Why there are lot of myths on Valuations in M&A and which valuation method is best?

In a M&A transactions, Valuation plays a very important to assess the value of the deal.

As Warren buffet says Price is what you pay and value is what you get.Hence acquirers need to be very clear that the price paid to the seller creates and adds values to the buyer’s shareholders.

Why most of M&A deals fail?

Yet we see that around 70% of M&A deals do not suceed and leads to shareholders value destruction.Two reasons why this happen is:

• Most of those deals should not have happened in the first place because most of these deals were not aligned to the long term strategy of the company.
• If the strategic rationale of the deal was sound then the integration strategy was flawed.The synergies that was conceptualized during the due diligence phases do not get executed in the integration.Primary reason generally is the cultural differences of the combined entity or the lack of comprehensive due diligence in identifying the risks.

Above two reasons shows why valuations becomes even more important as the purchase price should not only take into account the synergies but also the risks that M&A transaction shall bring.Hence valuation should not focus only on financial engineering but also look into details the fundamentals of the target business.

Importance on EPS accretive deals

Generally we see when there are M&A transactions involving a public company the one metric that shareholders very keenly focus is if the deal is EPS accretive or dilutive.This metric is highly flawed because all EPS accretive deals necessarily do not add value to shareholders.

Another important metric that PE firms look at is the EBITDA multiple of the target company.This is because PE firms generally exit their portfolio company in 3-5 years and hence they need to exit the company with high returns which are linked to final EBITDA value of portfolio company.In the case of strategic acquirer these need not be followed because general assumption is that the target company will exist till perpetuity with buyer.Hence importance should be given to the capability that target company brings and if that is aligned to the buyer growth strategy.In addition it is also important if the cultural compatibility is there post acquisition in order to realize the planned synergies.Better the environment or work culture between the buyer and seller better would be the future prospects of the deal.There are lot of instances where the combined entity would have failed to achieve synergies in 1st year but in 2nd and 3rd year the value addition would be high.This is because of the cross selling and the new market segment or customer segment this acquisition can create.

Valuation Methods

Most popular valuation methods used are

• Discounted Cash Flow
• Net Asset Value

Net Asset value is generally used flin capital intensive industries like manufacturing.The assumption is that even if the target business is not profitable its assets are attractive to the buyer.Hence in this case the target income and future business prospects is not given importance but the net value of its assets are valued.Again when assets are valued the book value of target balance sheet has to be corrected to it’s fair market value along with any changes in its liabilities like debt, litigations etc and net asset value at fair market value is obtained.Any difference between the final enterprise value and the net asset value would be entered as Goodwill.As per this transaction the buyer can generate substantial tax savings by depreciating the assets bought and also impairing the goodwill to a period of 15 years.

Discounted Cash Flow

This is by far the most popular method used as it gives importance to the future cash flows the target can generate and if any additional cash needs to be spent in Investments and working capital.This excess free cash shall be available to shareholders as dividend or equity.

In DCF, generally two models are created.These are the valuation of stand alone entity and the second would be the valuation of combined entity taking into account the synergies.The difference between the two will be the premium paid to the seller in addition to the enterprise value.In DCF care should be taken while taking the growth rate, discount rate and terminal rate as even small change can alter the final valuation considerably.Hence the target firm’s future growth plan, its additional investments, its orderbook with backlog and pipeline should be carefully analyzed to assess the growth rate so that the buyer can be confident that the seller can achieve that growth.

DCF valuation is just an indicator and a final decision cannot be taken with this alone.It has to be combined with other valuation methods like Comparable Analysis and Precedent Transactions method where the target is compared with its competitors to find its value.Proper research needs to be done to find the correct competitors as those companies should be similar to the target in terms of business and risk profile.Precedent transactions generally relies on similar acquisitions done in the past to get an idea but again these values are the final valuation that includes the premium as well as synergies that buyer would have forecasted.In Precedent transactions, care should be taken to ensure these are transactions that happened lately or in past 6 months.

Conclusion

Valuations are generally tricky and changes depending on the thought process and inputs of the buyer.In order to ensure that the buyer does not overpay the target, the board can choose to appoint an independent advisor to come up with fairness value of the transaction so that shareholders value does not get compromised.