We caught up with Stephen J. Goldberg and Thomas Theurkauf of Sun Mergers & Acquisitions and Sun Business Valuations to learn more about the valuations process for the fifth installment of PitchBook's M&A 101 series. The interview below has been edited for length and clarity.
PitchBook: Warren Buffett said something once about price being what you pay, value being what you get. Let's start with the deceptively simple question implied there: What are the most important differences between putting a price on, say, an asset or a target company and arriving at a valuation?
Goldberg and Theurkauf: That's an excellent question. In a formal business valuation, the report will result in a conclusion of value, which is typically expressed as one final number. This number in isolation means nothing unless there is a framework that can be used to interpret the result. Thankfully, each valuation report will include a standard of value used to interpret the conclusion.
The standard of value is usually in the form of a detailed definition that can be used to identify assumptions that would impact the conclusion, like the buyer type, transaction terms, assumed market conditions, etc. There are many commonly used standards of value. Each could result in a different conclusion even when valuing the same company at the same date. For example, imagine we are valuing the common stock of Disney. Our conclusion of value for Disney could be very different depending on the standard of value that we use.
The most commonly used standard is fair market value, the closest standard to the current market price. For Disney, that share price is known. The fair market value of Disney would be based on the current share price times the number of shares outstanding. The fair market value standard is used for a variety of purposes, including taxable events, litigation, reporting and small block transactions.
Another commonly used standard is investment value, which incorporates factors that are unique to a specific buyer. For example, if Netflix were going to buy Disney, there may be some synergies in the form of cost savings, cross-selling and diversification. Netflix might have to pay a premium above fair market value to purchase Disney. Investment value is more commonly used for fairness opinions and strategic transactions.
When interpreting the conclusions of a valuation report, it's very important to reference the standard of value.
Discounted cash flow has come to dominate other methods of valuation. But it's not even especially unique to the M&A process. So, what is DCF, where did it come from and how did it come to occupy the privileged place it does in the valuations process?
The discounted cash flow method is one of two methods within the income approach to value. Fundamentally, the income approach is a two-variable equation that includes an income stream and a required rate of return. Buying a business is like buying a stream of income. The value of that stream can be determined when the subject income stream is measurable and a fair rate of return on investment can be estimated.
Before we discuss the DCF, which is a multiperiod approach, let's first review the justified multiple of earnings method, which is a single-period approach. Both methods use the same underlying theory, and we feel that many business owners think of value in terms of multiples of earnings. Earnings multiples and required rates of return are effectively just a different expression of the same formula.
For example, imagine a savings account with a stated interest rate of 5%. If $100 were deposited, the income generated by the account would equal $5. This relationship can also be expressed as a multiple: $100 = 20 x $5. The 5% interest rate on the account equates to a 20x multiple investment. Values, rates of return and multiples are all part of the same equation.
The discounted free cash flow method is based on the same concepts except it also allows for a more customized income stream. In the DCF, the valuator uses a financial model to forecast the timing and magnitude of each cash flow over a number of years. Each of those is then individually discounted to the present value based on the required rate of return. The method is particularly helpful for valuing companies that expect uneven growth going forward or for modeling transactions with synergistic benefits. The DCF has come to be one of the most widely used methods because of its sound foundation in valuation theory and its flexibility.
What is weighted average cost of capital, and how does it factor alongside other considerations when arriving at a target company's valuation?
The weighted average cost of capital is one of several methods for measuring required rates of return that can be used in conjunction with an income approach method to determine value. The acquisition of a target company might include different types of capital, each with a different required rate of return. The WACC measures the weighted average required rate of return needed to purchase the target business in full.
Imagine a private equity investor who has the goal of generating returns greater than 20%. The investor finds a favorable target company to acquire for the portfolio. As part of the due diligence process, the investor discusses the transaction with their bank, who agrees to finance 90% of the purchase price in the form of an interest-only loan at 5%. If the investment is successful, the private equity investor will receive a return of 20%, and the bank will receive a return of 5%. The WACC for this transaction as a whole is 6.5% because 90% of the weighting is applied to the bank's required return of 5% and 10% of the weighting is applied to the private investor's required return of 20%.
Which emergent alternatives to DCF analyses do you find most intriguing and why?
Although DCF and other methods within the income approach are useful, we find that it's important to use multiple methods, including those within the market approach, which uses the values of comparable companies and their relative financial performance to calculate valuation multiples that are applied to the target company. A valuation multiple is usually calculated as some measure of value divided by some metric of financial performance. Examples include price to earnings and enterprise value to sales. Relevant valuation multiples are applied to the target company to estimate value.
An appraiser, for instance, may find that businesses like the target company tend to sell for 7.5 times earnings. The appraiser would then apply a 7.5x earnings multiple to the earnings of the target company to estimate value.
The most commonly used methods within the market approach are the guideline transaction method and the guideline public company method. The former uses recent transactions of comparable privately held companies to generate valuation multiples. One of its weaknesses is the timeliness of data. A transaction from four years ago might not reflect current market conditions. Nevertheless, it's difficult to form a sound opinion of value without first examining a sample of relevant transactions.
The guideline public company method is based on a similar premise, only it uses public companies to calculate valuation multiples. Data for public companies is easy to access, detailed and reflects current market conditions. That said, using public companies to value private businesses is not directly comparable. Investments in publicly traded companies tend to trade at a premium because they can be more quickly converted to cash compared to private companies. Therefore, it's important to use what's called a discount for lack of marketability when using the guideline public company method to value a privately held business.
What are the most significant ways that the valuations process for a privately held company differ from a target that's publicly traded? Why?
The value of any security or investment is impacted by some factors that have nothing to do with the underlying business—namely, the effects of marketability and control.
Investments in publicly traded companies are marketable, meaning they can be quickly converted to cash. An investment in a publicly traded company can be purchased in the morning and sold in the afternoon, but an investment in a privately held company might take nine to 12 months to convert back to cash. Generally, investors will require a discount to own shares in a privately held company because of this issue with marketability. When valuing a privately held company, then, it might be appropriate to include a discount for lack of marketability, depending on the methods and inputs used.
Another factor to assess is the level of control. Having a controlling interest adds value to an investment. A controlling shareholder can dictate dividend policy, capital structure and strategic planning, and has control over other important business decisions. Studies suggest that buyers of controlling interests typically pay a premium on a pro rata basis to gain control. Investments in public companies tend to be non-controlling, but that is not always the case. The appraiser needs to assess the level of control for each subject interest and adjust the value accordingly. The adjustment for control is known as the discount for lack of control or alternatively the control premium.
Activist investors have risen in prominence as the arbiters of the M&A process, with a hefty number of transactions falling apart recently in part under the pressure they can exert. What's going on when an activist investor or proxy advisor asserts, as so often they do, that a deal doesn't properly value the target company?
It may seem counterintuitive that the management of a publicly traded company would invest in an acquisition knowing that the deal might deteriorate value for shareholders, but it can happen. Sometimes the reason for these bad deals is poor corporate governance or compensation plans that misalign management incentives from shareholder goals. Other times, when top executives are compensated based on total revenues or total earnings, they are incentivized to make acquisitions even when the deals they strike could deteriorate value for shareholders. Activist investors play an important role in identifying when these issues arise.
All the same, some activist investors don't have the best of intentions. They can sometimes use false claims to generate negative sentiment and achieve returns as the stock price declines.
Corporate M&A requires rigorous diligence. That's why it's always important that the board of directors engage an independent advisory firm to review the deal, perform the due diligence and provide a fairness opinion. This process helps to protect both shareholders and directors.
Stephen J. Goldberg is the founder and managing partner of Sun Mergers & Acquisitions and Sun Business Valuations, both New Jersey-based firms specializing in managing the sale, merger and valuation of privately held, mid-market companies. With more than 30 years of M&A and valuation expertise, he started Sun to focus more narrowly on the exit strategy goals and valuation of family and entrepreneurially owned middle-market clients.
Thomas Theurkauf, a senior valuation associate at Sun, is a Certified Valuation Analyst who has completed over 150 valuation engagements in a wide range of industries and markets. Theurkauf has performed valuations for purposes including M&A, succession planning, buy-sell agreements, marital dissolutions, partnership disputes, partnership acquisitions, and estate and gift tax settlements.