The Value of a Valuation
Learn what makes up a good valuation and start the process before it's too late.
Whether looking at acquisitions or divestitures, understanding the factors that drive the valuation of a company is a crucial first step in the process, but one that parties often fail to invest sufficient resources into.
In general terms, what dictates the multiplier attributed to the valuation of a company, and ultimately as business owners, here's the answer to your question: “How much is my company worth?”
Supply & Demand
Companies in attractive, high-demand industries will command a higher multiplier than those in more basic or out-of-favor sectors. Today, education, technology and business support & service businesses are examples of high-demand industries which are generating very attractive multipliers; while oil & gas and construction are those currently at the lower end of the scale.
The supply aspect is also critical. If there are plenty of attractive, profitable and well-managed operations on the market for disposal (i.e. oversupply), prices will generally be lower as it will be a buyer's market. On the other side, if there is a high demand but a low number of quality companies available for acquisition, this will force buyers to pay a premium.
As a vendor, therefore, timing the sale of your company to coincide with demand in your market being at its highest will help you achieve the highest value. Many vendors I speak to think (wrongly) that increasing profitability is the only thing that they need to focus on, when in fact their company could be worth more with lower profits if they time the sale right.
Potentially this can allow knowledgeable vendors to exit earlier than they first perceived.
Despite every buyer focusing on historic financial performance, typically ranging from the last 12 months to three years of earnings, the reality is that a purchaser is buying the future. What ultimately matters to a buyer is not what the company earned last year, it’s what the company could earn in the future under their ownership.
Therefore, businesses with high potential growth rates will sell for higher multiples than their slow growth counterparts. In order to fully assess the growth potential of your business, you need to analyze it as an investor, not a seller, and spend the time compiling a detailed business plan that outlines exactly how the areas of growth can be crystallized, including specific details such as the necessary levels of CAPEX or investment, responsibility apportionment and timing.
If detailed and credible, then this should enhance the perception of growth potential, and can be tweaked for each prospective buyer to show synergies and diversification.
Risk plays a role in every business decision. It is common knowledge that safer assets have lower rates of return than high risk investments. The more risk a buyer is willing to take, the higher return they will demand. Therefore a buyer will offer less for a company that they perceive carries a lot of risk, whether that be from a high concentration of revenue to clients, reliance on one or two key members of staff or financial sustainability.
As a seller there are ways to mitigate the majority of risks a buyer will identify, albeit these risk mitigation strategies take time to instigate and mature. Therefore planning an exit years before implementation is critical to allow sufficient time for change, working in conjunction with an external expert to assess and mitigate the perceived risks that a buyer may identify.
This is closely related to risk, although often linked with external factors rather than competition for or dependency on clients. If the industry that a company operates within is heavily influenced by external factors, then the future earnings of the company are less secure, and therefore a buyer will look to protect their investment accordingly.
For example: those companies operating within the public sector are subject to cuts in spending or budget changes which often occur when new governments are elected. Therefore if the sale is closely timed to a general election, a buyer may well take this into account when making an offer.
Likewise, those companies operating in the property sector or those linked within the wider construction industries, can be significantly affected by changes in the property market and the economic climate, both at home and abroad. As seen in the late 2000s, if the housing market crashes due to issues in the financial world, then the revenues generated by these companies are highly likely to be affected.
Another final example is recruitment agencies or training operators, whose revenue streams are heavily influenced by employment levels within the private sector. Again revenues in these industries will experience peaks and troughs linked to growth curves and recessions accordingly, and this external volatility of the industry will be factored into a buyer’s valuation.
Synergistic Values & Savings
A strategic buyer will often pay more for a business if they believe the combination of the two companies presents synergies for further sales, along with the opportunity for cost reductions. This might be a company that operates within your industry, but with a different revenue stream; a trade buyer that operates within different geographical regions; or a company in a different sector providing different products or services to your client base.
These buyers can also pay a premium to secure a deal if they view it as a defensive move, making sure they are the successful bidder rather than risk the target company being acquired by a competitor or new entrant to the market, who could potentially threaten the growth of their existing company going forward.
As the old adage states: "A business is only worth what someone is willing to pay for it". However the process of maximizing the value of a company for the shareholders on exit has numerous factors which can be controlled, and timing an exit is above all the skill that is most crucial to master.
Written by Adam Croft
Adam has been a lead advisor in the UK for M&A for over 10 years. His insights and advice come from a successful history of the due diligence involved in solid valuations to complete successful mergers and acquisitions.