Last time I have focused on the reasons for M&A to fail and what key points one should keep in mind in order to have better chances of success! In this part, I intend to briefly introduce you to valuation methods of a firm.
The aim of valuation is to determine what a firm is worth. Value is determined based on historical and future financial parameters. Determination of firm value is a highly subjective exercise that calls for judgment. It changes and varies when business drivers and factors (both internal and external) as well as when the environmental conditions change. Since value estimation is subjective, it often serves as a basis for discussions. Moreover, there are many aspects of a business that is hard to quantify such as consumer behavior.
Companies can be valued from two perspectives: from looking at the inside of the firms -internal- or from the expectations of the market -external-. The internal methods estimate the value of all the future potential cash flows generated by the company. Therefore it relies on methods based on the concept of discounted cash flows (DCF).
With the external methods companies are valued through benchmarking competitors. These methods capture the market view of these companies, through which the value of a firm can be determined. Methods relying on external views are called multiple valuation methods because they involve the use of multiples. There are a number of methods to estimate what a company should be worth.
The value of a company can best be estimated by combining the range of values resulted from the different methods.
• DCF: Discounting all future free cash flows – the internal method.
Currently, there are several methods in use. The most popular is WACC (Weighted average cost of capital). Other alternatives include adjusted present value (APV) and Equity cash flows/Flow to equity (ECF/FTE).
• Industry comparables: Examining the multiples of competitors and other companies that engage in activities similar to those of the firm to be valued, this is an external method.
• M&A comparables: Examining the multiples of previous M&A transactions in the sector of the firms to be valued, this is also done with the external method.
To keep in mind
Using the results from these methods in combination, you can estimate the value of a company. However, biases and errors will always exist because different people may want to justify their points of view. As we have discussed earlier, bidder and target in an M&A usually have different views on what the company in question is worth. Remember that the comparables are open to subjective views and interpretations and also the internal method based on the internal data can be deceptive due to the assumptions you make about the future growth of the company.
In my next post, I will give you a small introduction into what the free cash flow is and why it is important for determining the value of a firm if it does so based on the internal data. Stay tuned!