Part 2 of the Valuation Framework delves into the critical aspects of business valuation, offering practical guidance for enhancing business value, particularly in the context of mergers and acquisitions (M&A). The article emphasizes that while buying right is essential, significant value can be generated post-purchase through operational excellence and strategic planning.
Key Takeaways from Valuation Framework: A 1-Minute Overview
Key Points:
- Valuation as Both Art and Science:
- Valuation requires a balance between quantitative analysis and qualitative insights.
- Simple metrics like EBITDA multiples are insufficient without thorough analysis.
- Quantitative Valuation Approaches:
- Projection Model: Essential for forecasting future performance. It requires rigor and key assumption analysis to ensure realistic and achievable projections.
- Discounted Cash Flow (DCF) Model: Central to valuation, involving detailed steps:
- Project Revenue Growth: Use bottom-up analysis to create realistic revenue projections.
- Build Cost of Goods Sold (COGS): Calculate input costs and identify ways to reduce them.
- Model Operating Expenses: Analyze and optimize fixed costs to enhance cash flow.
- Project Capital Expenditures: Differentiate between maintenance and growth capital needs.
- Calculate Operating Free Cash Flow: Determine actual cash generated after necessary investments.
- Estimate Terminal Value: Use either perpetuity growth or exit multiple methods to value future cash flows.
- Discount Cash Flows at WACC: Use weighted average cost of capital to bring future cash flows to present value, incorporating risk factors.
- Trading and Transaction Comparables:
- Assess market trends and comparable companies’ trading multiples to ensure accurate valuation.
- Ensure comparables are truly similar to avoid misvaluation.
- Valuation Pitfalls:
- Avoid biases and ensure assumptions are realistic and well-supported.
- Consider economic cycles, competitive impacts, and qualitative risks.
- Ensure comprehensive due diligence and avoid over-reliance on simplistic multiples.
Conclusion:
Valuing privately held businesses requires a thorough understanding of both quantitative metrics and qualitative factors. Effective valuation involves critical thinking, risk management, and rigorous financial analysis. Future articles will explore qualitative factors and key value drivers in more detail.
Appendix:
A checklist of common valuation pitfalls is provided to help avoid common errors in building a valuation model.
Full Article
Introduction
Welcome to part 2 of our Valuation Framework! If you missed our first one, you can read it here. This piece delves deeper into key valuation drivers, offering practical guidance for business owners and executives to enhance their business’s value.
The importance of valuation can be summed up with the very common investing maximum – ‘you make money on an investment when you buy it’. While this holds true, it’s just one piece of the puzzle, especially in the context of growing through M&A as a privately held business. Significant value can be generated post-purchase through operational excellence and strategic planning.
This article will spotlight some key areas to focus on. Getting the valuation right is crucial when buying and growing through strategic mergers and acquisitions. Overpaying can create additional challenges when executing value-enhancing initiatives. Thus, buying right is fundamental to buying and building enduring companies.
As I mentioned in Part 1, valuing a business is both an art and a science. It requires critical thinking, risk management, and adjustments to qualitative variables. Doing the ‘hard work’ requires a critical eye for detail and a rigorous financial and business analysis, which is often overlooked. It’s tempting to rely on simple metrics like a 3x adjusted EBITDA multiple, but without thorough analysis, acquirers can run into trouble.
Analyzing the intrinsic value of a business involves understanding its critical aspects that contribute to its value. This understanding is lost when focusing solely on multiples. While many acquirers take a very analytical approach to their valuation process, the qualitative analysis is often neglected. It’s crucial to strike a balance between both approaches. Some qualitative factors are challenging to quantify, and we’ll explore these in future articles.
Article Thesis
This article provides a comprehensive framework for conducting thorough valuations, including modeling best practices, assessing qualitative factors, navigating common pitfalls, and aligning valuations to deal strategy.
Quantitative Valuation Approaches
When valuing a business, the first step is to create a projection model that forecasts its future performance. Valuation, at its core, is a projection and future prediction exercise. The reason this method is underutilized is that it is hard. Predicting the future and understanding the interplay of variables in operating businesses is complex. However, we believe that just because something is ‘hard’ doesn’t mean it should be avoided. Instead, we approach it with rigor, focusing on key assumptions and considering worst and best-case scenarios to understand the entire playing field. This preparation ensures we are operationally prepared for any situation.
For an analysis involving a projection model that forecasts a business’s future cash flow, we use a discounted cash flow (DCF) model.
Discounted Cash Flow (DCF)
Below, we outline the major components involved in building a DCF model, along with some key considerations and philosophies we believe are important in this process.
Step 1 – Project Revenue Growth
Begin by building revenue projections. It’s common to choose a year-over-year growth rate based on what sounds good or is overly optimistic. We frequently see this following scenario – the market for company’s services is growing at 3%, yet the company wants to model 15-20% year-over-year revenue growth. We are supporters of optimism and going after big goals but revenue projections need to be rooted in reality. Size and skill of the sales team as an example. How, exactly, are we going to grow at 15-20% when the market is growing at 3%? What is great about this exercise is it forces a business to really think about and understand, practically speaking, what is special about their offering and what differentiates them from the competition. If there isn’t anything, how do we expect to grow at 5x the growth of the market?
For revenue projections, a bottom-up analysis works best. Map out historical growth patterns, sales personnel performance, and targets. Some example questions: How will sales person #1 grow her sales by 15%? How many accounts is this? What is her current pipeline? What activity is needed for her to acquire x amount of new accounts?
This approach ensures revenue projections are achievable and provide a roadmap for reaching those targets.
Another important analysis for B2B businesses is identifying opportunities to grow revenue through existing customer relationships. Determine how much additional revenue can be generated from existing customers and the activities needed to achieve this.
The point here is to make sure the revenue projections are backed up with a bottom-up analysis to ensure they are rooted in reality or, at the very least, outline a roadmap on how those revenue projections can be obtained. Here is the major risk factor: If an acquirer uses unrealistic revenue projections the downstream effect is that the resulting cash flow will be overstated. When cash flow is overstated, the value and corresponding value will be overstated, which leads companies to be in a scenario where they are overpaying, which drags down their return on capital results. All things a good, disciplined acquirer should be working hard to avoid.
Step 2 – Build Cost of Goods Sold
Construct the company’s gross profit profile. For product companies, calculate input costs like raw materials, direct labor, and allocatable manufacturing overhead. For service firms, estimate direct labor, third-party fulfillment expenses, and customer support resources. As we build the projections, the cost of goods sold (COGS) expense gets normalized and sized relative to the revenue baseline. A typical approach expresses COGS as a percentage of revenue – for example, 40% of projected sales. However, this calculation represents a starting point for diligence, not the final answer.
The real value lies in scrutinizing what core competencies and best practices the acquirer brings to systematically reduce these costs over time to enhance the enterprise value of the company. Dive deep into all the levers that can be pulled to lower COGS. Improving gross profit margins by 200-300bps can unlock significant value.
Step 3 – Model Operating Expenses
Outline the operating expense model, including employee costs, sales expenditures, administrative overheads, and non-cash depreciation/amortization.
With the revenue projections outlined, we now dive into the operating expense model. These critical costs represent the organizational infrastructure and resources required to operate the company. Employee costs, sales expenditures, administrative overheads, occupancy commitments, and non-cash depreciation/amortization collectively form the basis of fixed expenses.
While it is useful to analyze on a common-sized revenue percentage basis, a more nuanced approach sometimes is needed. Many of these fixed costs possess an embedded operational leverage effect. As the business scales, certain expenses remain static for prolonged periods. This is where an organization benefits from a cash flow perspective. As the company grows, it benefits from this operational leverage which enhances the company’s cash flow. From a practical perspective, acquirers are best served spending a good amount of their due diligence time understanding and fine-tuning the DCF model with a focus on enhancing operating cost efficiencies and synergies. This is a big area where an acquirer is able to drive value creation.
Step 4 – Project Capital Expenditures
With the P&L model constructed, we dive into critical nuances that impact an organization’s value. Capital expenditures can exert material impacts on the company’s free cash flow generation and, correspondingly, its intrinsic value. This analysis needs a bifurcated approach, delineating maintenance capital from growth capital requirements.
Maintenance capital expenditures represent the sustaining investments needed to preserve operational integrity. Growth capital supports future expansion, including incremental capacity investments in facilities, equipment, systems, and infrastructure.
The capital intensity of a business carries important valuation implications and needs to be fully understood and incorporated into a DCF model to accurately assess the company’s true cash flow and corresponding valuation.
As we model forward, maintenance capital gets benchmarked relative to existing fixed asset levels using well-established asset life methodology. Growth capital, however, necessitates granular forecasting based on projected revenue trajectories, strategic initiatives, and operational value-chain assessments. It is extremely important to accurately quantify both of these capital expenditure uses.
Step 5 – Calculate Operating Free Cash Flow
Operating free cash flow represents the actual cash a company generates from its core business operations after accounting for necessary investments to maintain that operating capability. Calculating it provides vital insight into the real cash flow a company generates.
To accelerate this analysis, we start with the net income of the business. To get to cash flow, we have to remove the impacts of non-cash items. We do this by starting with operating income and then adding back depreciation and amortization expenses.
Once we have the operating cash flow from the P&L, we now have to deduct this cash flow for both capital expenditures and changes in working capital. Consider how changes in working capital components—inventory, accounts receivable, and accounts payable—impact cash flow generation. Adjusting for these elements gives a clear picture of operating free cash flow.
When we take the operating cash flow and adjust for working capital investments and capital expenditures, we arrive at operating free cash flow. This shows how much cash the core operations actually generated that could be used to service debt, reinvest, or return to shareholders.
Step 6 – Estimate Terminal Value
Now that we have the operating free cash flow projected out, we are on to creating a terminal value within the DCF model. There are only so many years that one can reasonably model out with some level of visibility and clarity before it gets highly speculative and using guesswork versus basing predictions based on insights and practical operational assumptions. For this reason, a terminal value is created for the year following when we feel we can no longer forecast with reasonable insight. This value captures the expected value of the business’s operations into perpetuity beyond the forecasted period.
There are two different ways that one can come up with the terminal value which are discussed below.
The Perpetuity Growth Method
- Take the projected cash flow for the year immediately following the final explicit forecast period.
- Assume a perpetual cash flow growth rate.
- Discount this growing perpetuity of cash flows back to a present value using a required rate of return
Exit Multiple Method
- At the end of the explicit forecast period, apply a market multiple that is believed the company could sell for.
- Apply this multiple to whatever cash flow metric is being used for the final forecasted year.
- Discount this value back to a present value using the required rate of return.
The terminal value is then added to the present value of the cash flows from the explicit forecasted period to come up with the company’s enterprise value. There are key assumptions being used to calculate the terminal value, perpetual growth rate, WACC which need to be well formulated for accuracy. Not to mention all of the assumptions that go into deriving the cash flow through the explicit forecast period (usually 3-5 years). This is among the many reasons each assumption needs to be battle-tested and fully thought through when developing a DSC model.
Step 7 – Discount Cash Flows at WACC
When developing a DCF model, one very important variable is the discount rate used to bring the future cash flows to a present value. What is used is a weighted average cost of capital (WACC) assumption. The WACC represents the blended required rate of return that a company must generate from its investments in order to satisfy its capital, both debt and equity, providers. In other words, this is the average rate of return required to source this capital based on the risk profile of the investment.
The WACC is comprised of the following variables:
- The market value of its equity
- The market value of its debt
- The cost of equity for the risk being taken
- The cost of debt for the risk being taken
- Tax rate
To summarize and to keep this practical, what is important here is 1) The capital structure of the business (debt and equity mix) 2) the cost of capital and 3) The tax rate. The capital structure and the tax rate are relatively straightforward inputs. The cost of capital is much more nuanced, particularly the cost of equity which is the area we will focus on in a little more detail here.
The Cost of Equity – a common way of determining the equity cost is using the capital asset pricing model (CAPM) framework. The variables that go into this framework are:
The Risk-Free Rate – this is the rate that represents capital allocation to an asset that is deemed ‘risk-free’. This establishes a baseline to determine what an equity investor will demand in return for an investment that has much more inherent risk, such as a privately held operating business.
Beta – this is a factor that is used to measure the systematic risk of a business relative to the overall market. For example, a higher beta implies more volatility and risk. The CAPM framework requires a beta to derive the equity premium, over the risk-free rate, to derive at the total cost of equity that takes into account the risk of an asset. This is tricky for privately held businesses as they don’t have publicly traded shares to calculate a beta so a common practice is to use the betas of publicly traded comparable companies. Care is needed here to spend time to drill down, to the extent possible, companies that are as comparable as possible (i.e. similar business models, financial leverage and cash flow variability).
There are a couple steps that are needed to get to this factor. First, we take the leverage out of the beta (‘unlever the beta’) to take the financial risk out of the equation and then ‘relever’ it due to the capital structure of the business we are valuing.
Equity Risk Premium – to arrive at a total cost of equity, we need to add an equity risk premium into the equation. The equity risk premium is published by various financial institutions who track, historically, what the equity market has generated above the risk-free rate. This premium implies the return equity investors demand for taking equity risk. As of today, this rate is roughly 5.5% (per Duff and Phelps).
Size and Liquidity Risk – as a part of the equity risk premium, many privately held businesses operate in a very illiquid market and are inherently more risky due to the very nature of their size. This additional risk needs an additional equity risk premium to account for the risks associated with these factors. We add a size and liquidity risk premium onto the equity risk premium to get to our all-in cost of equity figure for our WACC calculation. To provide some detail to this as an example. Two companies in the same industry serving the same clients and having a similar business model could have drastically different size premiums. If one client is doing $100M and the other is doing $20M in revenue and both have similar EBITDA margins, say 20%, the size premium would be higher for the company generating $4M in EBITDA as they would have a harder time capitalizing and managing a negative event than the company generating $20M in EBITDA, assuming capitalization and leverage profile is similar.
In summary, the DCF framework is very helpful in analyzing and assessing a business’s value but also key insights that would lead to practical strategic operating tactics that would lead to driving value. Because of this versatility, we are often running these models for valuation and operational purposes.
Trading and Transaction Comparables
In addition to using DCF to value companies, we also need to be conscious of what is going on in the industry/market for similar companies in the sector we are valuing. This is a practice of using peers’ trading multiples (EV/Revenue, EV/EBITDA, P/E, etc.) as a proxy for what the market is willing to pay for similar companies. The key here is ensuring these comparable companies are truly comparable, meaning they are as much like the company you are valuing as possible. In isolation, we cannot use a 10x multiple on EBITDA for a company we are valuing because a company in its space traded at that same multiple. As we have discussed, the size of the company, business model, margin profile, customers served, growth trajectory, capitalization and other key risk factors have to be assessed in determining a true comparable and require adjustments to the multiple being used.
These multiples change as markets change so keeping a pulse on what comparable companies are trading at should be an actively managed and focused activity so leaders can be aware of shifts in the valuation market. This allows for leaders to make management decisions that allow the business to adjust to the various industry and market factors impacting their business. We will dig into these intrinsic value drivers in a follow-up article at a later date.
Conclusion
In summary, valuing privately held businesses requires a combination of science and art. The key is truly understanding a company’s business model, growth prospects, industry trends and other contributing characteristics that drive value. When creating a DCF model, it is important to have a complete understanding and can support the thinking for every assumption that is being made that drives the future cash flow of the business. Garbage in, garbage out. It is also important to have a keen understanding of assessing risk. This could be single-handedly the most important part of conducting a valuation, especially when considering a merger or acquisition. We discussed the ways in which one can quantify risk in creating a valuation for a business and will have future articles about how to think about both the qualitative factors to establishing a valuation as well as how to determine and build out what a business’s key value drivers are and how to incorporate them both into a valuation model but also how you can operationalize (i.e. manage) these key drivers post-acquisition. We leave you with a checklist of common valuation pitfalls for you to use as you think about building a bottom-up valuation model. See the appendix.
Appendix
Valuation Pitfalls Checklist
| Overconfidence and optimism bias in projections | |
| Failing to model economic cycles, disruptions, competitive impacts | |
| Not adjusting for potential integration/execution issues | |
| Overlooking or underestimating qualitative risks | |
| Missing or inability to get full transparency into risks | |
| Cultural or human capital integration challenges | |
| Over-reliance on simplistic market multiples or rules of thumb | |
| Flawed selection of comparables or multiples | |
| Failure to adjust/normalize for comparability differences | |
| Not sufficiently vetting assumptions and lacking bottom-up support | |
| Examples of poor assumptions around pricing, utilizations, etc. | |
| Lack of diligence on key parts of the business | |
| Model complexity obscuring drivers and making it a “black box” | |
| Over-complicating models rather than focusing on key drivers | |
| Losing sight of big picture value story |