By: Lucas Torpie, Analyst (Gladstone Associates)
A graduate of Drexel University with a major in Finance, Lucas oversees Valuations, Financial Modeling and Research for Gladstone.
The primary motivation behind any M&A transaction is to inorganically grow businesses and create greater value. At first glance, it would be reasonable to think that the value of the combined firms should be the sum of the values of the individual firms, 1 + 1 = 2. However, this is usually not the case, as it is essential to consider synergies. Synergies account for a new variable in the equation which transforms into: 1 + 1 + s = E, where “s” represents a combination of synergies and “E” represents the combined entity. Synergies can be realized in a number of ways such as by pooling talent, technology, and resources, or by streamlining operations to reduce cost. To determine the value of E, one must go through the highly complex process of calculating the combined synergies. The result of this calculation will provide an excellent baseline that can be used for many purposes, including M&A.
The combination of valuation methodologies provides a comprehensive analysis of a company. A market multiples approach looks at past M&A deals and determines the value of a company using precedent. The method includes using a range of valuation multiples. There is no single valuation model that fits every situation, which is why handling mergers and acquisitions is not an exact science.
Valuation Methods
There are two primary valuation methodologies used when assessing a firm. One is based on discounted cash flow, and the other applies a multiple of cash flow. Valuation multiples are based on the theory the similar assets will sell for similar prices i.e. the current market for such assets. Analysts will often complement a cash flow analysis with a multiples-based valuation.
Discounted Cash Flow (DCF): With this method, the current value of a company is equal to projected future cash flows discounted at a rate reflective of the risk associated with those cash flows. The main limitation of this method is the fact that it requires making many assumptions. Future cash flows can be affected by variables such as market demand, health of the overarching economy, and countless other unforeseen obstacles; which makes their prediction difficult.
Market Multiple Method: This valuation technique is dependent on information provided by precedent transactions of similar firms; the more similar the firm, the more accurate the multiple. Financial metrics and ratios such as firm size, EBIDTA margin, and growth are examined and compared to determine a fair multiple. This multiple is then applied to determine the value of the company. When dealing with transactions that take place in a private market, it is difficult to acquire the precedent transaction information needed to make an accurate decision on what multiple to use.
Strategic vs. Financial Buyers
Buyers have various motivations and views underlying their perceptions of value. Buyers can be broken down into two main categories, strategic and financial buyers. Strategic buyers usually focus on returns concerning their own cost of capital and use analysis that includes synergies and prospects for market expansion. They are concerned with long-term goals and how the acquired company fits into those plans. Financial buyers are more concerned about the financial return on investment and as a result offer lower multiples. It is critical for sellers to understand which type of buyer they want to attract based on their motivations.
Why Valuation Matters
Businesses involved on both sides of an M&A deal will come up with different values. The buyer will come up with the lower valuation, while the seller will want to value the company as high as possible. The best way to develop an objective value is to study similar ventures in the same industry and consider some primary metrics.
At Gladstone Associate, LLC, we base valuations on discounted cash flows, client and advisor demographics, and other factors and KPI’s with different levels of importance. Our proprietary valuation model includes intricate details and drivers of both financial and non-financial elements that validate premiums and discounts, so your valuation is customized and tailored to your firm’s unique characteristics. As Financial Services specialists, we have a large private database of transactions inclusive of RIA’s, Securities Brokers, Asset Managers, and Retirement/Benefits firms. Contact Gladstone to find out how we can provide you with a thorough valuation.
