The first step in any merger or acquisition process is always to carefully value the company involved in the transaction, otherwise known as the ‘target’. Before doing so, however, it is important to remember that ‘valuation’ and ‘price’ are not the same thing. Valuation refers to the intrinsic value of an asset, while price refers to what the buyer actually paid to acquire that asset. The price may go up or down, but the value remains stable; the price does not always reflect the true value of an asset, but rather the point of agreement between the buyer and seller at a given time.
With this in mind, we can now see that there are essentially two methods of business valuation. The first is comparable company analysis, also known as ‘valuation by multiples’. A market multiple is simply a means of expressing the market value of a company in relation to one or more key financial ratios. In order to be used effectively, these metrics, which include cash flow, earnings, and so on, must have a logical relationship to the perceived market value.
There are three main advantages to the comparable company approach. The first is objectivity, which is provided, at least to some extent, by the use of market multiples within the valuation itself. These can act as a benchmark for all other measurements. The second advantage is simplicity, as market multiples are easy to calculate and therefore accessible to everyone. Finally, the third benefit is relevance, because market multiples focus on key metrics used by investors, such as sales, operating income, and earnings.
There are, however, also several drawbacks to valuation by multiples, which analysts need to consider when estimating the value of a company. Firstly, this type of valuation tends to be overly simplistic, as it distils a huge amount of information into a single set of numbers. Secondly, it is a static valuation, meaning that it represents a snapshot of a company’s value at a particular point in time; it is less effective at considering the life cycle of each company and industry, as well as the ever-changing economic situation. Finally, valuation by multiples is potentially misleading, because there are many ways in which the values of two or more similar companies may differ.
The second valuation method is discounted cash flow (DCF), which estimates the value of a company based on its future cash flows, meaning that its value today is based on future projections. In other words, it is an estimate of how much cash the company will generate in the future; these cash flows are ‘discounted’, because one euro earned in the future is worth less than one euro earned today, given the rate of monetary value over time.
This may appear to be a less accurate valuation than the comparable company analysis, but it is important to remember that, in mergers and acquisitions, potential new buyers are more interested in the future of the company than in its past. Having said that, any valuation based on a projection of the future must, of course, be carried out very carefully.
To summarise, there is a key difference between a valuation by multiples and a DCF valuation. A multiple valuation compares many companies to each other, by looking at the past, whereas a DCF looks at the target company alone, and predicts what will happen in the future. When choosing which method to use, analysts should evaluate the specific situation, and above all, the reason for the merger or acquisition. If the motivation is growth, in other words to increase the size of the business, it may be wise to use a multiple valuation. If the motivation is diversification, on the other hand, a DCF analysis may be more useful.