How might acquisition targets be valued?
There are generally three approaches to valuation: the income, market and asset-based approaches. The income-based approach encompasses discounted cash flow models and their many different forms. In a market-based approach, precedent transaction multiples are generally used, while an asset-based approach necessitates valuing all assets of a business separately, then aggregating them to arrive at a total value.
Valuation professionals look for convergence among several different approaches when valuing a business, most often using the income and market approaches.
When using the market approach, how should appropriate precedent transactions be selected?
Ideally, one would be able to find numerous ‘pure-play’ comparable companies when performing a market-based valuation. However, in some instances, pure-play companies may simply not exist. When this is the case, valuation professionals should select from a more diverse basket of comparable companies, including firms with similar revenue, cost structure, downstream customers, upstream suppliers and geographic locations.
This larger list of firms can then be filtered to arrive at an appropriate list of comparable companies.
When using the income approach, how should an appropriate cost of capital be determined?
When valuing a target, it’s important to use a cost of capital commensurate with the riskiness of the project itself; the acquiring firm’s cost of capital should not be used in the valuation. In order to estimate an appropriate cost of capital, the acquiring firm must estimate the target’s cost of debt and cost of equity capital.
The cost of debt can be estimated using interest rates obtained by the firm or firms with similar credit ratings. The cost of equity, however, is significantly more complex.
Professionals must be sure that they take into account the target’s liquidity, organizational structure, geographic location and other risk-dependent factors when deriving this figure.
How should potential synergies be incorporated into the valuation?
Ideally, an acquiring firm should not pay for synergies — it should only pay for the value of the target as a standalone entity. However, synergies should nonetheless be estimated in order to understand the benefits that the acquirer can reap from the target firm through the acquisition.
For publicly traded entities, it might also be advantageous to estimate the amount of pretax synergies necessary for the acquisition to be an accretive transaction rather than a dilutive one. Such an analysis can help public company managers ensure a potential acquisition will not negatively impact the firm’s stock price.
ADAM WADECKI is manager of operations for Cendrowski Corporate Advisors LLC. Reach him at [email protected] or (866) 717-1607, or visit the company’s Web site at www.cca-advisors.com.