Reliable data key to business valuation

Mergers and acquisitions are back on the menu. Global markets appear to be scenting a rebound following news of a handful of huge mergers by cash-rich companies, including chipmaker Intel’s purchase of McAfee and mining giant BHP Billiton’s hostile takeover bid for Canada’s Potash Corporation.

According to research published by Bloomberg, August was one of the most active months for global M&A activity since the financial crisis struck in 2008, with the value of deals done exceeding $175bn (£113bn) by the middle of the month. And the deals keep getting bigger: in September, fast food chain Burger King was sold to 3G Capital, a private equity firm backed by three prominent Brazilian businessmen, for £2.6bn, while in August, UK oil explorer Dana Petroleum received a hostile £1.9bn takeover bid from South Korea’s state-owned KNOC. BHP Billiton’s summer bid for Potash is worth a cool £35bn.

Activity has also picked up in the UK. According to the Office of National Statistics, expenditure on acquisitions in the UK by UK companies increased from £1.3bn in the first quarter of 2010 to £1.9bn in Q2, in which 66 UK companies made acquisitions of other UK businesses with a value of over £1m per deal. So, as companies start dipping their toes back into the M&A pool, how can FDs ensure they don’t overpay in a buyer’s market?

Opposing views
Negotiating a purchase price is challenging at the best of times, but negotiations are even more fraught when the prospect of a double-dip recession looms. Nick Rea, partner in the valuations team at PricewaterhouseCoopers (PwC), says finance directors face a difficult task in accurately valuing potential takeover targets because there is more temptation for struggling businesses to be more positive about the strength of recovery in their own prospects than is really the case, pushing up the value they see in their business and the cost for the buyer.

It is particularly challenging for both target and acquirer to agree on value when the target business is in transition, either on the way up or on the way down. There are often striking differences between buyer and seller views as to how and when the target business will pick up.

“In the past two years it has become more difficult to make valuations because there is less certainty than normal operating conditions,” Rea tells Financial Director.

Allan Gasson, consulting partner and M&A strategy team leader in the strategy practice at Deloitte UK, says the question FDs need to ask is how deep and how long the recession will be. Buyers expect a gradual improvement in the economy and businesses over the next few years, while many sellers expect to bounce back with a V-shaped recovery and to achieve the kind of shareholder value they demonstrated immediately prior to the recession.

Uncertainty about the shape of the economic recovery has made it harder for FDs to value a company’s current and forecasted earnings, its cashflow and underlying management strength and its competitive position in the market.

Previous trends
Gasson points FDs to the valuation trends coming off the back of previous recessions. After the 1992 recession, for example, the automotive components industry took five years to recover valuations, giving bidders ample room to move.

“Automotive sales were down 38 percent in August 2010 versus August 2009. You have got to put those thoughts into sellers’ heads,” he says. Gasson believes the UK economy will take another seven years to recover ground lost during the current recession. That means oppor­tunities for depressed valuations and the length of the recovery period to be leveraged in the valuation.

“Buyers and sellers are amazed by how long that cycle takes,” he says. “The automotive cycle took five years, but this recession is going to drive that particular industry much deeper. What we are finding now is that people have a very naive approach to current expectations, typically drawing up a business plan that carries a very steep V-shape recovery, coming out in 2010 very strongly. We think this will be much more of an L-shaped recovery.”

The dearth of recent transactions is proving problematic to the valuation process.

“We rely heavily on transactions as data points that are situation specific,” says PwC’s Rea. “The intelligent use of market multiples from similar deals allow FDs to estimate target values. That is difficult now because of a lack of reliable market data.”

As a result of this, there has been a move towards a greater use of discounted cash­flow models to evaluate potential targets, which assumes that predictions will come to fruition exactly as planned and on time. This is evidently problematic to impose on the current economic reality. Because of volatil­ity in the markets, the ability to meet what in a lot of situations are very aggressive and overly optimistic forecasts is at great risk.