M&A Corner: Valuation via discounted cash flow or using multiples
Business owners often ask themselves whether they need a business valuation, and if so what kind of valuation is required. My previous column dealt with the first issue, and this one deals with the second. This is an important issue, so please bear with me during the slightly technical explanation.
The two most common methodologies for valuing small and medium-sized companies are the discounted cash flow (DCF) method, and the “multiples” method.
Under the DCF method, the company owners and advisers must calculate the detailed cash flow, usually for a period of four to seven years (known as the “explicit period”), and these must be discounted to a present value. The cash flows beyond the explicit period (usually assuming a more generalised, constant but conservative growth rate) are also discounted, to provide what’s known as a “terminal value”. Total value is the sum of the aforementioned two components.
Generally, there are two types commonly used types of multiple analysis:
• Comparable transactions. Under the comparable transactions method, the valuator looks at what transactions have taken place in the marketplace for comparable companies, and what types of multiples these companies traded at – such as a multiple of EBITDA (earnings before interest, tax and depreciation), as a multiple of EBIT (earnings before interest and tax) or as a multiple of revenues.
• Multiples for publicly listed companies. Under this method, valuators looks at what comparable publicly listed companies are valued at, once again, as a multiple of EBITDA, EBIT or revenues. Publically listed companies usually trade at higher multiples then smaller mid-sized private companies, as they have better corporate governance, are more transparent, etc. Hence, when valuing a private company, an appropriate discount must usually be applied to the multiple derived from public companies. However, this method has the advantage of being up-to-date. (You can take values from the most recent close of business of various stock exchanges. Using the comparable transactions method, past transactions, by definition, are already somewhat out of date).
Where the two valuation methodologies give a similar answer, this provides strong corroborative evidence that the valuator is on the right track. If the two valuation methodologies produce different results, the valuator needs to take another hard look at the results.
In my experience, given today’s economic environment, most business owners are incapable of forecasting revenues and cash flows beyond six months, let alone four to seven years. In such a case, I would recommend strongly against attempting a DCF analysis. Unless one has good visibility on revenues and cash flows years into the future, and unless one takes the time to build a quality cash flow forecast, the DCF valuation will not be worth the paper it is written on. Worse, it can be downright misleading. In such cases, limit yourself to a multiples analysis.
Where the valuator is relying solely on multiples analysis (and not performing a DCF analysis), there should be as many types of multiples analysis used as possible. The valuator should look at both comparable transactions and publicly listed entities, and if possible look at each of EBITDA, EBIT and revenues for each of them.
Multiples analysis is not without its hazards either. Does EBITDA or EBIT reflect the true economic performance of the company? Particularly in small to medium-sized privately owned corporations, it is easy for numerous distortions to creep in, that is to say, distortions that cloud the true economic performance of the company:
Has the owner charged a market salary for himself, possibly other family members in the management of the company? Is the company covering what are de facto personal expenses (e.g. travel, club memberships, etc.)? Are transactions with non-arms length entities truly at market rates, and do they make commercial sense?
The above list is far from exhaustive. Adjusting for such possible distortions may cause wild swings in valuation.
In other words, the quality and usefulness of a valuation is directly proportional to the experience and judgment of the valuator, and the degree of depth in to which the valuator delves. There is no magic bullet, no easy formula.
(Photo: forwardcom/sxc.hu)
