Conventional Valuation Methodologies in M&A

Imagine that you were assigned a task to value a certain company. If you have any experience in corporate finance, you will probably know where and how to start. But if you are new to the industry, you may get lost in your university notes or find it difficult to choose an appropriate method for your case. This article might help you to gain a basic understanding of the conventional valuation methodologies (DCF, multiples and asset value) that are used on a daily basis in M&A practice and the main advantages and disadvantages of each variant.

DCF Model

In a DCF model you are valuing a company based on its cash flows (“intrinsic” valuation).The model includes several assumptions based on your own view of the company. Usually DCF is helpful when your company is in a mature stage and has stable, predictable cash flows.

Firstly, you project the company’s Free Cash Flow (FCF) in the near term (next 5 to 10 years). Depending on which investor group you are targeting, you can either use Unlevered FCF (also known as FCF to the Firm) or Levered FCF (also known as FCF to Equity), where the formulas are as follows:

• Unlevered FCF:
  • (+) NOPAT, which is EBIT*(1-Tax Rate)
  • (+) Recurring Non-Cash Adjustments (such as Depreciation & Amortization, Deferred Income Taxes, etc.)
  • (+/–) Change in Working Capital from CFS
  • (–) Capital Expenditures
• Levered FCF:
  • (+) Net Income
  • (+) Recurring Non-Cash Adjustments (such as Depreciation & Amortization, Deferred Income Taxes, etc.)
  • (+/–) Change in Working Capital from CFS
  • (–) Capital Expenditures
  • (–) Debt Repayments.

As you can see, the Levered FCF is similar to the Unlevered version, but it also reflects interest (and the corresponding tax shield) and debt repayments. Levered FCF gives a slightly better estimate of how much cash flow is available to just the equity investors. However, this version is rarely applied in practice, partly because of disagreement over the debt repayments (whether only mandatory or also voluntary repayments should be included) and also due to the need for a debt schedule.

As a next step, you must calculate the discount rate that you will use to get the present value of the cash flows. If you chose Unlevered FCF, you must discount the cash flows with the WACC (Weighted Average Cost of Capital), which is a combination of Cost of Equity and Cost of Debt, usually based on the targeted capital structure of the company. In case of the Levered FCF, you will simply discount the Cost of Equity.

Then, in the so-called Terminal Period, you have two main possibilities to calculate the Terminal Value:

• Gordon Growth Method: assumes a constant cash flow growth rate, which should be in line with the GDP growth rate of your company’s country
• Multiples Method: you take the terminal EBITDA or EBIT or NOPAT or FCF Multiple and multiply it with the relevant metric.

Rather than relying on a single method, the best solution is to use different methods to cross-check your valuation (for instance, once you arrived at the Terminal Value by using the Gordon Growth Method, you should cross-check whether the result corresponds to a plausible EBITDA multiple).

Finally, after discounting the Free Cash Flows (from both the near term and terminal period) and summing them up, you arrive at the Implied Enterprise Value (if you used Unlevered FCF) or Implied Equity Value (if you used Levered FCF). In case of the Unlevered FCF you can also calculate the Equity Bridge, which will lead you to the Implied Equity Value.

Advantages of the DCF Model

• Relies on free cash flows rather than accounting figures
• Based on your own view of the company, not subject to market fluctuations/conditions
• Company-specific factors/scenarios/stages are well reflected.

Disadvantages of the DCF Model

• Dependent on long-term assumptions (which may be flawed)
• Extreme sensitivity to assumptions related to perpetual growth rate and discount rate
• Terminal value comprises far too much of the total value (65-75%)
• Disagreement over the calculation method of Cost of Equity and WACC
• Cash flows are hard to forecast in cyclical businesses

Multiples (or Comparables)

In this method you collect a group of Comparable Companies or Comparable Transactions, calculate their valuation multiples (usually EV/LTM EBITDA or EV/LTM Revenue) and then apply these to the respective figures of the company. When evaluating Comparable Transaction multiples, you should always consider the following premiums / discounts:

• Control Premium: the extra amount that acquirers must pay for a majority stake in a target company, usually ranging from 10% to 30%. The opposite is called “Discount for Lack of Control”
• Liquidity Premium: the extra amount that market participants pay for an equity interest that can be converted rapidly into cash. Its opposite is called “Discount for Lack of Marketability”
• (Small) Size Discount: an equity stake in a smaller company is worth less than in a bigger company, partly due to operational reasons (e.g. bigger companies are less exposed to external risks or market shocks)
• Other factors (such as Key Person Discount, etc.)

Overall, Comparable Transaction multiples tend to be higher than those of Comparable Companies, mainly driven by the Control Premium. However, this rule does not always hold up, as the different discounts can sometimes drive down valuations.

Obviously, multiples represent a “relative” valuation method, since you are estimating the implied value of your company using market data. This method sounds quite easy and fast, but to find the right Comparable Companies or Transactions takes time. Also, you should not forget that by selecting the group of comparable companies/transactions you make several significant assumptions, just like in a DCF model.

In general, Comparables are supplemental to a more complex model such as a DCF, but in some cases (e.g. if your company is in an early-stage and it is impossible to estimate its future cash flows, or if expected cash flows are negative) they can be the main indicators for your company’s implied value.

Advantages of Multiples (or Comparables)

• Involves simple calculations and easy to understand
• Based on real market data
• Not as dependent on future assumptions

Disadvantages of Multiples (or Comparables)

• Often hard to find accurately comparable companies/transactions
• Market valuation can be wrong
• Sometimes undervalues companies’ long-term potential

Asset-Based (or Liquidation) Valuation

This method estimates the market values of the company’s assets and liabilities. By subtracting the market-valued liabilities from the market-valued assets, you will arrive at the company’s Implied Equity Value. It is also called “Liquidation Valuation” since you calculate the value of the assets and liabilities with which they could be liquidated. Asset-Based Valuations are usually used in specific situations, such as distressed M&A carve-outs or Real Estate Transactions.

Advantages of Asset-Based (or Liquidation) Valuation

• Well suited for distressed M&A carve-out cases or Real Estate Transactions.

Disadvantages of Asset-Based (or Liquidation) Valuation

• Takes long time to calculate as one must value each asset of the company
• Difficult to determine the market value of certain items (such as intangibles)
• Tends to undervalue growing and healthy companies.

Now one can see that the main differences are rooted in the nature and complexity of the methodologies. Of course, there are several other variants out there (for instance LBO, which is used by Private Equities), but in this article I  summarized only the most conventional ones. And do not forget: for the sake of comparability, you should always calculate all the methodologies mentioned above, otherwise relying on just one figure can be misleading.