How Acquirers Value Your Business
Published 22 August 2016
If you think valuing a publicly listed business is not straight forward, try valuing a private company. The truth is that a business is worth whatever a buyer says it worth at a point in time. The value fundamentally, is based on the worth to the acquiring party and is driven by the impact that the seller’s business will have on their overall picture. So let’s look closer at how acquirers value a business.
I was struck by Philip Baker’s article in the Financial Review last week (10/08/16) entitled ‘When a High PE is really a low PE’ .
In his article he talked about the upcoming reporting season and the notion that a high PE (Price Earnings Ratio) is often considered a bad thing, how interest rates are tipped to stay low for some time with the resulting impact of continuing poor deposit rates. He suggested that the knock on effect of investors hungry for dividend yield could mean that investors may be willing to accept high price earnings ratios (expensive stocks) to secure a return, with capital growth taking back seat.
“In truth the process of valuation is never straightforward and one mistake (we would say one among many) is to compare the forward price earnings ratio of a stock to the entire market. Much better to compare the stock to the PE of whatever sector it’s in because the market’s PE is an average.”
Sensible advice – especially the bit about the valuation process never being straightforward. If you think valuing a publicly listed business is not straight forward, try valuing a private company. The truth is that a business is worth whatever a buyer says it worth at a point in time. The value fundamentally is based on the worth to the acquiring party and is driven by the impact that the seller’s business will have on their overall picture. People normally buy another business to solve a problem (although rarely admitted). The bigger the problem that’s potentially getting solved, the more they’ll pay. The business being acquired will provide revenue, customers and/or expertise, capability, IP etc. The synergies resulting from the acquisition or merger (whilst not readily given up by the buyer, who usually insists the synergies are theirs) will normally find their way into the valuation equation.
Financially engineered deals in the SME space normally favour the buyer. Traditional valuation methodologies in this space are generally useless as earnings are typically patchy, governance is poor and risks for the buyer are high. The only deals worth doing for vendors are with strategically motivated acquirers. This kind of buyer is hard to find, but well worth the effort.
To qualify as strategic, they must be already looking to acquire. This is important because if you are speaking to somebody who is not already looking, then they likely to be an opportunistic buyer and most opportunistic buyers default to a traditional valuation method based upon numbers only.
Secondly if somebody is looking to acquire it’s essential that you establish what they are looking for. What’s their criteria? In other words, what sort of problem is being solved? If your business does not match their acquisition criteria, then it is likely to become at best opportunistic for the buyer, resulting in either no offer or a low offer.
Now if a potential buyer has independently flagged that they are actively acquiring and have detailed what they are looking for and your business matches that criteria (at least at a high level), then now you have a potentially strategically motivated buyer who is much more likely to price accordingly. Prices in these circumstances can be much, much, higher than anything opportunistic.
So back to the listed world. As Philip Baker points out in his article, Domino’s Pizza is currently trading at a PE of 70 times! (And actually 80.99 as at 19 August 2016.) This is nose-bleedingly high. I am especially sensitive here as I sold my own Pizza home delivery chain in 1992 and by these standards I literally gave it away! (You can read my story here.) The current average PE of the ASX is 16. Other food businesses traded at a median of 24.3 in 2015 with Retail Food Group (RFG) and McDonalds currently hovering at around 23 as at 19 August 2016.
Dominoes stock has been in high demand – the fundamentals don’t appear to stack up when compared to other stocks. But Dominoes are solving a problem for their investors – they have delivered great capital growth since 2005 and whilst the yield is modest the market is always right!
When selling shares in a private business you have to create your own market. This is part of our 10 Steps to Prepare your Private Business for Sale process. You need to find people who want what you have. The laws of supply and demand still apply to private businesses: your business is worth what somebody will pay for it. The free market is beautiful thing – if you don’t like the price you don’t have to sell!
To learn more about how Oasis M&A creates a market see our page ‘Sell your business: Helping you maximise value when you sell your business’ or to contact us for a confidential discussion about your business.