The Verdict is In on the Sell Side: Business Valuation Basics
By Brian Goodhart
Valuation is a fundamental aspect of the complex and intricate world of mergers and acquisitions. It serves as the compass that guides decision-makers through the financial wilderness of corporate transactions. Today, we will delve into the intricate art and science of valuation, exploring its various components and purposes.
Valuation: An Art and Science
Valuation is both an art and a science. While it involves computationally rigorous analysis, it equally demands the judgment of the professionals performing it. It’s a balance where numbers meet intuition, and neither aspect should be ignored.
Purposes of Valuation
Before diving into the nuts and bolts of valuation, it’s crucial to understand its purposes. Valuation serves various functions, such as litigation in partner disputes and divorces, tax and estate matters, accounting and regulatory compliance, and the heart of it all, mergers and acquisitions. Each purpose carries a unique standard, perspective, and set of assumptions, making them distinct from one another.
Different Standards and Perspectives
For litigation or regulatory purposes, a fair value standard is applied, focusing on rational and unbiased approaches. In M&A, we seek fair market value or investment value, emphasizing the value to a specific party. These distinct standards guide the valuation process, with assumptions tailored to each situation.
Understanding the Premise
Valuation hinges on the premise underpinning it. Most valuations revolve around the concept of a “going concern,” assuming the business will continue to operate profitably in the future. However, other scenarios, like liquidation, replacement cost, or book value, demand entirely different approaches. Understanding the premise is the first step towards a successful valuation.
The Valuation Process
With the groundwork laid, let’s explore the valuation process:
Research: Valuation starts with comprehensive research. This includes macroeconomic trends, industry-specific data, and company-specific financial information. Analysts scour sources like The Wall Street Journal, Federal Reserve bulletins, Bloomberg, S&P Dun & Bradstreet, and various databases to gather vital insights.
Normalization: Normalization is a meticulous process aimed at understanding a company’s performance in a normal operating environment. It involves adjusting for non-recurring items, operating assets or liabilities, and accounting conversions. In M&A, normalized EBITDA is crucial for attaching a multiple and forecasting cash flows.
Cost of Capital: The cost of capital, a critical factor, combines the cost of equity and debt weighted by the firm’s capitalization. Models like the Capital Asset Pricing Model (CAPM) help calculate it, factoring in risk-free rates, market premiums, beta, and more.
Approaches to Valuation: There are three primary approaches to valuation:
– Income Approach: Comprising capitalization of earnings and discounted cash flow methods, it focuses on earnings and future cash flows.
– Market Approach: Involves deal comps and public comps, relying on transaction history and public company comparisons.
– Asset Approach: Determines the fair market value of a firm’s assets, useful for non-operating businesses and liquidation scenarios.
Discounts and Premiums: Depending on the specific situation, discounts and premiums may apply. Factors like control, marketability, and strategic context influence these adjustments.
Reconciliation: This step involves weighing the results from different valuation approaches and applying professional judgment to arrive at a single valuation figure. It’s where the art of valuation truly comes into play.
Valuation is a multifaceted process, blending art and science to arrive at a figure that drives critical business decisions. It serves various purposes, each with its unique standards. Thorough research, normalization, and understanding of the cost of capital are vital components. The three primary valuation approaches, along with discounts and premiums, play a crucial role in determining the final value. However, it’s the professional judgment that ultimately shapes the outcome. Valuation is not a one-size-fits-all endeavor; it’s a dynamic blend of expertise and data, serving as the cornerstone of M&A decisions. So, the next time you encounter the world of valuation, remember that it’s a meticulous dance between numbers and intuition, guided by purpose and expertise.
Brian Goodhart is Capstone’s Director of M&A Advisory Services and the host of the multi-part webinar series, “The Verdict is In on the Sell Side.” Visit https://www.capstonestrategic.com/the-verdict/ to view past episodes.