By Robert W. Bradford, President/CEO

Strategic Planning Expert Robert Bradford

By Robert Bradford, President/CEO

Strategic Planning Expert Robert Bradford

In my earlier posting about evaluating acquisition targets, I discussed four common approaches to evaluation a company:  market value, asset value, operating value and strategic value.  Today we will look at the exact approaches to market value and asset value, with objective formulae.

First, market value.  The objective numbers for this come, obviously, from a market – usually, the stock market.  There are two approaches here:  direct value and proxy value.  The formula for direct value is only applicable for public companies:

Value = Stock price X Number of shares outstanding

If there are very similar public companies on the stock market, you can use proxy value:

Value = Target company earnings X EPS of similar public company

Be aware that this second approach involves some shaky assumptions about the similarity of the two companies, and in some industries, assets, sales or some other number may be more useful in calculating a proxy value.  Due diligence when using this as a value basis should be about understanding the similarities and differences between the companies, as well as the normal look into the fundamental soundness of the business.

The second approach is asset value.  Again, there are two common approaches, each with limitations.  The easiest (and least accurate) is accounting asset value:

Value = Book value of net assets on balance sheet

The limitation of this valuation is that, as with any balance sheet item, assets may be over or undervalued.  The true value of a piece of real estate is rarely represented well on a balance sheet, for example.

A more difficult approach to asset value is market asset value:

Value = (Sum of market value of assets) – (Sum of market value of liabilities)

This requires an added step over the plain accounting value – you have to research and quantify the market value of the important assets of the company (usually, real estate and similar holdings).  There are times when this valuation is a very important part of what other buyers are willing to pay for an acquisition target, so you should be aware of it.

In postings to come, I will discuss the formulae for operating value and strategic value.

By Robert W. Bradford, CEO

Strategic Planning Expert Robert Bradford

Even with a strategically appropriate acquisition, price is an issue.  In the end, one could argue there are only two prices that matter in an acquisition offer:  the price offered by the buyer, and the price that the seller is willing to accept.  Reality is a bit more complicated than this, but we should always have an idea of several different approaches to pricing an acquisition.

The two simplest approaches to valuation are market value and asset value.  In market valuation, you attempt to calculate what you could sell the target company for, while in asset valuation, it’s what you could sell the underlying assets for that is important.  In both cases, valuation can be simplified if there is a clearly understood objective market for the company or its assets.  This isn’t always true – but both approaches to valuation can be useful, if for no other reason than to act as a proxy for the value you (or some other buyer) could extract from the acquisition with no further effort at integration.

Operating value is an attempt to understand the value of the target as an operating business.  A simple approach to this would be to attach a value to all anticipated cash flows of the target and discount them.  In reality, many acquisition deals are initially priced using this model.  This makes sense, because it reflects the true value of the target to the current owners at the moment of the sale.  Any price paid that is above the operating value must include some value based on assumptions about the future value of the business – either independently, or to the buyer.

Operating value could also be modified by assumptions about the integration of the target with the acquiring firm.  This value – the integrated operating value – is very useful to the buyer, since, with valid underlying assumptions, it may help identify a target whose sale price is lower than the value the buyer could extract from the acquisition.  Generally, you would figure integrated operating value by making assumptions about the increased revenue and decreased costs the combined companies would experience.  In practice, many people pay much more attention to the decrease in costs, because it is easier to trust that cost savings can be effected (for example, by reducing head count in overhead operations like accounting and IT) than it is to trust that revenue increases will result from an acquisition.

Strategic value is much more difficult to calculate.  In addition to the integrated operating value, you need to make assumptions about the strategic impact of the acquisition and attach a value to that impact.  For example, a software company acquiring a competitor may gain the following strategic benefits:  access to new technology, elimination of a market-disturbing behavior (such as aggressive pricing), a broader human-resource base, a wide range of cost reductions due to economies of scale, the ability to combine technologies from both companies to create value for customers, the ability to expand distribution, product development or marketing due to increased size.   Few of these values are widely understood – how, for example, would you put a number on “access to a broader human-resource base” – and this is one of the critically difficult areas of evaluating truly strategic acquisitions.

Robert Bradford is President/CEO of the Center for Simplified Strategic Planning, Inc.  He can be reached at rbradford@cssp.com.