Because of a great emphasis on growth in the business world, mergers and acquisitions ("M&A") are highly favored because they help a business expand rapidly: sometimes it's easier and faster to enter a new market, or increase your market share, by buying a business that's already in the market, rather than starting a new business from scratch.
Whether a merger or acquisition is an "exchange" - such as where the seller trades its stock or assets for stock in the buyer - or a "purchase" - like paying cash for the seller's stock - the parties need to set a purchase price. In an exchange, you need to figure out the ratio between the number of shares of the buyer's stock that are to be exchanged and the value of the seller's stock or assets. In a purchase, a cash value must be given to the seller's stock or assets.
The techniques for fixing the purchase price are essentially the same in exchanges and purchases, and usually one of four methods is used:
- Capitalizations of earnings
- Discounted cash flow
- Net return on assets or equity
- Market price
These techniques are generally based upon the parties' estimate of the future earnings of the corporation that will be acquired.
Valuing a business can be complex, so depending on your business skills and experience, you should consider getting some help from an experienced business law attorney.
Capitalization of Earnings
Capitalization of earnings focuses on the debt of the company that's being merged or acquired. It's a measurement of the ratio between the company's capital structure and its debts. To figure the ratio, you divide the company's long-term debt by the shareholder's equity plus the company's long-term debt.
Long term debt includes things like bank loans and mortgages; it's what the company uses to finance, or pay for, its operations. Shareholder equity is the company's total assets minus total liabilities, that is, the amount that the shareholders can claim after all debts and liabilities are paid.
For valuation purposes, the ratio indicates how much debt the company uses to finance its assets. Generally, if the company has low debt and high equity, it's financially sound, and so its sale price will be higher than if it has high debt and low equity.
Discounted Cash Flow (DCF)
This valuation method focuses on estimates of future streams of cash flows, which are then discounted to a "present value," that is, what they'd be worth today. For valuation purposes, a buyer is looking for a high DCF value.
DCF requires the parties to agree on:
- Which future cash streams to use and for how long. For example, a cash flow stream for a particular technology, like software, might extend only until it becomes obsolete
- An estimate of the revenue stream, that is, how much income will be generated in the future
- The rate of discount of this stream of cash flow to arrive at its present value
Using DCH can be complicated, so the professional services of an attorney or financial specialist are often used.
Net Return on Assets (ROA) & Return on Equity (ROE)
ROA is a ratio that's calculated by dividing the company's net income by its assets. The result is a measure of how well the company turns its investments into net income. In short, the higher the number the higher the value of the company.
For example, Company A has total assets of $ 5 million and net income of $ 2 million, and its ROA is 40%. Company B's total assets are $ 8 and its net income is also $ 2 million, and so its ROA is 25%. Clearly, Company A's value is higher because it makes more income on less investment.
ROE is a ratio that indicates how much profit the company made in comparison to shareholder equity - the amount of money invested by the shareholders. It's calculated by dividing net income by shareholder equity. Again, as with ROA, the higher the number, the better the value.
This method compares valuation data of similar companies to the company being merged or acquired. While the companies used as comparison must be the same or similar, "similarity" can be based on things other than similar products - for example, the markets into which they sell or the degree of brand dominance.
For a publicly traded company, the value can be measured in terms of price-earnings ratios ("P/E Ratio"). This ratio is computed by dividing selling price by earnings per share. For example, if the stock in Company B is selling for $ 25 per share, and it's earnings in the last year were $ 1.25 per share, its P/E ratio is 20. Company C trades at $ 23 with earnings of $ 1.75, so its P/E is 13. If you're Company A and looking to acquire another business, Company B is the better value.