From Theory to Practice

There are many ways to value a company in merger and acquisition situations. In this article, I will discuss several standards of value, in contrast to fair market value. Fair market value is, essentially, the average cash value a buyer is willing to pay a seller for a company when both parties have adequate information about the company and neither is compelled to buy or sell.

I also will focus on the most common valuation method, where buyers ascribe a multiple to earnings — typically earnings before interest, tax, depreciation and amortization, or EBITDA — where the multiple is based on required rates of return that reflect the risk of the business and the industry.

Here then, from a practical perspective, are the most common valuation errors and misconceptions in the M&A market today.

Issues Regarding Standards of Value

Ignoring Investment Value. While it is certainly understandable that buyers prefer not to pay more than fair market value for an acquisition candidate, it sometimes is financially advantageous to do so. Consider a situation where a buyer determines that the average, or fair market value, of a firm generating $1 million in EBITDA is $4 million. This suggests a required, risk-adjusted, fair market value EBITDA return on investment of 25 percent ($1 million annual earnings divided by the $4 million investment).

If the seller wanted $4.5 million for the business, a buyer focused solely on fair market value would walk away. But what if this particular buyer could confidently reduce $250,000 in redundant overhead? With $1.25 million in EBITDA and a price of $4.5 million, the buyer's unique EBITDA return would be nearly 28 percent. In fact, this particular buyer could pay up to $5 million and still receive a risk-appropriate 25 percent return.

As such, the buyer's investment value — the specific price an individual buyer is willing to (or could) pay for an individual seller based on the unique goals of the buyer and the unique attributes of the seller — is greater than fair market. In this case, the acquisition gives a greater ROI than other equivalent deals priced at fair market where revenue-enhancing or cost-reducing synergies can't be realized. So, in valuing any acquisition candidate, buyers should first determine their own unique investment value to identify the highest price they can pay and still receive an appropriate ROI. Then, they should negotiate the best deal possible.