The valuation methodologies we will learn are largely practiced by all types of investors including strategic buyers (M&A), active buyers (LBO, venture capital), and passive buyers (mutual funds, hedge funds). However, there are some differences in practice.
Which of the following buyers would be willing to pay the highest price for shares of a company?
· A mutual fund seeking to acquire a 1% position
· A competitor of that company seeking to buy the whole company after identifying significant synergies such as cross-selling into its customer base and utilizing the target’s manufacturing facilities which have only 50% capacity utilization
· An LBO firm seeking to buy the whole company by taking out a bank loan for 70% of the purchase price, assume an active role in management, achieve better operational efficiency, then sell it in five years
There is the “public market valuation” which is the market cap. But is it a fair valuation? Competent investors perform their own valuation calculations. Has the valuation been hyped or beaten down too much? A major variable in public valuations is the expected growth rate in the future, and the crowd can be wrong.
Both publicly traded and private companies are valued by the same methodologies unless the investment is a strategic one. In that case, synergies are included in the valuation.
There are three methodologies for valuing companies:
· “Comparable public companies” comparing all peers’ valuations as multiples to financial results, such as the PE multiple, viewed in the context of growth and operating efficiency
· “Precedent transactions” for M&A. At which multiples were peers acquired in the past? Should our client get a similar price to the last deal?
· “Discounted cash flow” DCF determines the intrinsic value of a company. The present value of all of the company’s projected future cash flows.
To value companies, we need to start with the following data:
· Historical income statement (at least the last 5 years)
· Historical balance sheet (at least the last 5 years)
· Historical cash flow statement (at least the last 5 years)
How many years of data that is needed depends on how much things are different today, or maybe in the future, versus the past. If it is a cyclical company, we want enough years to capture two up-cycles and down-cycles. We also want financial results during the last recession and boom.
We then make projections for each financial statement based on historical data and trends if there are any, and on what we expect about the company’s and the sector’s future. Do not assume the past is entirely a guide to the future. Judgment is a big part of making projections.