Andrew Greta's Business Development Blog

Valuation Overview:

One of the central questions of business development is “how much should I pay” for a business acquisition, partnership, asset, or piece of intellectual property. The answer isn’t something you can boil down to a one-size-fits-all computer model (a fact which keeps us BD professionals gainfully employed). But what’s always true is you’ll need to pay more than the stand-alone price (i.e. the current market cap for a public company, or the top bid in a competitive auction for a private one).

But if we pay more than the stand-alone value, how do we make a return on the deal? If it’s already “fairly” priced, where’s the upside? Since 70% of acquisitions end up destroying shareholder value, it’s clearly a question that CEO’s worldwide either don’t ask or just don’t understand. And I’m sure some of the others simply get lucky by playing the “greater fool” theory and re-selling their purchases to someone even more gullible or idiotic then themselves.

But if you believe that doing business is about more than rolling the dice on betting on random market outcomes, the real secret to generating positive investment returns is by operating an acquired business or asset in a way that’s more productive (faster, cheaper, stronger, or bigger) than anyone else in the market could and creating true economic value.

If you want to be one of the winners, a good valuation analysis should cover the following areas at a bare minimum:

1) Business Review

The first step to determining value is to understand the target business, what their fundamental drivers are and what the strategic fit as an acquisition or business partner really is (a good starting tool is the “business model napkin” as explained in an earlier post). Why are you uniquely situated to realize more value from the business than it currently generates or can be tapped by your competitors? This is your value hypothesis that gets tested and either confirmed or negated in the following steps.

2) Comparable Analysis:

One way of quickly gaining an appreciation for general valuation is the same one real estate appraisers rely on to value property – looking at the “comps”. While not a precise measure (due to variations between businesses and differences in how each buyer assesses economic value), this quick and dirty approach can give some idea of how the general market values companies and sectors to get an initial read. Appropriate metrics can vary by industries, but typically some combination of EBITDA (earnings before interest, taxes, depreciation, and amortization) and revenue multiples, along with price-to-book, and price-to-earnings are typical starting points to establish a reasonably robust range.

3) Financial Review:

Now it’s time to dig into the company financials, understand the ratios and revenue-expense trends to establish a baseline financial pro-forma model. Most rookie desktop analysis starts with the past 3-5 years of operating history and forecasts forward on an average trend line – and I’ve seen that approach accepted by execs as high as the CFO. The best financial analysts dig under the hood instead and ask the tough questions about current and future circumstances to develop a more robust approach? Is 2006 truly a banner year for truck manufacturing, or are buyers simply front-loading their orders ahead of changing diesel emissions laws? Are these high lease revenues sustainable for the next 5-years or do the contracts expire in 3-months?

4) Valuation Model:

Here’s where your value hypothesis gets integrated into your baseline pro-forma to determine the premium you can pay for an acquisition and still generate positive economic value. Are you consolidating back office operations and generating massive savings through headcount reductions? Or are you buying a ready-made distribution channel to boost revenues? A valuation model is only as good as the assumptions you make so be careful and make sure the synergies are grounded in reality and realizable. Output metrics can include return on equity (ROE), return on investment (ROI), and return on total capital (ROTC) over a reasonable investment horizon of 5-years or so. Discounted cash flow models (DCFs) and their ilk (IRR, NPV), can be useful as well, but be careful! It’s too easy to make small tweaks to a discount rate or perpetuity growth assumption and see wide (and unrealistic) swings in valuation. The rule of thumb is that if your terminal value is more than 60% of your total present value, go back to the drawing board.

5) Sensitivities:

Finally, once you’ve got a solid valuation model along with a good comparable analysis you should be able to start narrowing a reasonable valuation range. From here, stress test it by identifying the key assumptions that drive value and doing a worst-case scenario. Items like sales growth and synergy levels are good starting points, and a “recession” case isn’t a bad idea if your business is particularly impacted by the normal business cycle. Then be sure to articulate any non-quantifiable “special case” issues which might sway a decision. Does the acquisition look weak in isolation but prevent core business erosion as a defensive play? Is it a key piece of intellectual property or branding that will have spillover benefits to other areas of your business?

Walk away if the picture doesn’t work instead of force-fitting a bad, value destroying deal. There will be more opportunities along shortly, but don’t expect it to be easy pickings. Identifying and creating value takes hard work, creativity, and a willingness to make tough decisions. The low hanging fruit was eaten long ago and today’s nectar goes to those willing to search hard, be selective, and diligently execute truly unique value-creating ideas.

Labels: Business Development Basics, Valuation

posted by Andrew Greta  # 4:14 PM