Financial Analysis and Valuation of Companies

The development of the value of a company is the best long-term measure of how good a job the present management of a company is doing. There are a number of situations where a corporate valuation is needed.  These can arise from the early stages in a company’s development to the very late. Only when understanding Valuation can sellers begin to understand how to maximize the value of their company. The financial evaluation process involves both a self-evaluation by the acquiring company and the evaluation of the candidate for acquisition. Corporate valuations are carried out in a number of different situations and for a number of different reasons. Included amongst the most common needs for valuing a company are:

• Raising capital for growth
• Creating an incentive program to keep and attract employees
• Executing a merger, acquisition or divestiture
• Conducting an initial public offering (IPO)

• What is the maximum price that should be paid for the Target Company?
• What are the principle areas of risk?
• What are the earnings, cash flow, and balance sheet implications of the acquisition?
• What is the best way to finance the acquisition?

Maximizing company value and shareholder wealth is increasingly the most important task facing today’s manager. At ABCO we understand the importance of measuring corporate value. Normally a mixture of valuation models are used in order to get a number of reference points for the valuation discussion. A stand-alone Discounted Cash Flow (DCF) valuation is used for a fundamental discussion of the two companies, their operations and their future earnings potential. In addition, financial and operative ratios (multiples) are used to allow for effective comparisons in the discussions and negotiations. The most popular models used by us are:

Ratio based valuations (also called multiple-based valuation) are frequently used in our valuation of companies. Using this method, the price of an acquisition is viewed as either a multiple of earnings, book value, cash flow, etc. Companies with characteristics such as superior sales and earnings, growth records, better financial returns and prospects, sustained consistent performance and strong brand franchises will be acquired for higher multiples. There are two different types of multiples: fundamental and relative, with relative multiples being the most commonly used.

• Identify an appropriate variable (i.e. earnings, cash flow) for valuing the company
• Find the necessary inputs for the calculation
• Adjust the numbers if needed
• Compute the ratio
• Apply the multiple to estimate the company value or compare it with ratios for similar companies to view the relative value of the company

• Identify an appropriate variable for valuing the company
• Find comparable companies or industry average with available data
• Adjust for differences between companies
• Calculate the ratio of the comparable companies or the industry
• Apply the ratio of comparable companies or industry average to a chosen company variable to estimate the company value

Both relative and fundamental multiples can then be used to obtain enterprise and equity   values. If used correctly, using both fundamental and relative multiples give a good assessment of the value of the company in question.

The use of a multiples is often an expedient way to assess the value of a company, since the calculation of a multiple is usually uncomplicated and the data needed for a company and an industry is generally easily available.

This is the most commonly used stand-alone valuation model. It applies not only to internal growth investments such as additions to existing capacity, but equally to external growth investments, such as acquisitions.

• The incremental cash flows expected to be generated as a result of an acquisition
• The discount rate or cost of capital, that is the minimum acceptable rate of return required by the market for new investments by the company

In projecting a cash flow stream of a prospective acquisition, what should be taken into account is the cash flow contribution the candidate is expected to make to the acquiring company. Acquisitions generally provide new postacquisition investment opportunities whose initial outlays and subsequent benefits also need to be incorporated in the cash flow schedule. A common practice is to forecast cash flows for 5 to10 years. A better approach suggests that the forecast duration for cash flows should continue only as long as the expected rate of return on incremental investment required to support forecasted sales growth exceed the cost of capital. This is the recommended approach to acquisition analysis.

Doing a DCF valuation can be a cumbersome task and there is usually room for mistakes. A quick way to check the reasonability of the results from a DCF valuation can be through comparison with suitable multiples.

In arriving at acquisition values we at ABCO go beyond DCF analysis and use accumulated knowledge and judgement. A thorough knowledge of comparable precedent transactions, and an up-to-date and accurate assessment of the wishes, corporate strategies, business economics and peculiarities of the known and potential participants in any given merger or acquisition transaction are all essential to this valuation.

These methods attempt to value the company by reference to the value of the assets held by the company. The simplest method is to use the balance sheet values of the assets held. A better approach used by us is to use the current market (net realisable value) value of the assets held by the company. Whichever method is used will all depend on the circumstances and purpose of the valuation. For example the orderly liquidation of a company. An asset stripper (i.e. someone who wishes to acquire a company with a view to selling off its assets) would probably be most interested in using these valuation methods.

These methods are however likely to present a conservative value, due to the fact that intangible assets such as goodwill, brand names, etc might not be recorded on the balance sheet, and would therefore be ignored for the purpose of valuing the company. It may also be that assets are recorded at historic costs and therefore below their current market values. Obviously during a period of inflation, the current market value of assets held would exceed the historic cost figures. Replacement cost can be used as an indicator of the market value of the assets held by the business. This approach would take into account tangible assets such as plant, fixtures, stock, etc as well as the intangible assets discussed above.

In order to gain insight into a company’s future financial performance, its’ internal resources, intellectual capital and environment must all be analysed. The company’s future financial performance is of primary interest when valuing a company and the past (e.g. last year’s financial data) is mainly interesting as a guideline for forecasting the future. The two most common approaches to valuation are the DCF model and ratio-based valuation. The use of any of the models depends on the situation and the company’s objectives, as well as the industry the company is active in, how mature the company is and the required detail of the valuation.

However, more than anything else the process of determining company value, especially in the early stages depends on the credibility and the track record of management team, industry opportunity, and of course the negotiating skills of the parties. Other factors such as historical net cash flow, the likelihood of continued profitability into the future, risk, competition, changes in technology, owner non-compete, as well as working capital requirements, etc are also considered.