What a Business Is Worth to You
Businesses don’t typically just advertise that they’re for sale and at what price they’re being sold. These transactions are all handled through very careful financial valuations, usually done separately by both parties who then meet to negotiate price.
For corporations, this transaction almost always includes a shareholder vote as well. The shareholders have the right to turn down the acquisition or, if they don’t want to turn it down outright, voice their concern about pricing so that the price can be renegotiated.
Often, the price is set as a proportion exchange in stocks, the purchase price of a controlling interest in stock at an agreed upon price per share, the exchange of assets or liabilities, or simply an outright purchase.
Exactly how corporations assess the price they’re willing to pay for an acquisition is very involved, though. Corporations use several methods to evaluate the purchase price of a company. In fact, several methods are typically used, compared, evaluated, compared again, and then some average or estimate is developed using some combination of those evaluation methods.
If you have differentials in the estimated price between the different methods you’ve used, you need to determine why that differential exists and what price to use.
Partnerships and joint ventures don’t really have a purchase price; rather, the corporations tend to come to an agreement regarding the amount of investment, types of investment, and relative proportion share of the income earned.
For example, if both corporations are contributing 50 percent of the investment, then they’ll each likely earn 50 percent of the income generated from the venture. These deals tend to get a little more complicated when one corporation is investing intangible assets like expertise, but then the market value of consulting or outsourcing that expertise or the market value of wages for hiring a similar position are all common measures of the contribution of such intangible assets.
Even for buyouts and hostile takeovers, often the analysis is no more complex than those used for investing in the stock of these companies. The book value of the company, the market value, or combinations of both are used in conjunction with these metrics in order to determine whether the company is over- or underpriced in regards to what that company is asking for payment in the acquisition.
The other forms of valuations, the ones really worth discussing in detail, are the mergers and the acquisitions. How does one company place a value on another company in these cases? Typically, professional reports developed by M&A firms are extremely detailed, assessing every aspect of the business.
These reports are always done from the perspective of the acquiring corporation because the benefits that are generated for such a firm are indefinite, while the sale price is a one-time transaction (potentially broken up into several payments).
This is why it’s common for companies to pay something called a control premium — an amount paid for a company that is more than the actual value of the company. This is done when it’s believed that the acquiring firm can derive more value from the acquired company than the acquired company is currently able to produce on their own.
For example, a company may be worth $1 million, but the acquiring company feels that it can make that company more successful than it currently is by utilizing economies of scope, so it’s willing to pay $1.25 million instead, expecting to generate positive returns on investment beginning in five years and continuing each year indefinitely. Sure, sounds like a good plan, but how did they figure that out?
First and easiest, comparing the book value of the company and the market value of the company is a great way to get you started. The book value is found in the balance sheet and is just the total value of all their assets minus the value of intangible assets and liabilities. It’s the sum of all the physical assets the company owns minus the debt it holds.
That number tells you what you could get for that company if you just decided to sell it off based on the total amount paid by the company for its assets (which can be optimistically high if the company is doing poorly, or pessimistically low if the company has a lot of future potential for earnings). Of course, most M&A isn’t motivated by this intention.
Now compare that to the market value of the corporation — that is, the total number of shares of stock outstanding times the market price per share. If nothing else, that will tell you what market sentiment is for this company, as well as what you could make off of selling its assets in a worst-case scenario.
Another method is to simply compare the company in question to the sale price of other comparable companies. Now, there may not be any companies that are perfectly matched for such a comparison, but this analysis still provides valuable information.
Just as if you were buying a house and you wanted to set a sort-of baseline value to compare one house to another, figuring out what companies of the same relative size are worth will tell you how much over or under the average the company in question is selling for.
In addition, figuring out how much companies in the same industry but of different size are worth will also help provide valuable information of what market expectations of price will be relative to their size, industry, earnings, or similar evaluations. That brings me to the next evaluation.
The cash-flow method of evaluating a company is a little trickier. Using historical data and sales projection for the next several years, it becomes possible to determine the future cash flows for the corporation. Using the present value of future cash flows, the company can estimate exactly how much money it’ll generate off of the business.
Now, the reason this evaluation becomes so tricky is that the company also has to consider how cash flows will change under the ownership of the corporation. What will be the nature of the changes, and how will those changes influence costs, revenues, and profits? If this can all be determined within a reasonable estimated range, then it’s much easier to estimate the value of the corporation.
If nothing else, it will tell you how long it will take to start generating a positive return on investment, if at all. Is the price set so high that you’ll never generate a return? Will it take 100 years to generate a return? Using the time value of money, price negotiations for M&A will frequently measure price in years rather than in dollar, which may sound strange for some.
Larger corporations may also use measures of market share. This method will still eventually come down to what that market share is worth and how much additional revenues will be generated using that market share and the ability to expand on the newly acquired share, but particularly for high-competition industries, such as soda and tech, the value of market share can be very high.
People with very high brand loyalty, say the competition between Coke and Pepsi, means that taking market share can be like digging through concrete using a wax spoon.
Price isn’t just set by valuation, however. The amount that the acquiring company can afford will play a big role. It’s not simply about what value they can extract out of the other company if they simply can’t afford the high price.
The company being acquired must also be convinced that the price is fair, because if it’s too low, then it has little incentive for it to agree to M&A. This is more a matter of the company’s own asset availability than valuation, but it still plays a significant role in price-setting negotiations.
A number of other methods are used to value a business. These staples are included in pretty much all reports, and they’re very easy to do with a bit of practice. It doesn’t explain how the company intends to make the purchase, though.