M&A Valuations: The “Strategic Investment” pitfall

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by

Frontline Capital
in

Abstract

The global M&A market is rife with examples of deals involving out-of-range multiples. Business transactions are complex, time-sensitive, and involve many moving parts, making it easy for founders and shareholders to lose track of the investment case.

In this article, we discuss Investment Fundamentals, Valuation Standards and Fair Value adjustments.

The “Strategic Investment” pitfall

During a buy-side valuation assignment on an auction process, I once requested the investment team specify their targeted returns in order to determine the maximum admissible bid. Their response was:

“This deal is a strategic investment; it is not a question of money.”

Provocatively, I would contend that unless you operate a Charitable Incorporated Organisation (CIO), every transaction fundamentally revolves around financial considerations.

The “Strategic Investment” argument is a hallmark of some of the most poorly priced deals I have seen. Let us then discuss the practical steps required to execute robust asset valuations.

Investment fundamentals

Corporate investors often spend too much time debating the merits of multiples-based valuations derived from statistically insignificant sample sizes, without adequately considering the following:

  • Investment returns: What returns do we anticipate?
  • Investment alternatives: How do these returns compare to alternative investment opportunities?
  • Purchase price: How much are we willing to spend in acquiring the asset?

Careful screening for relevant Comparable Companies and Precedent Transactions is essential to build truly comparable data sets. Each sector and industry features a diverse array of business models and capital structures, resulting in varying levels of growth potential, profitability, and consequently, a wide range of valuation multiples.

By shifting the emphasis from potentially misleading comparative analyses to the fundamental principles of investment returns, we can achieve a much more disciplined and practical evaluation of an asset’s worth.

Valuation standards

The International Valuation Standards (IVS), prescribed by The City Code of Takeovers and Mergers (The City Code), identify three main approaches to asset valuation, based on the economic principles of price equilibrium, anticipation of benefits, or substitution:

  • The market based approach: provides an indication of value by comparing the asset with identical or comparable assets for which price information is available.
  • The income based approach: provides an indication of value by converting future cash flow to a single current value. Under the income approach, the value of an asset is determined by reference to the value of income, cash flow or cost savings generated by the asset.
  • The cost based approach: provides an indication of value using the economic principle that a buyer will pay no more for an asset than the cost to obtain an asset of equal utility, whether by purchase or by construction, unless undue time, inconvenience, risk or other factors are involved.

The IVS recommends that the valuer apply the most relevant approach(es) with due consideration given to the specific object of the valuation exercise and the bases of value.

Valuation scope

Know what you are buying into or selling. Start by determining the proposed object of the transaction. Are we looking to carry-out a valuation of the entire entity, shares, or a shareholding in the entity (whether a controlling or non-controlling interest), or a specific business activity of the entity?

In this context, we distinguish between:

  • The Firm Value (FV): Often described as the total value of the equity in a business plus the value of its debt or debt-related liabilities, minus any cash or cash equivalents available to meet those liabilities.
  • The Enterprise Value (EV): The total value of the operations of the business, excluding the value of any non-operating assets and liabilities.
  • The Equity Value (EqV): The value of a business to all of its equity shareholders.

Fair Value adjustments

Stay grounded and assess the tangible worth of what you are buying into or selling. Divide the scope into cohesive blocks of assets, equity instruments and liabilities. Then, starting from Book Value, apply Fair Value adjustments using one of either market, income or cost based valuation approach. Typically:

  • Cash flow generating assets: Cashflow Generating Units or CGUs, smallest group(s) of identifiable operating assets generating independent cashflows.
  • Non-cash flow generating assets: Marketable securities, loans receivable, idle equipment, and vacant land.
  • Cash and cash-like items: Cash book value minus adjustment for cost incurred in extracting cash.
  • Working capital adjustments: Adjustment on cash and cash like items accounting for temporary deviations on normal levels of working capital.
  • Debt and debt-like items: Bank loans, accrued interests, break costs, overdraft, financial leases.
  • Sub-blocks of equity: Non controlling interests, Convertibles and Options.

In practice, a great deal of the valuation exercise rests on the cash flow generating assets and the credibility of the business plan, whose assumptions are always the subject of particular scrutiny from buy-side teams during the diligence stage.

Avoid presenting unrealistic projections; disciplined investors will see right through and may be deterred from engaging in a sell-side led process.

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