Acquisitions: Valuation

Valuation methods in company valuation

Valuation is an important step in the process of business acquisitions, where the buyer spells out a value communicated to the seller through a non-binding indicative bid.

The valuation is based on the aggregate information obtained during the acquisition process together with the buyer's knowledge of the industry and the market. During a due diligence, once additional information is obtained, the assumptions underlying the valuation should be verified to ensure that the valuation is not based on incorrect assumptions. In this article, we explore the most common valuation methods and delve into DCF valuation (DCF stands for Discounted Cash Flow).

Common valuation methods

There are several valuation methods that can be used to assess the value of a company with the most commonly used methods being:

1. DCF valuation

DCF valuation is done by forecasting future free cash flows and discounting to present value using a relevant discount rate. This method takes into account the future earning capacity of the company and is particularly useful for companies with stable and predictable cash flows.

2. Multiple Valuation

Multiple valuation makes use of comparable companies' valuation multiples or transaction multiples, such as EV/EBITDA (operating value/EBITDA), EV/Sales (operating value/revenue), or P/E (price/profit) ratios. This method is quick and simple, but requires careful comparisons with similar companies to be reliable.

3. Substance Valuation

Asset valuation focuses on assessing the assets and liabilities of the company. This method is especially useful for companies with significant tangible assets, such as real estate or machinery. The net asset value provides a picture of the company's book value.

Immersion in the DCF valuation

The DCF valuation is a method that calculates the value of a company by discounting its expected future cash flows at a present value. Below is a description of the key elements of a DCF valuation and how the process goes:

Key elements of a DCF valuation

1. Future Cash Flows
   • Calculating future cash flows is a key component. Future cash flows include the company's income less expenses, taxes, investments, as well as change in working capital.
   • Cash flows are estimated on an annual basis and should extend over a forecast period, usually 5-10 years.
2. Terminal value
   • After the forecast period, a terminal value is estimated that represents the value of the company's free cash flows after the forecast period, that is, the perpetual cash flow.
   • An important assumption is the perpetual growth rate, which is usually set at 2%, which is in line with the Riksbank's long-term inflation target.
3. Discount rate
   • The discount rate used to discount the future cash flows at present value is decisive for valuation, and shall reflect the risk level of the entity.
   • The most common discount rate is the WACC (WACC), which is a weighted average of the cost of equity and debt.

What components are included in the WACC rate?

1. Cost of Equity represents the return expected by shareholders for investing in the company. It can be calculated using the Capital Asset Pricing Model (CAPM)
2. The cost of debt is the interest the company pays on borrowing, adjusted for tax deduction because interest expense is deductible.
3. Capital structure represents the proportion of the company's financing that comes from equity and liabilities, respectively.
4. Risk premiums and adjustments represents additional risk premiums or adjustments that may need to be applied depending on specific risk factors for the company or industry. Examples of such adjustments may include small company premiums, company-specific risk premiums (e.g. customer or supplier dependence, person dependency or forecast risk), regulatory risk premiums, market risk, environmental risk, etc.

A rule of thumb is that the higher the risk, the higher the discount rate.

How does the process of a DCF valuation take place?

1. Collect financial data
   • Start by collecting historical financial data and forecasts for revenues, expenses, investments, working capital and taxes.
   • Analyze the company's business plan, market analyses and other relevant information.
2. Forecasting future cash flows
   • Analyze historical performance and trends to make realistic forecasts.
   • Estimate future revenues based on market growth, company strategies and competitive position.
   • Subtract future expenses including operating expenses, investments and changes in working capital to produce free cash flows.
3. Calculate terminal value
4. Calculate discount rate (WACC rate)
5. Discounting cash flows and terminal value
   • Discounting the forecasted free cash flows at present value
6. Summing up the present values
   • Add the discounted cash flows and the discounted terminal value to get the total value of the company.

Consider synergies and integration costs

The valuation of a business acquisition should also take into account possible synergies and integration costs. Synergies can lead to cost savings or increased revenues. Integration costs, on the other hand, are the costs incurred in the merger of two companies, including the costs of system integration, restructuring and other conversions. Whether the buyer should pay for future potential synergies is a matter of negotiation between buyers and sellers.

Operating value vs. share value

The DCF valuation provides an enterprise value for the company. In order to calculate the equity value in the next step, cash and cash equivalents as of the valuation date need to be added while interest-bearing liabilities are deducted. Finally, an adjustment is made for other non-operating assets and liabilities. Here is an example:

• Operating Value (EV): SEK 100 million
• Cash and cash equivalents: SEK 10 million
• Interest-bearing liabilities: SEK 20 million
• Other non-operating assets: SEK 5 million
• Other non-operating liabilities: SEK 10 million

Share value: SEK 85 million

A DCF valuation provides a forward-looking view of a company's value by focusing on its ability to generate future free cash flows. It takes into account both the company's current financial position and its potential growth opportunities, making it a relevant method for determining a company's value in an acquisition process.

At FLB Partners, we offer expertise and support throughout the acquisition process, from strategic planning to integration. Contact us today to discuss how we can help your company with the acquisition process.