Valuation and Modeling
IntroductionHow much is this company worth?
Or, What can we buy (or sell) it for?
The purpose of this section is to help a buyer (or seller) answer both questions. The first question is about value, which is general and abstract. The second question is about price, which is specific and concrete.
Some believe that the only thing that really matters is price. No matter that Lehman Brothers had $600 billion in assets when it sold to Barclays for only $250 million in cash and assumption of liabilities; price proponents would say that in the end, its worth was no more or less than $250 million. (To be sure, this happened back in the panicked market of 2008—the same market that enabled JP Morgan to buy Bear Stearns for $2 per share—but there are such fire sales even today, with the purchase of the UK branch of Silicon Valley bank and its debts for merely 1 £ total.) Nor would price proponents blink at the 219 percent premium Abbott Labs paid for Medical Optics when spending $2.8 billion on the company in 2009, or the $44 billion Facebook Elon Musk paid for Twitter in 2022, setting a record . The pricing school of thought shrugs at the discrepancy, rejecting any notion that Lehman, Bear Stearns, or Silicon Valley were undervalued, that Medical Optics or Twitter were overvalued: if the price is set honestly at arm’s length (with no fraud or self-interest involved), they believe that price is value, value is price.
Previous editions have noted that value essentially exists only in the minds of the people setting it, while price reflects real-world market behavior and is sometimes the only criterion we have available to estimate an asset’s intrinsic value. Yet while price is a tangible concept with a clear legal definition that can be a reality check against theory, it has its limits. It can only occur in a transaction setting within a contract. As such, it can never be enough. To hold price up as the be-all-and-end-all of value would be like saying that public companies are only worth their current stock price, when we all know how volatile stock prices can be—and how much more a buyer will pay for control in the form of a premium. So instead of mere pricing, the more enlightened members of the M&A community support the use and study of valuation based on theories developed in the academic and professional fields—and, equally as important, modeling, through which abstract concepts become actionable.
Valuation and modeling, as distinct from mere pricing, have great utility for buyers and sellers alike. In a depressed market, a reliable valuation and model combination can help sellers either hold out for a better buyer, or alternatively reinforce the price being offered from potential, albeit, bottom-feeding buyers. In a manic market, a professional valuation, supported by financial modeling, can either help buyers avoid caving into fads, or alternatively support a view that the time is right to sell. Despite a reliable valuation and model combination, the price ultimately any acquirer pays for a company represents and comes down to the outcome of a number and ultimately a final negotiation between what the buyer is willing to pay and what a seller is willing to accept—and behind that final price lie many valid considerations on both sides that do not cease to be true once the price is set.
Although price can be expressed as a single number—the $X that Company A paid for Company B—it is hardly a simple matter. The amount that might be paid for the same company may vary greatly among different buyers at different times. One might say that just as beauty lies in the eyes of the beholder, so too value lies in the equations of the buyer and seller. But which equations to use?
There is no limit to the possible approaches and methodologies one can take to valuation. There are more than a dozen in use. (See Exhibit 3-1) Which should you choose?
Of the models listed in Exhibit 3-1, two dominate: comparable companies and transactions, and discounted cash flow. The comparable companies approach is recognized in courts of law around the world when appraisals are challenged. And in at least the U.S., discounted cash flow is also often recognized as valid. Even so, it is not always easy to use either one, given the number of variables that need to be factored in, including some that are purely hypothetical. Fortunately, help is available. Investment bankers stand ready to produce fairness opinions to opine on a valuation of a public company transaction that might be challenged by shareholders. Appraisers have credentials to value even the most unusual assets—and they can avail themselves of global standards (as discussed at the end of this section). As for economic analysis, you don’t have to be a financial economist yourself to get this work done. Any accredited business school is likely to have a team of them ready, willing, and able to help—at an affordable price, or even pro bono.
Exhibit 3-1 Valuation Approaches and Methodologies
But even before consulting a specialist, it is valuable to learn the basics. The purpose of this section is to explain how deal price comes about, and why.