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An Overview of M&A Valuation Methods

Show Notes Of Podcast

What is M&A valuation?

Valuation is the amount an acquirer calculates as being appropriate to pay for a target. Oftentimes, investment banks are hired to perform target valuation. Of course, acquirers do not always follow the numbers, and while valuation is certainly a mix of art and science, emotions and deal hunger can cloud sound valuation.

Overpaying in M&A has been an all too common downfall of acquirers in recent years. Not only does overpaying make acquirer value creation more difficult (which is ironic since generating value is the primary goal of M&A), but it also drastically reduces shareholder value. Consequently, for a deal to be successful, one of the building blocks is appropriate valuation via specific valuation methods used to determine a fair and appropriate price. 

Overpaying in M&A has been an all too common downfall of acquirers in recent years. Not only does overpaying make acquirer value creation more difficult (which is ironic since generating value is the primary goal of M&A), but it also drastically reduces shareholder value. Consequently, for a deal to be successful, one of the building blocks is appropriate valuation via specific valuation methods used to determine a fair and appropriate price. 

What is M&A valuation?

Valuation is the amount an acquirer calculates as being appropriate to pay for a target. Oftentimes, investment banks are hired to perform target valuation. Of course, acquirers do not always follow the numbers, and while valuation is certainly a mix of art and science, emotions and deal hunger can cloud sound valuation.

What are the three types of company value?

  1. Market value (also known as “open market valuation”) - Market value is the value investors assign to a business. Specifically, it is determined by taking the number of outstanding shares and multiplying by the company’s current stock price.
  2. Enterprise value - Enterprise value is sometimes thought of as a more comprehensive valuation method as it includes the debt of the company in addition to the market capitalization. 
  3. Book value - Book value is calculated by subtracting the company’s liabilities from its assets. 

Common questions investment bankers ask when performing valuation

  • Is the target public or private?
  • Is the acquirer a company or private equity firm? 
  • What are the details of the purchase (hostile, friendly takeover post negotiation, etc)?
  • How is the current market? Are there any comparable deals taking place?

What are common M&A valuation methods?

While there are many valuation methods, the most common include:

  1. Comparable company analysis - This method uses similar companies to determine the target’s value. Most notably, this means businesses of the same size and in the same industry. Enterprise value to sales, price to book, price and  price to earnings are all measures used for this comparison. 
  2. Earnings Before Interest, Tax, Depreciation & Amortization (EBITA) - This method helps predict a company’s earning potential. There are two formulas for calculating EBITA: (1) net profit + interest + taxes + depreciation and amortization, and (2) operating income + depreciation and amortization. 
  3. Leveraged buyout analysis - This method looks to determine the highest price that should/could be paid for a company, taking into account current debt markets for financing, and the desired minimum rate of return. 

Discounted cash flow analysis - Discounted cash flow analysis is a valuation method that uses the time value of money to project the value of a company/investment in the future. It can be defined as: the sum of the cash flow in each period divided by one plus the discount rate (WACC) raised to the power of the period number.

Read also:
A Review of Business Valuation Methods Available to Buyers
Navigating Intangible Asset Valuation

What are other valuation considerations?

  • Acquirer’s cash flow
  • Timing of the deal 
  • Current economic conditions
  • Risk 
  • Target’s growth and predicted stability
  • Negotiation
  • Target’s age/stage in company’s life cycle 
  • Acquirer’s and target’s competition

Examples of failed valuation/companies overpaying for targets

  1. Mondelez and Hershey - While Mondelez ultimately abandoned its efforts to acquire Hershey, Hershey’s consistent demand for a higher price shows how acquirers can be swayed from valuation best practices in the heat of negotiation. 
  2. Microsoft and LinkedIn - In the opinion of many, Microsoft overpaid for LinkedIn. In fact, Forbes magazine noted in multiple articles that Microsoft was destroying shareholder value and vastly overpaying for LinkedIn. Ultimately, though, the jury still seems to be out on the ultimate benefits to Microsoft by this merger - there still might be future benefits that would support the purchase price...
  3. Men’s Wearhouse and Jos. A Banks - Similar to the headlines surrounding the Microsoft/LinkedIn deal, Men’s Wearhouse was criticized in the press and by practitioners for overpaying for the struggling Jos. A Bank. The deal did not lead to captured synergies as Men’s Wearhouse had hoped.
Read also:
Top Valuation Mistakes Made During M&A Deals You Can Avoid

How the Approach to Valuation Frames Success for Diligence and Integration

Final Thoughts

Valuation is not only incredibly important, but also very deal specific. While we have provided an overview of M&A valuation and valuation methods, valuation calculations and considerations ultimately depend upon many factors, such as the buyer’s position, the buyer’s defined strategy, the current economic conditions, and the industry involved - to name a few. In the end, of course, practitioners must remember paying a specific price for a target does not automatically equate to deal value.

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Overpaying in M&A has been an all too common downfall of acquirers in recent years. Not only does overpaying make acquirer value creation more difficult (which is ironic since generating value is the primary goal of M&A), but it also drastically reduces shareholder value. Consequently, for a deal to be successful, one of the building blocks is appropriate valuation via specific valuation methods used to determine a fair and appropriate price. 

What is M&A valuation?

Valuation is the amount an acquirer calculates as being appropriate to pay for a target. Oftentimes, investment banks are hired to perform target valuation. Of course, acquirers do not always follow the numbers, and while valuation is certainly a mix of art and science, emotions and deal hunger can cloud sound valuation.

What are the three types of company value?

  1. Market value (also known as “open market valuation”) - Market value is the value investors assign to a business. Specifically, it is determined by taking the number of outstanding shares and multiplying by the company’s current stock price.
  2. Enterprise value - Enterprise value is sometimes thought of as a more comprehensive valuation method as it includes the debt of the company in addition to the market capitalization. 
  3. Book value - Book value is calculated by subtracting the company’s liabilities from its assets. 

Common questions investment bankers ask when performing valuation

  • Is the target public or private?
  • Is the acquirer a company or private equity firm? 
  • What are the details of the purchase (hostile, friendly takeover post negotiation, etc)?
  • How is the current market? Are there any comparable deals taking place?

What are common M&A valuation methods?

While there are many valuation methods, the most common include:

  1. Comparable company analysis - This method uses similar companies to determine the target’s value. Most notably, this means businesses of the same size and in the same industry. Enterprise value to sales, price to book, price and  price to earnings are all measures used for this comparison. 
  2. Earnings Before Interest, Tax, Depreciation & Amortization (EBITA) - This method helps predict a company’s earning potential. There are two formulas for calculating EBITA: (1) net profit + interest + taxes + depreciation and amortization, and (2) operating income + depreciation and amortization. 
  3. Leveraged buyout analysis - This method looks to determine the highest price that should/could be paid for a company, taking into account current debt markets for financing, and the desired minimum rate of return. 

Discounted cash flow analysis - Discounted cash flow analysis is a valuation method that uses the time value of money to project the value of a company/investment in the future. It can be defined as: the sum of the cash flow in each period divided by one plus the discount rate (WACC) raised to the power of the period number.

Read also:
A Review of Business Valuation Methods Available to Buyers
Navigating Intangible Asset Valuation

What are other valuation considerations?

  • Acquirer’s cash flow
  • Timing of the deal 
  • Current economic conditions
  • Risk 
  • Target’s growth and predicted stability
  • Negotiation
  • Target’s age/stage in company’s life cycle 
  • Acquirer’s and target’s competition

Examples of failed valuation/companies overpaying for targets

  1. Mondelez and Hershey - While Mondelez ultimately abandoned its efforts to acquire Hershey, Hershey’s consistent demand for a higher price shows how acquirers can be swayed from valuation best practices in the heat of negotiation. 
  2. Microsoft and LinkedIn - In the opinion of many, Microsoft overpaid for LinkedIn. In fact, Forbes magazine noted in multiple articles that Microsoft was destroying shareholder value and vastly overpaying for LinkedIn. Ultimately, though, the jury still seems to be out on the ultimate benefits to Microsoft by this merger - there still might be future benefits that would support the purchase price...
  3. Men’s Wearhouse and Jos. A Banks - Similar to the headlines surrounding the Microsoft/LinkedIn deal, Men’s Wearhouse was criticized in the press and by practitioners for overpaying for the struggling Jos. A Bank. The deal did not lead to captured synergies as Men’s Wearhouse had hoped.
Read also:
Top Valuation Mistakes Made During M&A Deals You Can Avoid

How the Approach to Valuation Frames Success for Diligence and Integration

Final Thoughts

Valuation is not only incredibly important, but also very deal specific. While we have provided an overview of M&A valuation and valuation methods, valuation calculations and considerations ultimately depend upon many factors, such as the buyer’s position, the buyer’s defined strategy, the current economic conditions, and the industry involved - to name a few. In the end, of course, practitioners must remember paying a specific price for a target does not automatically equate to deal value.

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