From Theory to Practice

There are many ways to value a company in merger and acquisition situations. In this article, I will discuss several standards of value, in contrast to fair market value. Fair market value is, essentially, the average cash value a buyer is willing to pay a seller for a company when both parties have adequate information about the company and neither is compelled to buy or sell.

I also will focus on the most common valuation method, where buyers ascribe a multiple to earnings — typically earnings before interest, tax, depreciation and amortization, or EBITDA — where the multiple is based on required rates of return that reflect the risk of the business and the industry.

Here then, from a practical perspective, are the most common valuation errors and misconceptions in the M&A market today.

Issues Regarding Standards of Value

Ignoring Investment Value. While it is certainly understandable that buyers prefer not to pay more than fair market value for an acquisition candidate, it sometimes is financially advantageous to do so. Consider a situation where a buyer determines that the average, or fair market value, of a firm generating $1 million in EBITDA is $4 million. This suggests a required, risk-adjusted, fair market value EBITDA return on investment of 25 percent ($1 million annual earnings divided by the $4 million investment).

If the seller wanted $4.5 million for the business, a buyer focused solely on fair market value would walk away. But what if this particular buyer could confidently reduce $250,000 in redundant overhead? With $1.25 million in EBITDA and a price of $4.5 million, the buyer’s unique EBITDA return would be nearly 28 percent. In fact, this particular buyer could pay up to $5 million and still receive a risk-appropriate 25 percent return.

As such, the buyer’s investment value — the specific price an individual buyer is willing to (or could) pay for an individual seller based on the unique goals of the buyer and the unique attributes of the seller — is greater than fair market. In this case, the acquisition gives a greater ROI than other equivalent deals priced at fair market where revenue-enhancing or cost-reducing synergies can’t be realized. So, in valuing any acquisition candidate, buyers should first determine their own unique investment value to identify the highest price they can pay and still receive an appropriate ROI. Then, they should negotiate the best deal possible.

Equating Loan Value to Market Value. In an industry with minimal assets to use as collateral for loans and in which many lenders have been forced to take huge write-downs in the wake of numerous bankruptcies, it’s no surprise that bankers are extremely cautious in financing home care M&A activity. Accordingly, these lenders require substantial loan coverage (basically, the cash-flow cushion available to cover principal and interest), which drives down the amount they are comfortable lending to buyers to fund transactions.

While this creates a real and meaningful constraint on how much a specific buyer can offer an acquisition candidate in a highly leveraged transaction, it does not necessarily reflect the market as a whole — a market comprised of buyers with vastly different financial resources. As such, it must be remembered that “loan value,” while critical to a specific buyer, is not the same as fair market value.

Equating Goal Pricing to Market Value. The best-prepared sellers are often those who have a clear idea of the financial goals and objectives they would like to realize from a divestiture. But imputing a sale price based on what a seller hopes to achieve has little to do with the actual value of the firm.

Not surprisingly, sellers who rely on “goal pricing” often wind up substantially overvaluing or undervaluing their firms. Don’t confuse goal pricing as a method of valuation. It can, however, be an extremely powerful decision tool that can be used to drive business development strategies and the timing of a possible sale.

Issues Regarding Earnings

Applying Multiples to Historical Earnings. Buyers are interested in the future economic benefits a firm can deliver — namely, profits. So, when we assign a value to an acquisition candidate, historical earnings are relevant only to the extent they predict future earnings. Yet, buyers and sellers often focus entirely on the last fiscal year, or at best, trailing 12 months earnings to assess value.

Such a focus isn’t problematic for a no-growth firm, where the future is likely to be carbon copy of the past. But, what about firms in the midst of significant growth (or decline)? In this case, basing value strictly on the last 12 months may lead to substantial undervaluation (or overvaluation) of the firm.

First, analyze whether or not the firm has developed fundamental strengths (or weaknesses) to support continued and predictable growth (or decline). Next, quantify these trends, and then use this information to predict reasonably future performance, which is the correct basis for valuation.

Improperly Defining Earnings. It’s well understood that in M&A situations, earnings must be adjusted to arrive at a figure that is representative of what the typical buyer is likely to realize. The most common adjustments — and the easiest to identify — are those related to excess owner’s compensation and perks and extraordinary one-time expenses. But there are many other items that should be carefully scrutinized to see how they impact earnings.

The ways that companies handle revenue recognition, held billings, accounts receivable reserves and write-offs, equipment capitalization, calculation of cost of goods, depreciation, dividends, related company transactions, and equipment leasing, to name a few, all can have a significant upward (or downward) impact on earnings. In our experience, more errors in valuation are made in improperly defining “representative” earnings than in choosing the “wrong” earnings multiple.

Issues Regarding Multiples

Applying Cash Value Multiples to Non-cash Transactions. By definition, the fair market value of a business represents a cash value, essentially the present value of a business (as of a specific day) in cash. The problem arises when cash value multiples are used to determine the value of a firm, but the deal is structured with substantial non-cash remuneration such as notes, contingent payments or stock that has not been discounted to reflect risk and illiquidity.

Say the fair market multiple of a business with $1 million in EBITDA is five times EBITDA, but the deal is structured 25 percent in cash, 25 percent in below-prime interest rate notes, 25 percent in restricted stock, and 25 percent in contingent payments. In this example, the “cash value” of the deal is substantially less than $5 million, and is in reality, substantially below fair market value. To compensate, non-cash payments must be greater to yield a cash equivalent value consistent with the original valuation multiple.

Mismatching Multiples to the Balance Sheet. Multiples mean very little when it is unclear exactly what is being acquired from a balance sheet perspective. On the asset side of the ledger, fair market value multiples contemplate that the buyer will receive all of the working capital and operating assets of the firm necessary to sustain the business at its current capacity. Often overlooked, however, is the fact that working capital includes current assets and current liabilities. If working capital funds are sufficient, fair market value further assumes that the buyer is assuming normal non-interest-bearing trade payables and accrued expenses.

As for interest bearing debt, when values are driven off of EBITDA — earnings before interest expense — it assumes a “debt-free” transaction, where the seller pays off interest-bearing debt from the proceeds of the transaction. It’s not that any of these items can’t be changed; deals are often structured where sellers keep receivables, sellers pay off working capital liabilities, or buyers assume-interest bearing debt. Rather, it must be realized that any change to the basic model has an impact on the “real” value of the deal and may yield a transaction worth substantially more (or less) than the fair market multiple might imply.

Doubling Up on Risk. We see this error most frequently in situations where buyers perceive that an acquisition candidate is subject to substantial risk. The risk may be due to external issues like anticipated changes in reimbursement, or to internal matters such as concentration of business with specific referral sources or managed care contracts.

The problem arises when a buyer builds his concern into the valuation by using a lower, risk-adjusted multiple and a lower, risk-adjusted earnings projection. From a valuation perspective, it’s perfectly sound and appropriate to factor in increased risk with a reduced multiple or reduced earnings — just not both at the same time. “Doubling up” on risk can severely, and inappropriately, undervalue a firm.

Making the leap from valuation theory to practical applications in mergers and acquisitions can often be tricky. In addition to understanding the principles behind the math, the key to success often comes from evaluating the unique interplay of risk and opportunity inherent in each deal.

Dexter W. Braff is president of The Braff Group, a health care merger and acquisition firm with seven offices nationwide. He can be reached by phone at 888/922-5169; by e-mail at [email protected]; or on the Web at www.thebraffgroup.com.