The ups and downs in ‘earnings multiples’ is a perennial topic of discussion in the mergers & acquisition (M&A) market. When the M&A market is favorable to sellers, the ratio of the acquired companies’ pre-deal annual profit (EBITDA) relative to the amount paid by the buyers (enterprise value) runs high. When buyers have the upper hand, as is the case today (fall 2023), or when the market experiences a downturn, multiples fall, sometimes dramatically.
The casual observer could be forgiven for thinking that multiples are the best (or only!) way to value a company, but in the context of buying a private company that is a risky misconception that may lead buyers to overpay for an acquisition. Historical average multiples – even those in respect of the acquisition of analogous businesses – are a pseudo-objective measure of value. They represent past prices paid relative to the past financial performance of businesses that have been acquired in a given market. They do not account for the subjective strengths & weaknesses of the target business or the future prospects of growth and synergies. Nor do acquisition multiples consider the buyer’s own cost of capital or risk appetite.
“Historical average multiples – even those in respect of the acquisition of analogous businesses – are a pseudo-objective measure of value”
We would argue that, at best, multiples provide a sense check that can help stop a buyer from overpaying.
Want to value a business?… focus on future cashflow!
When considering an acquisition, a buyer needs to remember that they are making an investment. They are deploying their scarce capital, and seeking a return for that. The focus for valuing a private company is therefore to evaluate the potential future cashflows of the business. This is best done by developing a long-range forecast for the business and using this to create a discounted cashflow (DCF) model. This approach makes financial modeling a vital skill for effective acquisitions.
A DCF model projects future cash flows (including an exit value), incorporates a discount rate that accounts for the time value of money and risk, and sums these present values to arrive at an estimated current value. When the cost of making the acquisition (purchase price, deal costs, integration costs, etc.) is deducted, net present value (NPV) is arrived at. Typically, any NPV greater than $zero indicates that the investment would be better than doing nothing i.e. not making the investment at all.
The NPV to a given buyer of a proposed acquisition may well fall short of enterprise value implied by precedent multiples. If that buyer did not consider the time and risk-adjusted value of future cash flows, it risks overpaying (at least in the context of its own expectations of a risk-adjusted return). Discounted cashflow is therefore a critically important part of valuing a company.
Buyer beware – DCF has its limitations!
Importantly, the DCF approach has its limitations. As we tell clients, modeling and discounting future cash flows is part science, part art. Private Equity Info‘s Andy captured the shortcoming perfectly in this great article on Medium. As he say,: “While the… [DCF] methodology is the most rigorous and financially sound for business valuation, it does have several significant limitations, namely:
- Extreme sensitivity to certain input assumptions.
- Uncertainty in calculating the terminal value of the company.”
Jones’s article is well worth a read. He points out the challenges of forecasting future revenue, especially for middle-market companies. WACC in the context of private companies is illusive and can have a significant impact on the valuation.
Without a better alternative, we are stuck with an imperfect tool in the form of a DCF. Despite its shortcomings, the exercise of creating a DCF has some ancillary benefits to the buyer: first, it forces the buyer to think about the risks associated with its investment and to consider return it expects in the context of those returns; second, it also forces a buyer to forecast the cash requirements associated with a deal: debt repayment, funding increases in working capital, etc.
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If you have questions or need help with evaluating acquisition opportunities reach out to Chris Perfect today by email: chrisperfect@conceptandperspective.com
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