Valuation essentials for CFOs. (Valuation).

So much has been written about "value" and "creating value" that maximizing shareholder value is a primary concern at most public companies. But many financial executives must make calculations and decisions about value for entities for which no stock market price exists. Thinly traded public companies, divisions of public companies and all privately held companies operate year after year without senior executives knowing the answers to these basic questions:

* What is the company or business segment worth?

* What factors most affect the company's value?

* How much more would a strategic buyer pay to acquire it?

* What is the entity's real return on investment and rate of return?

* Does that return justify the risk?

* Are the owners better off selling and, if so, how, when and to whom?

As part of their broad responsibilities, financial executives become involved in merger and acquisition (M&A) decisions. While the media cover the mega M&A deals, the median transaction size in the United States last year was under $50 million, and about 60 percent of the sellers were private companies. So the real merger and acquisition action is in the middle market, where stock prices are unknown and little information is revealed to the public. For these very common deals, the following uncertainties abound:

* Do profits, usually expressed as EBIT or EBITDA, represent the company's true return?

* What is an appropriate rate of return or multiple considering the investment's risk?

* Has the seller properly prepared and packaged the company to get the right price?

* Has the buyer found the best target and accurately quantified potential synergies?

* Does the deal make sense at the quoted price?

Today's financial executives must possess fundamental valuation knowledge, and this should not be limited to price earnings multiples that apply to large public companies. Since most valuation decisions involve entities that lack a stock market price, a working knowledge of the following issues is critical.

Stand Alone Fair Market Value Versus Strategic Value -- While the worth of a company or business segment to its present owners -- fair market value -- is important to know, it's frequently more beneficial, particularly to value-oriented executives, to know what that business is worth to a strategic buyer. Companies should be investments held to generate a return to shareholders, but conditions may render a company uncompetitive. When this happens, on a stand-alone basis, the business possesses strategic disadvantages that prevent it from earning an adequate risk-adjusted return. If management cannot adequately improve the business, the owners should consider selling the company to a strategic buyer willing to pay more than its stand-alone value. The proceeds could then be invested in better value-creating opportunities. The key is to understand the distinction between stand-alone and strategic value and know how to accurately compute each, including synergistic benefits.

Although the middle market is described in various ways, for the purposes of this discussion it is assumed to include companies with annual sales ranging from approximately $10 million to $500 million. Hard data on these businesses is frequently unavailable because they are privately held or are divisions of large corporations that do not provide detailed segment data. Middle-market companies tend to be more risky than large or mid-cap public firms because of the limitations created by their size.

To compensate for this added risk, they should earn a higher return, but many fail to, particularly family-owned businesses. It's not that family ownership is structurally unsound -- it's the non-financial goals that frequently accompany family enterprises that often hamper financial performance. These range from a desire to maintain control of the business in the family, to providing employment for family members, to achieving charitable goals.

Quantifying Synergy -- A company's higher value to a strategic buyer occurs through the synergies that can be created through a combination. Typically the buyer creates these synergies by bringing together the entities and leveraging the buyer's capabilities to overcome the seller's weaknesses. Sellers, of course, want to be paid for the added synergistic value that the buyer most often creates.

Thus, the acquiring and target firms already have built into their stock values investors' expectations of the increase in value that each company can achieve while operating as a standalone business. Synergy is the improvement in excess of these anticipated improvements, which makes success in the acquisition process a much more elusive goal whose likelihood generally decreases as the size of the acquisition premium increases. Buyers must recognize that if most of the value-creating potential from the acquisition is paid to the sellers in the form of a premium, little potential value creation exists for the acquiring firm.

Rates of Return and Multiples -- Financial executives frequently hear of or read about rates of return or multiples of earnings that should be achieved on investments, but too few understand where they come from, on what economic data they are based or the level of reliability they carry.

While an explanation of the derivation of required rates of return for equity and debt is beyond the scope of this article, CFOs should know certain benchmarks. Begin with the fact that the average long-term rate of return on large-cap stocks -- the largest 20 percent of public companies in the United States -- is about 13 percent.

As public companies decrease in size, their stability declines and their risk increases. Accordingly, the average long-term return on micro cap stocks -- the bottom 20 percent of public companies in the United States -- is about 18 percent, and for the bottom 10 percent, the return is about 21 percent. The largest micro-cap stock has a total equity value of less than $200 million, so although these companies are small by public company standards, many are relatively large compared to middle-market companies.

CFOs can conclude that the smallest public companies have historically earned returns on equity of about 20 percent. Therefore, most middle-market companies should earn at least this return and probably more, with the required return on smaller businesses gradually increasing to 30 percent. It is for this reason that venture capitalists evaluating startups generally demand returns in the range of 35 to 40 percent.

Note further that the return to which these rates apply is after-tax net cash flow to equity rather than some measure of income. The rates of return quoted above are derived from public companies that only produce dividends and capital appreciation for investors, after the company's internal needs -- including working capital, capital expenditures and income taxes -- have been considered. Other measures, such as net income after taxes, net income before taxes, or EBIT, can be used to determine value, but the rate of return must be adjusted accordingly or value will be distorted.

After establishing an appropriate base market rate, it must be adjusted based on the target company's specific risk characteristics. This adjustment should reflect the competitive analysis of the business and the target company's specific strategic strengths and weaknesses.

Rates of return can also be expressed as multiples of some level of operating performance. The key to effective use of any multiple are to understand its source -- and from that its reliability -- and then to gauge the appropriateness of use of that multiple given the risk profile of the target company.

Three Common Business Valuation Approaches -- Businesses vary in the nature of their operations, the markets they serve and the assets they own. For this reason, there are three primary valuation approaches, as illustrated in the table on the previous page.

To achieve a reliable value, you should attempt to use each of these three approaches in every appraisal assignment, although this is not always practical. For example, a company may lack a positive return to discount, which may prevent use of the income approach. Use of the market approach may not be possible because of the lack of adequately similar companies for comparison. The asset approach generally cannot accurately portray general intangible value that is not shown at market value on a company's balance sheet.

Thus, each approach brings constraints that may limit its use or effectiveness in a specific appraisal assignment. It's even more important, however, to recognize that each approach brings a unique focus on value and what drives it. While the income approach most often looks at future returns discounted to reflect their relative level of risk, the market approach establishes value based on the price paid for alternative investments, while the asset approach establishes value based on a hypothetical sale of the company's underlying assets.

The strengths and weaknesses of each methodology and the circumstances present in the company being appraised and the industry in which it operates determine which of the approaches can be used and the relative reliability of the results from application of that approach. The chart below provides a summary of the circumstances in which each approach is generally most applicable.

For financial executives to maximize value in a middle market company, they must be able to measure it. And because M&A activity constitutes the largest form of discretionary spending for most companies, it is essential that value be measured accurately. CFOs should resist the temptation to relay on unfounded rules of thumb or multiples for critical valuation decisions. Value can be accurately measured and enhanced in a business. The secret is attention to details and proper application of sound methodologies.

SUMMARY OF APPLICABILITY OF BUSINESS VALUATION APPROACHES

Income Approach                Market Approach

The company derives            There are an adequate
significant value from         number of companies that
its operations                 are reasonably similar
                               to the subject company.

The company generates a        There are merger and
positive income of cash flow.  acquisition transactions
                               that involve targets that
                               are reasonably similar.

The company possesses          There is adequate data
significant intangible value.  available about the
                               companies used for
                               comparative purposes.

The company's risk can         The companies generate multiples
be accurately quantified       that provide a reasonable
through a rate of return.      indication of market conditions
                               and prices as of
                               the appraisal date.

The company's future           The subject company is
performance can be             large enough to be compared to
accurately estimated           the companies used in
through a forecast.            the market approach.

Income Approach                Asset Approach

The company derives            The company owns a significant
significant value from         amount of tangible assets.
its operations


The company generates a        The company creates little
positive income of cash flow.  value from its operations.



The company possesses          The company's balance
significant intangible value.  sheet includes most
                               of its tangible assets.


The company's risk can         It is possible to
be accurately quantified       obtain accurate
through a rate of return.      appraisals of the value
                               of the company's assets.


The company's future           The ownership interest being
performance can be             appraised possesses
accurately estimated           control or access
through a forecast.            to the underlying assets.

This article is adapted from Valuation for M&A: Building Value in Private Companies, by Frank C. Evans and David M. Bishop, John Wiley & Sons Inc., New York, 2001. Evans is a Principal at Smith Evans Strimbu Valuation Advisory Services and can be reached at FEvans(c)SESvaluations.com.