M&A Valuation Methods: All You Need to Know
In this article, we will go over the concept of M&A along with the methods used to value a business during the M&A process.
You might have heard about mergers and acquisitions (M&A) in the business world, but did you know how to value a company before you decide during the M&A process? All businesses are worth a certain amount in terms of economic value, and this economic value is quantified using several methods under the business valuation process. Well, M&A are agreements that include the combining of two businesses in some way. As a matter of fact, mergers and acquisitions are sometimes used interchangeably, although they are different. In this article, we will go over the concept of M&A along with the methods used to value a business during the M&A process.
M&A valuation methods
Merger and acquisition or M&A are transactions that occur when two companies decide to combine their operations in some way. Before we dive into the concept of M&A valuation methods, let us look at the basics of M&A. In practical terms, a merger is generally whereby two similar-sized businesses merge to form a new single business. While an acquisition occurs when a large business acquires and takes over a smaller business.
In this regard, merger and acquisition help improve the efficiency of businesses by expanding, growing, and improving their operations and reach. During the M&A transaction, valuing a business is an important step in the decision-making process. Based on the valuation results, the deal between the two businesses can be carried out.
What is M&A?
Merger and acquisition (M&A) are transactions in which two companies combine. A merger is the combining of two similar companies to form a single entity and acquisition is the acquisition of one company by another. These are commonly used practices in business to increase strength in operations, improve performance, and create a more efficient business. Moreover, M&A plays a crucial role in creating change in the overall environment of a company by creating a new business entity, or by creating a new strategic partnership in the market.
In essence, M&A can provide businesses with some strategic benefits if properly executed. Mergers and acquisitions have been utilized by many businesses for a long time to expand their scope of operations and reach into other markets. In fact, there are plenty of examples of successful M&A transactions in the marketplace today.
How does M&A work?
M&A is a complex and complicated process that requires careful planning on the part of the entities involved in the M&A. Through a series of financial transactions, multiple company entities and assets are combined under the umbrella term of merger and acquisition (M&A). The entire process of merging or acquiring a firm, from beginning to end, is covered by the merger and acquisition process.
This process includes several important steps such as, identifying targets and generating interest, internal and external business due diligence, negotiations, closing, and creating integration plans. Overall, the mechanism that is involved in merger and acquisition is one of the most comprehensive business processes. However, the benefits of the M&A process can only be realized if all the components are executed properly.
Types of M&A
There are several types of merger and acquisition activities that businesses can perform. The following are some of the common types of M&A:
- Mergers – A merger is when two similar companies combine to form a single company. The combined plan of action is commonly referred to as a merger agreement between the interested parties. It is important to note that mergers are usually performed if the two companies are practically similar in nature, size, and stage.
- Acquisitions – An acquisition occurs when a company acquires another company or a firm. In this case, the acquired firm retains its name and organizational structure while the acquiring corporation acquires the majority of the stake. It is important to differentiate between a merger and an acquisition during the M&A process.
- Consolidation – By integrating core companies and abandoning existing corporate structures, consolidation results in the creation of a new company. Shares of common ownership in the new company are distributed to shareholders of the two companies who have approved the consolidation.
- Tender offer – When a company puts forward an offer to purchase the outstanding shares of another company, it is known as a tender offer. By passing management and the board of directors, the acquiring business makes the offer straight to the shareholders of the target company. As a result, the shareholders can gain the most value.
- Acquisition of assets – As the name implies, the acquisition of assets occurs when a company acquires other companies’ assets. During the acquisition of assets, shareholders must approve the transaction in order for the acquisition to proceed. Generally, in the case of bankruptcy, the acquisition of assets takes place.
- Management acquisition – An important concept in M&A is management acquisition, which is also referred to as a management-led buyout (MBO). In management acquisition, Executives of one company buy a majority interest in another, making it private. In order to help fund a deal, these former executives frequently collaborate with a financier or previous corporate officers.
How to value M&A?
Probably you know that now, business valuation plays an important role in merger and acquisition transactions. But do you know how to value them? In order to find out how to value M&A, we need to understand the basic components of valuing a company and the valuation steps involved in each M&A process. As a matter of fact, there are various M&A valuation methods and approaches that can be used by businesses in order to value the target company. While it is essential to note that, mathematical calculations, financial analysis, future projections, estimations, and qualitative data are used to value the target company. Below mentioned are a few popular and common methods that are used by different businesses.
General M&A valuation methods
It is important to learn the basic valuation methods that can be applied in every business transaction. Here are the top four methods that can be used in valuing companies:
- Asset-based approach – The asset approach is considered to be the most basic valuation method, which is used in order to find out the value of a company based on its net asset value (NAV). This approach works on the principle NAV, which is assets minus liabilities. Basically, all the assets including tangible and intangible assets are added up, and then the amount of this total is subtracted from the liabilities, which gives us the value of the company.
- Cost-based approach – The cost approach is also referred to as the replacement value approach or reproduction value approach. In this method, the cost of replicating the same business is taken into consideration and that value is used in order to value the business. In practical terms, the value of the company is directly proportional to the amount of money required to create a new business that is identical.
- Market-based approach – The market approach to valuing a company is based on the fact that by comparing the company with similar companies in the market, we can easily find out the exact value of a company. In this way, by comparing the company with its competitors, the appropriate value of that particular company can be determined. However, it is important to remember that, this method is useful when comparable companies are available.
- DCF approach – DCF or discounted cash flow approach is a popular valuation method which is also known as the income-based approach. In the DCF method, the company’s value is determined by discounting the expected cash flows for the next five years to the present value. To calculate the present value, future cash flows are projected and discounted. According to the present value, the valuation of the company can be determined.
8 important M&A valuation methods
Now that you are well informed about the general methods of M&A, it is time to understand the specific M&A valuation methods that are used during a deal. Below mentioned are the 8 valuation methods of M&A:
- EBITDA – Earnings Before Interest, Tax, Depreciation, and Amortization, or EBITDA, is a metric used to compare a company’s financial performance to that of other businesses of a similar size without taking into account factors like corporate taxation, capital spending, and working capital financing that could cause distortions. Thus, it is a very useful metric in order to find out the value or the worth of a company.
- Net Asset – Similar to the asset approach, the net asset value (NAV) of a company is directly proportional to its merger and acquisition valuation result. The net asset value is calculated by adding up all the assets of the company and then taking away the liabilities. It is important to mention that, this method is useful for most solid, asset-rich companies, like real estate or manufacturing businesses.
- P/E ratio – The PE ratio or price per earnings is calculated by dividing the company’s valuation by its tax after profits. The valuator should multiply the company’s after-tax profit by a suitable multiple to determine its worth based on price earnings. To assess the equity worth of a company, deduct any debt and add any surplus cash. Therefore, the P/E ratio can be used as a way to measure the equity worth of a company.
- Comparable analysis – As the name suggests, this method is similar to the market approach wherein comparable companies are compared with the target company in order to find out its value. The target company’s sales, earnings, assets, and other relevant information are recorded and then compared, which helps in finding the precise value of a company. Hence, this method is used when there are comparable companies available.
- Revenue multiple – This approach can be used in order to value companies in industries with well-defined sales and profit margins. It is a useful indicator for comparing companies with varying profit levels but with similar comparable margins, goods, markets, and competition. As a result, we can determine the value of the company with the help of a revenue multiple.
- Precedent analysis – This method is used when similar transactions are available that have been completed in the recent past. The EBITA and revenue multipliers, in addition to any other multiple that the analyst wants, may be included in the precedent analysis approach. Basically, this method is used to determine the value of a company by comparing it with similar transactions.
- Dividend yield – This approach is built on a similar idea as the DCF approach, wherein the company’s present value is determined by discounting a series of its future dividends. In other words, the projected dividend payments are identified and analyzed, and based on a suitable discount rate, it is discounted to the present value. Likewise, according to the present value, the valuation of the company can be measured.
- Football field chart – A football field valuation chart enables you to easily compare a company’s valuation using several approaches including precedent analysis, comparable analysis, and DCF. The aggregate results are then used to determine the value of the company. Typically, the purpose of a football field chart is to determine the valuation of a company based on a combination of valuation methods.
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