M&A Valuation Methods to Determine a Company's Worth

Companies should never enter a deal blindly, especially one as consequential as a merger or acquisition. This is what makes the M&A valuation process so important, as it provides a company with a clearer understanding of a target company’s worth. Most M&A transactions use multiple valuation methods for triangulation, making it essential to understand how this process works and how each method provides part of the larger picture.  

What Is Looked At in an M&A Valuation?

The business valuation in mergers and acquisitions process aims to put a dollar amount on a business by accounting for several factors and aspects of its operation. Two companies within the same niche that have the same market size may differ in valuation when you consider other aspects of business operation. The emphasis should always be on the strategic value of the target company, rather than solely on the financials. Just because a company seems like a bargain doesn’t necessarily mean it will be a strong fit for the acquiring company.  

While valuing a business, appraisers tend to look at factors such as these:

• Stage of the company’s lifecycle
• Business history and reputation
• Observable growth
• Marketplace competition
• Prospects
• Cost for the buyer to build a similar business from scratch

If buyers could easily build an equivalent business from scratch without significant overhead, they are likely to attach a low value to the seller's company. They could make one just like it, so why would they pay a lot to acquire it? In this case, a seller would not have a lot of bargaining chips.

On the other hand, if the seller's company would be cost- or labor-intensive to replicate and there are outstanding prospects for the business, then it is truly a seller's market for the M&A.

While these factors impact the perceived value of the business, both parties want hard numbers to guide the negotiations. This is where the M&A valuation model provides value. An appraiser will take a range of factors into account to come up with an independent valuation for the business. When both sides understand the valuation models, or how the appraiser determined the company's worth, they can determine how much to offer or whether a buyer's offer is fair. Without this understanding, the M&A lacks objective data to guide negotiations.

The Three Primary M&A Valuation Methods  

While there are several business valuation methods used to determine the worth of a business, appraisers typically choose one of these three M&A valuation methods:

• Cost approach: The most straightforward approach, a cost-based valuation estimates what it would cost to replicate the business from scratch. This approach works best with businesses that are physical or tangible in nature. For example, you could gauge the cost of replicating a manufacturing business by summing the total of tangible assets for the business. Cost approaches to company valuations work less well for businesses that rely on intellectual capital and other intangibles. To give an example, it's difficult to objectively value an employee's talents or skills in a service-based businesses such as a Software as a Service provider, so these companies are less likely to be valued with a cost approach.
• Market approach (Comparable Company Analysis): A market-based approach looks at similar company that sold recently to estimate the value of a company. This method is frequently used when there are other businesses, such as the seller's company in the same niche and geographic area. After all, a business that recently sold in another state or country does not provide useful data. This method isn't likely to be used with companies run by individuals or maverick companies in hybrid niches, since direct competitors are scarce.
• Discounted cash flow (DCF) approach: The discounted cash flow approach to a business valuation compares the potential future value of the business with its present-day cash flow perspective. If a business is projected to be worth a hefty sum in a given period through DCF analysis — say, five years from now — an appraiser will work backward from the future valuation to determine its present-day worth. This estimate then becomes the company valuation now, even though the potential future income is hypothetical. One of the key discount rates commonly used is Weighted Average Cost of Capital (WACC). This is used to determine the minimum return for satisfying investors and creditors and represents the company’s average cost of financing from debt and equity weighted by market value.

To understand how each of these M&A models relate to each other and how they should be used, refer to this table:  

Key Financial Metrics Used in M&A Valuation 

After selecting the most relevant appraisal method, an appraiser will then look at these factors to come up with the valuation:

• Assets: Adding the material worth of a company's assets and subtracting liabilities is a simple yet effective way to gauge value.
• Earnings before interest, tax, depreciation & amortization (EBITDA): Taking EBITDA allows buyers to compare the seller's company with competitors by taking out these four factors. Because these factors can cause distortions, EBITDA is critical for determining the true value of a company.
• Revenue multiple: This determines the value of a business proportionate to its revenue and can be used to determine whether the seller's company is “cheap” or expensive to acquire. It can be a good metric for valuing companies that have well-defined sales and profit margins.
• Real option analysis: “Real options” are simply asset-based choices, such as machinery or business property, rather than intangible assets such as IP. Enticing or valuable real options can sweeten a deal.
• P/E (price earnings) ratio: The ratio expresses a company's share price divided by after-tax profits and can help buyers and sellers compare a company to competitors. Many times, this metric is used to determine the equity worth of a company.
• Dividend yield: Similar to discounted cash flow, this gauges the present value of a future dividend to “prove” worth.
• Entry cost: The entry cost sums up the cost from scratch to start an equivalent business; it helps the buyer weigh the pros and cons of the M&A terms.
• Precedent analysis: Comparable to the cost valuation method, this gauges the precedent price paid in similar M&A deals. This can be important for establishing a baseline comparison.

Advanced Valuation Techniques  

For more-complex M&A deals, there are several advanced valuation methods that may be employed. These include:  

• Real options analysis: This method is used to determine whether an M&A deal is worth pursuing at the present time, or if it would be better to hold off until more information becomes available.  
• Scenario modeling: This can be a valuable tool for predicting how revenue projections for a target company may change based on future market conditions, operational changes, or new strategies.  
• Synergy valuation: Companies use this process to determine the value that may be created by a merger or acquisition by forecasting any cost savings, added revenues, or other financial advantages the deal may create.  
• Control premiums and discounts: Deals that are heavily weighted in one company’s favor can provide additional value to that company, and calculating the control premiums and discounts can be critical in helping a firm make the decision to pull the trigger. 

How to Prepare for an M&A Valuation

Given the breadth of information looked at in M&A valuation methods, you may be wondering how to prepare for M&As and the hefty due diligence required to support the valuation.

In M&A due diligence, the buyer and seller disclose material facts about their business. Think of it as a fact-finding mission where the buyer and seller fact-check their claims to finalize the deal.

Staying organized and enhancing process readiness is key to successfully navigating M&A due diligence. One of the best ways to stay organized and ready is by using a virtual data room where both sides can upload and review key documents. A virtual data room offers secure, encrypted storage to ensure the safety, transparency, and accuracy of deal data. Stakeholders can access the data room remotely to upload documents, perform due diligence and speed the deal to a successful close. 

DFIN's M&A software was built with security and efficiency in mind. Discover why leading players in the M&A market view choose our M&A solutions to meet their business needs.