When selling companies, the price and hence the valuation of the business play a central role

Company valuations are an important tool in the decision-making process for both buyers and sellers.
Valuation and Merger & Acquisition (M&A) specialists assess the value of an enterprise using a combination of different methods.

In today's economy, the corporate landscape is constantly changing. New businesses are created, existing ones close or change hands, and they are all permanently adapting to the changing environment. Changes of ownership play a prominent role in this process, be it in the form of succession in the case of family businesses or the sale or takeover of a listed company.

Buying or selling a company is generally a major event, one that must be planned and executed carefully. While in addition to the price a wide range of other factors must also be right, the price does play a vital role, and in order to determine whether it reflects the actual value of the company, the parties involved generally rely on a company valuation carried out by an independent Valuation Specialist. The bigger and more complex the transaction, the more important such valuations become.

Discounted cash flow is the basis

A company valuation will aim to calculate a range within which the value of the business lies, using generally accepted methodologies. Typically, a professional company valuation employs a number of approaches, but discounted cash flow (DCF) is the most common, along with the trading multiples method, which looks at the market value of comparable companies. Other approaches, such as the net asset value and capitalised earnings methods or option price models, are generally confined to very specific cases.

The DCF model starts with free cash flow, which is operating profit after tax plus depreciation minus capital expenditure and changes in working capital. The level of future free cash flows is arrived at by considering a broad spectrum of factors, including market growth, the company's competitive position and its product range. Free cash flow is the stream of payments that is available to creditors and investors. The sum of all future free cash flows therefore corresponds to the economic value of the business to those creditors and investors. The present value of future cash flows is calculated by discounting them using a specific factor that reflects the company's cost of capital. Put more simply, the sum of discounted future free cash flows represents the company's present operating value - referred to as its enterprise value. The equity value is obtained by taking the enterprise value, deducting net debt and adding non-operating assets, such as non-core assets.

Trading multiples as a plausibility check of the DCF value

The trading multiples method takes the opposite approach, starting from the market valuation of comparable companies. Where a company is listed, its current equity value is known, as are estimated future operating data such as sales, or earnings before interest, tax, depreciation and amortisation (EBITDA). These can be used to calculate multipliers such as the ratio of enterprise value to EBITDA. If data are available for a number of companies within a sector, it is possible to calculate an average. If this average is ± four, for example, and the EBITDA of an unlisted but comparable company is R10million, the company's theoretical enterprise value will be somewhere in the region of R40million. The trading multiples method thus makes it possible to check the plausibility of the DCF value. Financial analysts valuing listed companies often also compare the equity value with operating cash flow or net profit. The ratio of equity value to net profit corresponds to that between share price and earnings per share. This figure is known as the price/earnings ratio (P/E ratio for short), and many investors set great store by it when assessing the value of a potential investment. Net profit, however, can be strongly influenced by the accounting methods used and by companies' varying levels of indebtedness. For this reason, valuation specialists rarely refer to to the P/E ratio when offering advice on buying or selling companies.

M&A specialists take the value analysis a step further, using comprehensive M&A databases to determine the trading multiples of businesses - also private, unlisted companies - sold in the recent past. In the analysis of unlisted companies, specific issues such as illiquidity discounts, control premiums, etc. also need to be considered.

A combined approach is best

A combination of approaches will usually provide reliable and comparable results. Valuations are therefore a key element in assessing a purchase offer, potential acquisition or current share price, and the conclusions reached are then used in purchase or sales negotiations. After all, the selling price is what the buyer is required to pay and what his or her decision is ultimately based on.