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February 01, 2023 5 minute read

Valuation in M&A: How to Select the Right Model

Valuation influences M&A deal success more than any other factor. According to the Harvard Business Review:

Recent research shows that acquisitions in the 1990s have just as poor a record as they did in the 1970s. There are plenty of reasons for this poor performance: irrational exuberance about the strategic importance of the deal, enthusiasm built up during the excitement of negotiations, and weak integration skills, to name a few. Many failures occur, though, simply because the acquiring company paid too much for the acquisition. It wasn’t a good deal on the day it was made—and it never will be. 

Creating value hinges on an accurate valuation. Every added dollar you pay for a company is a dollar you’ll have to earn back to break even on the deal.

To that end, you should be intimately familiar with the most common valuation methods. Each of the following methods is appropriate for a certain type of deal. Understanding which method to apply can save you millions of dollars or more on your next deal.

What Is M&A Valuation?

Valuation in M&A refers to the process of valuing (often arriving at a dollar figure for) a business before its purchase. Since the seller is incentivized to overvalue their business and the buyer is incentivized to undervalue it, arriving at the final number typically takes a bit of haggling. However, the broad strokes of valuation tend to be standardized.

Over the years, different valuation models have popped up to account for various business types, life cycle stages, and circumstances. Buyers must take multiple variables into account when selecting the best valuation model. 

Regardless of the model used, most valuations account for core business factors, such as revenue, liabilities, physical assets, intellectual property, and projected growth. Non-tangible assets, including branding and reputation, may also influence the final price.

Strategic deals take advantage of synergies and may see the buyer paying a premium above the normal market price. Synergy refers to additional value created beyond the sum of the two combined companies. Arriving at a fair value for this deal type is more of an art than a science: As a recent survey of M&A deal-makers pointed out, 72% of those polled reported that they had great difficulty arriving at an accurate valuation for a strategic deal. 

This is mainly because synergies are notoriously tricky to predict. Buyers tend to overestimate synergies, arriving at figures that fail to materialize in the real world. Generally speaking, it would be healthier for the buyer team to discount future synergies instead when arriving at a valuation. 

Common Methods for Valuation

Over the decades, multiple M&A valuation models have been used. The diversity of valuation models accounts for different industries, expected outcomes, and limitations, and different valuation models can lead to wildly different figures. Even within the same model, disparate accounting systems may cause the buying and selling sides to arrive at different valuation figures. Still, selecting the suitable model for your business can help you determine a fair market price.

Income Approach

Income approaches to business valuation rely on looking at a business’s current and projected earnings. Several common factors and methods to consider include:

  • Earnings Before Interest, Tax, Depreciation, and Amortization: Creative corporate accounting sometimes means that a company’s net revenue doesn’t accurately represent its financial state. Examining a business’s earnings before interest, tax, depreciation, and amortization are considered can help you better understand a business’s current health.
  • Dividend Yield: This approach attempts to provide an accurate, current valuation by looking ahead to the total price of future dividends. However, this model is rife with limitations since the formula underpinning it relies on multiple assumptions regarding future dividend growth and payout rate. 
  • P/E Ratio: The price-over-earnings ratio is a familiar formula investors use to compare companies within the same industry. Dividing the price of a stock share by the company’s earnings is a handy way to arrive at a shorthand number that allows investors to compare similar companies easily. M&A buyers can use this information to influence their valuation by sussing out if a company is overvalued or undervalued.
  • Revenue Multiples: One of the most common ways of valuing a company, revenue multiples are calculated with equity values and revenue. Revenue multiples sidestep the difficulties of accurately assessing the value of an unprofitable company. This model is also useful when looking at young companies that appear poised for explosive growth. Determining the multiple to assign can be tricky and will depend on the industry, the market, buyer sentiment, and other factors. The lack of attention paid to debts represents a significant downside of this approach. 

Market Approach

The market approach to valuation involves looking at what comparable businesses have sold for. This valuation model works best for businesses that fit a particular profile. For example, seeing what a similar business sold for in your geographic area earlier this year may give you a rough number on which to base your valuation. Market approaches commonly account for differences in size and scale by multiplying or dividing a company’s value according to differences in earnings and assets.

Asset Approach

Sometimes, businesses are bought and sold primarily for the underlying value of their assets. Asset valuation is fairly straightforward compared to some of the methods discussed above. Since you’re valuing the business for its physical and intellectual property, you can safely ignore current and projected revenues. 

The buy side will want to use their accounting team to arrive at an independent valuation. Since accounting models differ between firms, the two teams may need to spend some time in further deliberations. 

Intangible assets such as branding or unique pieces of intellectual property may also slow this process down.

How Does Valuation Impact Dealmaking?

The valuation model you adopt will influence the type of deal that you make. In the tech world, infant companies often receive valuations based on a multiple of their current revenue. Factors influencing this decision include the fact that apps and software are knowledge-heavy products with the potential for rapid mass roll-out. With that in mind, it’s reasonable to assume that a cloud-based software development firm could achieve rapid revenue growth with the right fundamentals and products, given a hot market.

In the heady days of the pandemic tech bubble, the bandwagon effect was fully in force. Private equity companies during that period may have felt pressure to use greater multiples than they would use under more normal circumstances or in a down market. 

On the other hand, it might make more sense to evaluate a manufacturer with erratic revenue and a robust factory system using just the value of its physical assets. Under these circumstances, the company price tag would have a firmer grounding in reality.

However, users of the market approach may find themselves locked in heated negotiations. Anyone who’s ever bought a house knows that basing a home’s value on comparable sales is tricky. Just as no two homes are exactly alike, neither are any two businesses. Accounting for minor differences can lead to major disagreements. 

How Are Valuations Impacting the Current M&A Market?

2021 proved to be a banner year for M&A deals, with a record-setting $5.9 trillion in value created through large M&A deals. That level of enthusiasm quickly tapered off in 2022, however. The number of sales, particularly large ones, tumbled alongside the S&P 500. In a down market, pessimism has dampened valuation levels, reducing much of the earlier interest that had sprung up around deal-making.

Since future earnings heavily influence specific valuations, it’s only logical that a slower economy and fears of a recession would reduce valuations. Lower valuations may deter sellers from engaging in deal-making. 

However, savvy buyers may take advantage of lower valuations to scoop up businesses at a discount compared to what they would’ve traded at just a year earlier. 

Studies of the 2007 to 2009 financial crisis indicate companies that acquired new businesses during the downturn outperformed those that didn’t, so take advantage of the currently gloomy economic climate. With companies trading at a discount, now is the time to buy. 

Devensoft provides an all-in-one software tool that will streamline your next M&A deal. Get in touch today to schedule a personalized demo.

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