. In case of public company valuation, the quality of datasets available on the target company as well as comparable companies are far higher than a private company.As public companies need to come with quarterly announcement of its performance, it is easier to revalue the company based on the recent developments.
  3. For a private company that has revenues and earnings information available and that is in existence for longer period, it is easier to compare the target with public companies to arrive at EBITDA or revenue multiples.The private companies further are discounted as against a public company due to the lack of marketability as they cannot be easily sold.
  4. In case of early stage VC owned companies which has a different business model and have not been in existence for a longer time, datasets available for comparison is too limited.Hence valuation of such companies are generally not correct and depends on quality of judgment and how VC firms price these companies.


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