As a fractional corporate development executive, one of our responsibilities is to offer our advice on the valuation of the operating companies our clients are looking to acquire. One of the things I am most frequently telling clients is some version of ‘value is based on the future free cash flow of the operating business discounted back today at a rate that adequately incorporates the risk of those cash flows being realized’. The purpose of this article is to highlight some of the major muscle movements in a valuation process.
Future Free Cash Flow
To determine the future free cash flow, we need to build a projection model that allows us to flex the important assumptions that could considerably impact the valuation. There are people who argue that trying to predict the future is a waste of time due to the number of variables that we don’t have control over. While there are some merits to this argument, it doesn’t mean that we shouldn’t do a scenario analysis to understand the financial impacts, including valuation impacts, of critical assumptions so we can create mitigation strategies. It is also the most accurate way to determine the range of value for an asset so, in our opinion, it is a must.
Every business is different so the sensitivity of assumptions will be different for each business but a few common assumptions that drive a projection model generally fall into the following categories:
- Revenue growth rate
- Gross profit margins
- Operating margins
- Including projected synergies occurring from the acquisition
- Tax rate
- Predicted future capital expenditures
- Working capital and operating cycle assumptions
- Capital structure
- Discount rate
A big part of putting together useful projections is having a good understanding of the leadership and management talent who will be responsible for achieving the numbers that are being projected into the future. The important point here is to make sure the projections are rooted in ‘reality’. This is accomplished by fully vetting the assumptions that are being made as well as being realistic on the capacity and abilities of the key individuals responsible for the results. Big ‘misses’ here can be the difference between a good and bad deal, so we recommend you don’t glaze over major assumptions around the abilities, capacity, and interests of your key employees.
Bottom-Up Valuation Support
Once the bones of the projection model have been built, it is time to start making decisions on the assumptions that will drive the most important part of the valuation – the free cash flow. Too often, these numbers are picked out of the air with no real thought to them. For example, you are modeling 7% revenue growth for the next 5 years. Where did you get the 7% from? How many new customers does that equate to? What is the assumption around the average sale size? How many salespeople need to hit their quota for these numbers to be realized? Have you factored in attrition/customer loss? How many salespeople do you have? What is their capacity for bringing in new business? How many salespeople do you plan on hiring? How long does it take for them to be producing?
The same goes into assumptions for the cost of goods sold and operating expenses. Every assumption needs a detailed justification and thesis, and this bottom-up approach forces you to do the work required to in a way that will lead to higher-quality projections.
In addition to the assumptions that go into driving the business projections, a valuation also must make assumptions that go into the discount rate. The discount rate is the rate in which you discount the future cash flows of the company (or combined company) that is being acquired. The discount rate is incredibly important in determining value because it considers important investment factors that quantify the risk of a particular company. When there is increased risk, there is a ‘premium’ that is added into the rate and, as the discount rate goes up, the value of what a purchaser should pay today goes down. As the discount rate goes down, representing risk profile going down, the value of what a purchaser should, or can, pay today goes up. These premiums are the mechanism in which a valuation process attempts to quantify the risk that comes with investing in each particular company.
As stated in Valuation for M&A by Chris Mellen and Frank Evans,
“Investments bring substantial differences in their levels of risk. To maximize value, buyers and sellers must be able to identify and quantify risk. In merger and acquisition, this is done primarily through application of the income approach, where risk is expressed through a cost of capital”.
Or other words, the risk is quantified in the computation of the WACC or discount rate.
There can be numerous factors that go into increasing or decreasing a discount rate and it will vary from company to company but the overall framework for determining what drives the value of a company, and the corresponding risk factors, can be summarized into a few overarching categories which are:
- Organizational structure and legal
- Strategic plan, market dynamics and positioning
- Sales and marketing
- Leadership and management
- Operations and technology
- Human resources
- Finance and access to capital
These categories are left broad and overarching for simplicity and purposes of this article, but it cannot be overstated that each area needs a deep analysis and understanding to properly assess its contribution to, or deduction of, that particular risk profile which, in turn can factor into an increase or decrease to the valuation. When they say ‘the devil is in the details’, this is what they are referring to. The details matter and a buyer must have an adequate handle on them if they are going to properly incorporate them into the valuation.
Valuation determinations is a craft. It involves part ‘art’ coupled with part ‘science’ and, of course, some math. As companies grow through mergers and acquisitions, they will want someone in their corner who can explain and assess the value drivers of a target company, quantify the risks of the transaction, and build a projection model that allows for worst, base and best-case scenarios with assumptions that are battle tested so the leadership team can make an educated and informed decision on proceeding or not with the transaction.