Valuation analysis is the act of determining how much an asset, portfolio of assets, stream of cash flows or business is worth. It is performed by corporations, investors, analysts and bankers for a wide range of situations. Examples of when valuation analysis should be performed include: (1) when an investor needs to determine what price should be paid for an investment – the investor could be an individual purchasing securities, or the investor could be a company or group of investors buying another company; (2) as a tool in making strategic decisions; (3) when a company is preparing for an initial public offering in order to determine a valuation range for its stock; (4) when prospective partners are creating a joint venture in order to know how to split the partnership fairly; (5) by investment bankers when providing a fairness opinion; (6) by management when issuing stock options to determine the proper strike price for the options; and (7) in litigation work in order to detemine potential damages. This chapter will provide both a conceptual discussion of valuation and an overview of the most commonly used valuation techniques.
Value is Relative
Value is a relative concept, not an absolute one. An asset or business may simultaneously be worth a certain price to one buyer and a different price to another buyer, or one price to a buyer at one point in time and a signiﬁcantly different price to the same buyer two years later. For a seller, that means there is a range of values (not one absolute value) that represents a fair price for the asset or business. In addition, the nominal value of an asset or business can be affected by prevailing macroeconomic conditions, such as the interest rate environment. Speciﬁcally, low interest rates lower the cost of capital for a company. A low cost of capital allows buyers to afford higher purchase prices because return thresholds are easier to achieve. The opposite holds true in a high interest rate environment — with high interest rates, a buyer’s cost of capital increases, which drives purchase prices down.
When performing valuation analysis, those new to M&A often try to ﬁnd one correct answer or one correct number. There is no absolute correct answer or number when it comes to valuation. Instead, a range of values is more appropriate. This is partly because the same asset is worth different amounts to different buyers, and partly because valuation is based on assumptions. Each change in assumptions leads to a different valuation result. It is impossible to know with certainty which assumptions will ultimately prove correct since assumptions relate to the future. Therefore, it is impossible to know with certainty what the “correct” valuation is since it is based on assumptions which have a natural margin of error built into them. As a result, analytically rigorous valuation analysis must recognize that buyer preferences, prevailing conditions and margin of error all play a role in valuation. The only way to capture such disparities is to provide a range of values rather than a speciﬁc value when performing valuation analysis.
A business owner or executive might think his business or asset is worth a certain amount – perhaps someone told him his company was worth a certain value in the past and that particular number has stuck in his mind, or perhaps the company has a team that regularly performs internal valuation analysis. Regardless of how someone has come to believe what his company is worth, it is important to remember that no seller can decide independently what her business or asset is worth. Nor can a buyer decide independently what an asset or business is worth. It takes a willing buyer and a willing seller to determine a market value. Also, a buyer cannot buy if the seller is not ready to sell; and a seller cannot sell unless a buyer is ready to buy.
Consider the price you might pay for a home. You cannot go to a “home supermarket,” select the home you want with a nonnegotiable sticker price on it, and walk to the checkout counter to pay for it. When selling a home, sellers have listing prices that represent the price or value they want for the home. When buying a home, buyers make offers based on (r) what they think the home is worth and (2) what they can afford. Imagine that your friend Steve is a prospective buyer. He has searched and searched and ﬁnally found a New York City apartment that he likes which is listed at $800,000. However, given the apartment’s size, features, associated liabilities (e.g. plumbing and electrical issues), and the neighborhood, he does not think it is worth $800,000. So he makes an offer for $730,000. The seller considers Steve’s offer, but decides she would like to hold out for a higher price. A few weeks later, Marc, another buyer, makes an offer for $780,000 and the seller accepts it. They sign a legal agreement binding each other to the sale.
In this example (which is not at all uncommon), two independent buyers came to a different conclusion as to the value of the home. Is one of them right and one of them wrong? No. The same apartment was simply worth more to one party than to another. Perhaps Marc works only a few blocks from the building and therefore ascribed a signiﬁcant amount of value to location. Regardless of the reason, there was $50,000 of value ($780,000 – $730,000 = $50,000) that existed for Marc that did not exist for Steve and, as a result, Marc was willing to pay more for the same apartment. And the seller who thought her apartment was worth $800,000 realizes that it is only worth $730,000 to $780,000 (which is the range of values offered by interested buyers for the apartment).
While more complex, selling a business or a company’s asset is not very different in theory from selling a home. Different buyers will come to different conclusions regarding value. Some buyers will be emotional about the company or asset whereas some buyers will make their decision based solely on the ﬁnancial and strategic merits of the transaction. The goal of a seller is to ﬁnd the buyer who is willing to offer the highest value £1 who can deliver the best contractual terms (including, importantly, the greatest certainty to closing).
When performing valuation analysis, it is important to remember:
– There are no absolute prices, only relative values;
– Different buyers will allocate different values to different components based on how they plan to run the company or use the asset; and
– Prevailing factors, such as interest rates, industry growth rates, and consolidation trends, will affect valuation levels.
The best indicator of value for a public company is the current stock price. The market provides the best leading indicator of fair value because it reﬂects the price an investor is willing to pay at any given moment for a non-controlling share of the company. However, the current market price must be tested to see if the market price reflects the intrinsic value of the company (i.e., to check if the market is correctly valuing the company). Also, with a private company, there is no current stock price to refer to so other valuation methods must be used.
So how do people agree on a value for a non-controlling interest or a controlling interest in a company? Agreed upon valuation methodologies provide a common language for buyers, sellers, advisors, analysts, creditors, lenders and courts. While there are many valuation methods, the ﬁve listed below are the most commonly used in M&A and corporate ﬁnance analysis:
1. Comparable company analysis
2. Comparable transaction analysis and premiums paid analysis
3. Discounted cash flow analysis (DCF)
4. Leveraged buyout analysis (LEO)
5. Breakup analysis
Some of these methodologies are more appropriate in certain situations than in others. Most often, some combination of these ﬁve valuation methodologies is used to triangulate to a valuation range. This means that many or all of these analyses are performed and then a valuation range is determined based on the conclusions from each of the analyses. There are also specialized valuation techniques such as recapitalization analysis and liquidation analysis that are used in speciﬁc circumstances. In addition, certain industries, including natural resources, ﬁnancial institutions, and real estate, have specialized industry-speciﬁc valuation methodologies that are regularly used.