Valuation: Theory, Practice and Reality
I attended a luncheon last week where a private equity firm’s panelist claimed that business valuation is too theoretical and inappropriate in the transactional world. I instinctively question broad-based statements like this, when I hear them; however I listened attentively. The panelist correctly asserted that most valuation firms focus on compliance and litigation work as opposed to transactions. However, his criticism of valuation work was illogical and inconsistent, and offered no better alternative.
To make his case he defined enterprise value in transactional terms as: what it would take to buy 100% (equity + debt) of the company excluding cash, in an arm’s length deal. Okay, so far this was sounding a lot like the willing buyer/willing seller concept of Fair Market Value.
He went on to discuss how firms are typically valued by valuation analysts. These were his assertions:
- The income approach, known as discounted cash flow (DCF), is too theoretical. I disagree. This approach seeks to price businesses by assigning a risk-based rate of return to the expected future income. Strategic buyers use the DCF approach whenever they expect non-linear growth in the business. In business valuation we determine value to a strategic buyer under the Investment Value standard. Risk assessment also very similar to what bankers and insurance people do, although evaluating the risk of a going concern involves qualitative assessments that are harder to quantify. Proper application of valuation theory, tempered by common sense can provide clear insight into fundamental value.
- Comparable transactions are the most important. This is consistent with business valuation theory, and I agree in concept. In reality, a lack of data and inconsistent reporting of private business transactions makes accurate comparisons difficult. Therefore, this approach is often used as a reality check against income approach results.
- The factors used to gauge a company’s debt capacity are very similar to analyzing equity value (like customer concentration, poor systems, etc.). Agreed. Again, it’s pricing the risk of the operation. A bank won’t lend money to a risky firm, or if they do, terms and pricing will be more stringent. The income approach he decried as “too theoretical,” works the same way.
He went on to discuss the price ranges that he sees in transactions. Typically, he said, adjusted EV/EBITDA multiples range from 3.9 to 6.9. This range can be explained by varying degrees of profit margins, expected growth and risk, as well as potential synergistic benefits. But he gave no indication how to quantify these issues.
In the end, I suspect that the panelist just didn’t understand business valuation very well, and described the world as he sees it through a narrow lens.
Two concluding points:
First, when valuing your life’s work, all reasonable valuation approaches should be considered. One approach may be more appropriate than another. All approaches lend insight into value. It’s not an all or nothing exercise.
Second, don’t trust your business to someone who lacks valuation expertise, someone with a limited point of view, or someone who may have an agenda.
Exit Strategies brings independence and over 100 years of combined valuation and M&A transaction expertise to every engagement. Contact us for a free confidential consultation with one of our senior advisors.
