Our M&A consultants discuss how to value a target business for your next M&A deal, and the process of sourcing a target company that aligns with your plans in the first place.
Valuing a target business is the cornerstone of defining what makes a good deal. Regardless of a business’s reasons for pursuing an M&A deal, the price must be right, or you could be left with a millstone around your neck.
According to Experian, acquisitions remain the dominant deal type, even though deal volumes dropped 23% in H1 2023. However, 2024 brought a resurgence to the market, with businesses becoming more aggressive in their strategic M&A moves, and it will likely only grow.
In this guide, we’ll discuss how to value a target business for your next M&A deal and the process of sourcing a target company that aligns with your plans in the first place.
Determining the purchase price for a target company in an acquisition
Company valuation is critical because overpaying can quickly turn a deal sour. An accurate valuation helps you set a reasonable price, but where does determining purchase price begin?
Start with the company’s financial records for the past five years. Auditing these records provides a short to medium-term view of financial performance and gives potential buyers a reasonable idea of its underlying value and potential gains in the future.
According to the International Accounting Bulletin, undervalued UK companies have formed the backbone of the UK’s recent M&A resurgence, and the growth in deal values and volume appears to bear out that prediction.
However, data only forms the raw backbone of a valuation. The methods used to evaluate M&A targets are essential because using an inappropriate method can result in incorrect valuations.
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Why valuation is important in Employee Ownership Trusts
No single “correct” method exists for valuing M&A targets. Ultimately, the price you pay depends on what you are willing to pay. Calculating an acquisition price must always be seen as a rough estimate and a benchmark for negotiations.
Generally, M&A valuation involves choosing from three main umbrellas: market-driven valuation, earnings-driven valuation, and resource-based valuation. Company directors may also deploy several techniques to provide a broader range of estimates and acquire further guidance.
Let’s focus on each of the three methods.
Market-driven valuation
Market-driven valuation compares a target company to similar companies in the same marketplace. By far, the most common way to do this is by using a comparable company analysis, relying on the fact that similar companies will have similar valuation multiples.
The price-to-earnings (P/E) ratio is another technique that falls under this umbrella. The P/E ratio method is designed for publicly traded companies. It involves taking the current share price and dividing it by earnings per share. Factors included in this calculation include:
Earnings-driven valuation
Earnings-driven valuation focuses on the stated earnings of the company. The discounted cash flow (DCF) method estimates value based on expected future cash flows. Valuation agents analyse current cash flows, apply a discount rate and determine a total value.
Resource-based valuation
Resource-based or asset-based valuation is most commonly used for businesses with significant tangible assets, such as real estate, manufacturing facilities and machinery. It’s also a technique used for determining liquidation values.
An example of resource-based valuation is replacement cost assessment, which determines what it would cost to replace the company’s current assets with similar new ones.
Find a target company for an M&A
Before you can think about valuation, you’ll need a target company to value. If you’ve got a firm objective in mind, you’ll likely build a shortlist of companies to analyse before settling on the most suitable one.
Unlike buying a property, there’s no reliable dedicated nationwide marketplace where entrepreneurs can look up what’s for sale. In some cases, the company you’re targeting may have no plans of being taken over and require a cautious approach to frame the idea in an attractive light.
Finding a target company requires laying out your objectives and beginning your search based on those. Examples could include expanding your market share, eliminating the competition, acquiring assets, acquiring talent, or moving into a similar but different market.
With those established, you can begin assessing targets by assessing the market. Generally, companies will hire an M&A consultant to streamline this process. Since many of the juiciest targets won’t advertise that they’re looking for a buyer, a consultant unlocks opportunities by leveraging their expertise and industry connections to find suitable connections.
Once you’ve done some basic due diligence, you’ll reach out to a target company and trigger negotiations.
The importance of valuation in M&As
M&A success lives and dies on the valuation. It all goes back to how you expect your profit from an M&A transaction and whether the deal's value can surpass the price you paid. Business history is littered with companies that overpaid in M&As to their cost.
For example, Bank of America acquired Merrill Lynch for £33 billion in 2009 in the aftermath of the biggest global financial crisis to date. Although a valid strategic move, it soon became apparent that Bank of America had overpaid, with asset write-downs following the deal due to the shock of the financial crisis.
Working with a professional M&A valuation agent is crucial to avoid making the same mistakes. Here are some reasons why:
However, valuations are merely the starting point for an M&A transaction. Even with an accurate valuation, it doesn’t mean your deal will be successful because there are so many other hurdles to success you’ll have to overcome.
With negotiations, due diligence and post-merger/acquisition integration, getting everything across the line requires tailored support, and that’s where an M&A consultant comes in.
At Hilton Smythe, we’ve got decades of collective experience supporting every aspect of the M&A transaction process. To learn more about getting accurate valuations and making your next M&A transaction a success, speak to the team today.