The Role of Business Valuation in M&A Transactions

Fundamentals of Business Valuation in the M&A Context

Valuing a business is a complex task that requires several methods to get a comprehensive picture of the value. Three academic methods for business valuation are the discounted earnings approach, the net asset value approach, and the discounted cash flow approach (DCF). The discounted earnings approach assumes that a company's value depends on its future earnings. The net asset value approach, on the other hand, refers to the net asset or substance value of the company by considering the difference between assets and liabilities. The DCF approach ultimately discounts a company’s future cash flows to their present value.

In M&A practice, the capitalized earnings method hardly plays a role. The net asset value approach plays a role in liquidations and in cases where substantial physical values lie in a company, for example in real estate transactions. Out of these three methods, the DCF approach is the most relevant in practice. It is particularly common in the financial services, real estate, and infrastructure sectors – where cash flows can be planned over the long term and where the corporate financing structure has a major influence on the value of the company. Synergies can also be simulated and predicted quite practically with the DCF method.

In practice, however, companies, financial investors, and M&A advisors mainly use the multiples approach, which is somewhat ridiculed by academics, namely transaction multiples as well as trading multiples. This method compares the company with similar companies based on key figures such as sales, EBITDA, or profit. Operational key figures such as the number of employees or locations can also serve as a reference value. The companies typically come from the same or a related industry and are either listed on the stock exchange or have undergone an M&A transaction where the company value is publicly available.

The objective of the multiple analysis is to determine or contextualize the value of the target company based on the market value of the comparable companies. Of course, differences in growth, risk profile, capital efficiency, financing structure, and size can both cause and justify significant differences in multiples even for companies coming from the same industry.

Financial investors typically use another method and that is they look at the return on equity that can be achieved for a given entry purchase price today and an expected exit price in the future. Since these investors have a specific target return, they can also solve the equation for the purchase price that will give them the desired return. In this approach, also known as the LBO approach, the financing structure of the company plays a major role, hence the name (LBO = leveraged buyout). It is important to note in this context, that different classes of financial investors (e.g., venture capital, private equity, infrastructure) have widely different return expectations.

When making acquisitions, listed companies typically analyse the impact of the acquisition on their stock market price. A range of purchase prices is simulated, and a maximum price is defined. Here, too, synergies are decisive and are often communicated to the capital market when the transaction is completed.

Given the variety of methods involved in practice, it is important to combine different approaches, analyse the specifics of a company and industry, and consider the details of the transaction to ultimately achieve a sound basis for smart decisions.

A valuation analysis is crucial to successfully prepare the sale process of a business and to reach an agreement between seller and buyer. A sound analysis also allows to identify strengths, weaknesses, growth potentials and risks, and in some cases to successfully address and mitigate them before the sale. This allows companies to prepare optimally for negotiations with their consultants. It also helps to develop realistic price expectations and identify suitable transaction structures that meet the interests of all parties involved. After all, all M&A transactions have one thing in common: although they come from diametrically different directions, the seller and buyer must come to an agreement regarding valuation, and they must do so at the same time for a jointly defined transaction object. Not an easy feat!

A detailed business valuation can also help identify suitable buyers or strategic partners. By analysing strengths and weaknesses, the competitive position, and growth opportunities, a company can determine which players best fit its profile. This allows for targeted approaches to potential buyers and partners, increasing the likelihood of a successful transaction.

The importance of industry trends and comprehensive competitive analysis in the context of business valuation should not be underestimated. A deep understanding of the industry in which a company operates allows for early identification of opportunities and risks and the ability to adjust the valuation accordingly. Comprehensive industry knowledge also facilitates the identification of M&A opportunities that arise from market changes or regulatory developments.

The role of future potential and possible synergies in valuing companies in the M&A context is likewise of central importance. Future growth opportunities and the possibility of realising synergies significantly influence a company's value. Potential buyers are willing to pay a premium for companies that stand out due to high future potential or the possibility of realising synergies.

Success Factors and Best Practices in Business Valuation and the Sales Process

Open and transparent communication towards stakeholders throughout the entire M&A process is crucial. Building trust and ensuring smooth cooperation between the parties involved facilitates negotiations and increases the likelihood of a successful transaction. This applies to both internal stakeholders such as employees and executives and external players such as investors and potential buyers. Particularly in shareholder- managed companies, it is important to involve the management team, which is no part of the shareholder group, at the right time – ideally not only when the potential buyers demand it. Dealing with customers and suppliers is particularly sensitive and requires a sophisticated strategy, especially when these stakeholders also represent potential buyers.

Companies can use the valuation analysis to optimise the sale strategy in accordance with seller’s objectives. The maximum purchase price is typically only one objective of the seller and must be weighed against other goals. A well-founded valuation helps with setting the priorities when negotiating contract terms and conditions in a goal-oriented manner. A flexible sale strategy based on the insights from the valuation also allows for an appropriate response to changes in the market environment or the expectations of potential buyers.

Conclusion

A well-founded business valuation is of central importance in an M&A transaction. A precise valuation is the key to successful negotiations, the identification of M&A opportunities, and the development of an effective sales strategy. Companies preparing for the sale process or looking to explore M&A opportunities should ensure that they have the necessary resources and expertise for a professional valuation. A solid valuation, coupled with a clear strategy and transparent communication, forms the foundation for a successful transaction.