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The Critical Element Missed By The Typical Valuation Model

Posted by Rock LaManna on Mon, Sep 10, 2012 @ 09:09 AM

The critical element missed by the typical valuation model resized 600

The valuation model used in a merger and acquisition transaction is absolutely critical, and is comprised of two components.  One part is relatively easy to generate, and one part is more art than science.  Guess which one is critical to the success of an M&A?

To answer that question, let’s take a look at the two components of a valuation model.  The first component includes the historical financial data from a company.  The most common formula for this calculates a company’s Earning Before Interest, Taxes, Depreciation and Amortization (EBITDA).  

As financial guru Lee Rust describes, “(EBITDA) is the cash available to service debt.”  Determining EBITDA is relatively straight forward, as you have most of the historical data available at your fingertips.

Now comes the hard part and the most critical element – the second component, which uses “multiples” to determine a company’s value.   The multiples are influenced by a large number of intangible items, which Rust describes as:
  • The extent of synergy between the buyer and the target
  • The characteristics of the markets and the operations of the target company
  • The fair market value of the assets to be purchased
  • The net book value of these assets after subtracting all assumed debits
  • Other numerous items that make corporate evaluations “more art than science”

It’s the comment “more art than science,” which should be a cause of concern for CEOs, private investors, or anyone else interested in an M&A.  It’s not like there isn’t a steady stream of information available for use in a valuation report.  It’s understanding which stream you’re going to drink from for your final numbers.

This requires knowing and understanding not only the benchmarks of other companies and industries, but also the status of the industry leaders.  Not only must you crunch numbers like nobody’s business, but you’ve got to have an instinctive feel and a long-term history with a sector to accurately evaluate it.

Whenever I generate a valuation report for my clients, I always look for industry-specific appraisers to help me validate current data and market multiples.  They, more than anyone, are locked into that critical element every valuation report must have.  

The potential benefits, or losses, are simply too big to choose otherwise.

Photo by: Mr. T in DC.

 

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Topics: Valuation Model, Valuations

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