Buying or selling a business can be scary. The key to success in buying another company is knowing the value that company will bring to your existing portfolio and paying a price to maximize that value. This is not a simple task, by any means. There are many factors to consider when determining the price you should pay for an acquisition; be sure to cover all the bases and conduct a thorough valuation of the company you’re considering before making an offer.
One common assessment of a company is its intrinsic value, which is the value of a company based on multiple underlying metrics and assumptions of a business. This is often called the “true value” of a company.
One metric that may be used to calculate the base financial value of a business is the discounted cash flow method, which takes into account the net present value of all future cash flows of a business discounted by a weighted cost of capital of the business.
Another factor that can play a role in a company’s intrinsic value is the qualitative assessment. For instance, let’s assume the discounted cash flow method determined a business to be valued at $20 million. The limitation on the financial analysis may be that it is not factoring in the future value of a company that has a technology yet to be launched due to lack of capital to get it off the ground. If the buyer sees the value in launching that new technology, there is likely additional intrinsic value above and beyond the quantitative value of $20 million.
This is important because, as a buyer, you don’t want to overpay for a business, but you don’t want to lose a business that can add value to your portfolio. Knowing your competitors who may also be trying to purchase the business will help you evaluate what you should offer.
A company’s market value is more objective. This is the value of a company based what the market is willing to pay for it, and it can be measured in many forms, such as stock price, sales ratios, EBITDA multiples, and offer price.
In publicly traded companies, market value is determined by multiplying the company’s outstanding shares by the current price on the stock exchange. For example, if a company has 100,000 shares outstanding and the current market price is $50, the company’s market value is $5,000,000.
Market value can also be calculated by determining the ratio of sales volume to the market value of comparable companies and arriving at a market value based on the individual company’s sales. For example, if a company is valued at 1.5 times its annual sales (a sales to market value of 1.5:1), then a comparable company with annual sales of $1 million could be valued at $1.5 million.
These are just two possible methods of determining market value.
When a company being purchased is more valuable to a buyer that has complementary resources that can accelerate the value of both companies, this is referred to as synergy value. The basic principle is that the combination of the two companies will have a greater total value than either individually. Two types of synergies that may apply are operating synergies and financial synergies.
- Operating synergy is the idea that the acquisition will enhance operations of the acquiring company to ultimately save time and money. Examples may include increased sales, reduced costs, and expanded global footprint, among others.
- Financial synergy means the purchased company will add tangible value through items such as tax benefits, increased debt capacity, and/or diversification benefits.
These types of synergies are likely more applicable to strategic buyers since they can ascertain both operating and financial synergies. This may put them in a better position to purchase a company than a financial buyer who may only be able to take advantage of the financial synergies of an acquisition.
All of the factors above, and many more, can help you determine how much to pay for a potential acquisition target. In order to fully assess the value of a company, it is critical to have a documented due diligence process to thoroughly assess the ultimate price you are willing to pay for an acquisition.
If you are looking to add value to your company through an acquisition, joint venture, or divestiture, the professionals at Cornerstone Consulting Organization can help you go through the due diligence process. Don’t make the mistake many companies do when buying or selling a business by paying too much or getting to little. Let us help you maximize the value to your company.
Written by Chris Ostrander