How are M&As Valued: Understanding the Valuation Process
Globally, the transaction value of mergers and acquisitions (M&As) reached $2.69 trillion by the end of 2024, according to German research firm Statista, with the average M&A deal size standing at $181 million. These figures bring up a key question how are these values determined?
To understand that we need to look at the valuation process, a critical component of the M&A process is the valuation of the target company.
Valuation involves determining the fair value of a given company or asset. However, there is no one way to determine the value of a business. There are various valuation methods, some more common than others for M&A deals.
Business leaders should understand the common reasons businesses consider a valuation, how M&A deals are valued, and the common types of M&A deal valuations.
Other reasons for a business valuation
Armed with a business valuation, business owners can determine the fair value of their company, including its assets, patents, and shareholder stakes.
A business valuation offers insights into an entity’s financial health and future potential to mitigate risks, make decisions, and maximize returns.
Businesses seek out valuations for a variety of reasons. Chief among those are adding new shareholders or co-founders, selling a stake to an investor or accelerator, expanding to a new market, and selling or acquiring a business unit, among others.
A valuation also helps leaders apply for loans, attract investors, make decisions related to estate planning, tax purposes, among others.
Common types of M&A valuations
When it comes to M&A deal valuations, some methods are more common than others. Some focus on future financial projections and cashflow, while others offer estimates based on market figures.
However, the best way to determine a company’s worth is to use multiple valuation methods.
Consult with an M&A advisor or a strategy consultancy to help you determine the best valuation methods for your M&A strategy.
Here are the 3 valuation approaches common for mergers and acquisitions.
1- Asset-based approach
This approach values a company’s assets, tangible and intangible, including properties owned, hardware, and machinery. It’s widely used for M&A valuations in industries such as mining, manufacturing, and real estate.
Asset-based valuation methods estimate the value of an entity based on the liquidation value of its assets.
2- Discounted Cash Flow (DCF)
This M&A valuation method focuses on the target company’s earning potential. The most popular income-based valuation method is the DCF analysis.
By forecasting future cash flows and discounting them to their present value, DCF provides a comprehensive valuation that reflects the intrinsic value of the business.
3- Market-based approach
This valuation method mainly focuses on comparisons with similar companies in the market. Due to their market-centered nature, market-based M&A valuation methods are widely used.
Common market-based valuation methods include the Comparable Companies Analysis (Comps) and the Precedent Transactions Analysis.
Analysts use financial metrics such price-to-earnings (P/E), price-to-book (P/B), Enterprise Value to Sales (EV/Sales), Enterprise Value to EBITDA (EV/EBITDA), to assess the value of a target company based on similar publicly-traded companies or past M&A transactions.
By applying these multiples to the target’s financial data, analysts can estimate its enterprise value or equity value.
The downside of this M&A valuation method is it becomes difficult to estimate value if the target company is in a niche industry.
4- Replacement Cost
In a few cases, acquisitions are based on the cost of replacing the target company. For example, this can be the value of its equipment, staffing costs, top talents, and tech process.
In other words, it will cost the acquiring company the same if it built a competing company from scratch.
Also read: 5 Ways to Retain Employees During Mergers and Acquisitions
Understanding the valuation process
The business valuation process involves several steps. It begins with engaging a valuation expert or financial advisor. At the same time, there is legwork you, as a business leader, should do as well.
The valuation process begins with data collection, including financial documents, market insights and data, and contracts. This should include financial and legal due diligence.
Next, you need to conduct a performance analysis, which involves reviewing your company’s historical performance and forecasting future trends.
After that, you need to choose the M&A valuation methods you’ll use to estimate the value of the whole business, specific business units, or both.
It’s important to consider how much each unit contributes to the overall business, what the M&A strategy is, along with next steps such as post-merger integration.
The next steps in the M&A valuation process include value adjustment for factors such as reliance on personnel, marketability challenges,…etc.
Then, it’s time to prepare a detailed report outlining the valuation process, assumptions, and conclusions. Armed with the results of the valuation, it’s time to negotiate with potential investors or buyers.
Common M&A valuation mistakes
Depending on the size of the deal, a merger or acquisition deal can take years. However, taking note of some of the top reasons why M&A deals fail can help you overcome post-merger challenges.
Common culprits that cause an M&A deal to stall or fall through include strategic and culture misalignment, weak internal communications, as well as shortfalls in due diligence.
In an M&A transaction, the due diligence process involves the buyer and seller exchanging information to ensure accuracy and transparency on both ends.
Due diligence shortfalls can come in various forms, including legal and regulatory due diligence, financial, operational, or even technological due diligence.
Also read: Why Improving Internal Communications Matters
Surviving M&A valuations
Often business owners, especially new founders, want a high valuation. The bigger the figure, the more eyes light up, right?
Wrong. Overvaluation is a big issue in the business arena. It’s because of that, that companies use several valuation methods to offer a fair value of their company.
One valuation method alone, with inflated numbers, can cause the M&A deal to fail or the business to struggle after the merger or acquisition.
Make sure you’re working with an M&A expert throughout the valuation, merger, and post-merger process. They will help you streamline operations, take note of aspects you may overlook as you focus on your numbers, and ensure a successful result.