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How to Analyze a Company’s Potential

05 February 2019 by National Bank
Analysing a company’s potential

Making a business acquisition is a quick way to grow your company. But this type of transaction also carries several risks. In order to succeed, careful preparation is required. In this series of 4 articles, learn out about the important steps to take before, during and after an acquisition. 

During the acquisition: Do in-depth analysis

Before completing the purchase, it is essential to take the time to correctly evaluate the target company. The results of this evaluation will enable you to determine if the selling price is fair or not, so this step is of the utmost importance. Of course, a valuation is not an end in itself, but rather a tool for negotiating a final price.

1- Do an evaluation

Although it’s extremely important, the evaluation cannot establish the value of the target company in absolute terms. But it should take into account the market and context in which the company operates. A valuation is based on the expected profits that a company is likely to generate and/or on a comparison to the price paid for similar companies.

The valuation of a company performed in the context of an acquisition is comparable to that of a stock market investment: The buyer wants to pay a price that will allow them to achieve a favourable return.

There are several different valuation methods, but all of them are based on two simple notions: the ability of the company to generate profits and the expected return on the capital invested.

The company’s ability to generate profits is often expressed as its ability to manage free cash flows, i.e. the surplus cash that it will generate in the future.

Discounted cash flow method

Discounted cash flow (DCF) is the most common and advanced valuation method. It involves estimating the expected cash flows a company will generate during its useful life, and then calculating the present value using an appropriate discount rate.

This exercise therefore consists of anticipating cash flows, i.e. creating a financial forecast to project a company’s results and financial position in the future.

The financial forecasting model should establish the free cash flows that a company’s operations are likely to generate in the future. The concept of free cash flows is simple: Essentially, it is the money that the owner will be able to pocket each year, after ensuring the survival and growth, if any, of the company. The owner can choose to reinvest these profits in order to grow the company, either through investments or acquisitions. Any such decision should be evaluated using the same metric: What will the value of free cash flows be?

Here is a simple financial forecasting model to show how to determine free cash flows:

In the cash flow model, historical results should serve as the basis for financial forecasts. But they don’t tell the whole story. Adjustments must be made to more recent results to “normalize” them, that is, remove anything that pertains to the company’s current ownership that may not accurately reflect its actual state, as well as any non-recurring items.

For instance, any non-essential expenses incurred by the company may not be necessary in the future. Similarly, superfluous or redundant assets retained by the company’s owner could be sold off once the acquisition is finalized. Conversely, revenues may need to be re-evaluated. If a large, one-time-only sale was made to a customer, it is best not to factor it in when evaluating future cash flows.

In short, a “spring cleaning” of historical results is necessary to provide as accurate a picture as possible of what the company will look like after it’s acquired. Once the historical results are restated, they can be used to establish financial forecasts that will provide a clear valuation.

The forecasts are based on the knowledge of the target company that the buyer has developed, and on what the buyer plans to do with the new acquisition. And they should take into account any changes the new owner wants to make. The buyer may want to test different scenarios (pessimistic, realistic, optimistic) to determine if the assumptions are reasonable. The new owner may also want to include some wiggle room in case things do not go as well as planned. Of course, the forecasts will become more refined as the buyer becomes more familiar with the target company. And due diligence, which involves a detailed examination of the company’s results, plays a large part in this deepening understanding.

Estimate potential return

An investment decision should be viewed like any other business decision: The selling price must be greater than the costs incurred to realize a profit. The greater the risk to make a profit, the greater the potential margin should be. In company valuations, this margin is represented by the discount rate used to calculate the present value of free cash flows. This helps to offset two specific risks: The higher the rate, the more the valuation of expected long-term and higher-risk cash flows will be reduced.

A higher rate of return is required for a small, emerging company than for a large one that has reached maturity and whose future cash flows are easier to estimate.

Other factors can also justify requiring a higher rate of return. For instance, a company faces greater risk if it operates in a highly competitive market, compared to a rival company that enjoys an undeniable competitive advantage (thanks, for instance, to a patent, a privileged market position, favourable business locations or because it owns a popular brand). The company that lacks this positioning may have to lower its prices to keep its market share. This has to be taken into account when establishing a selling-price valuation for an acquisition.

The required rate of return (RRR) when acquiring a private company falls somewhere between two extremes: the average return that large publicly traded corporations achieve (about 7%), and the expected return of small start-ups (40% or more).

But determining a required rate of return is not an exact science. What’s most important is to be aware of the rate required and be able to clearly establish the impact of a variation in this rate on the company’s value. Keep in mind that the discounted cash flow method allows you to develop a model that will provide a basis for negotiating an acquisition price. The goal is not to obtain an exact valuation of a company, but rather to have as clear a vision as possible in order to determine the right price to pay.

If the rate of return used to evaluate the company is too low, the company may be overvalued. And that means the price may be too high. On the other hand, if the rate is too high, the price will be low, and therefore not easy to swallow for the seller.

The comparables method

The comparable transactions method is another widely used means to evaluate a company in the context of an acquisition. It involves determining a valuation by analyzing the price that other comparable companies have sold for recently using identical comparison criteria. As much as possible, the sample should include companies in the same field of business, of the same size, with similar results and located in a similar geographical area, etc.

Then, ratios are applied to determine a valuation. In cases where a more formal, DCF-based evaluation is not used, the most widely used method for evaluating a target company is the Enterprise value (EV)/Earnings before interest, tax, depreciation and amortization (EBITDA) multiple.

The basic information used is the EBITDA, in other words the cash flows produced by business operations, minus financial expenses, tax, depreciation and amortization. This amount must also be adjusted, or “normalized,” as previously indicated in order to arrive at a figure that correctly represents the anticipated future performance of the company.

For instance, if a company has an adjusted EBITDA of $200,000 and the multiple of the enterprise value over EBITDA is 5 times, the company will have a value of $1 million. The same exercise can be carried out by analyzing the evolution of the EV/EBITDA multiple over a period of years. It should be noted that relying solely on this valuation method may not provide a complete picture, since there may be other factors that influence the price, such as the presence of surplus assets and/or outstanding debt within the company. That’s why we recommend you consult with your professional accountants for greater insight.

2- Measure the impact of synergies

One of the key factors in a successful acquisition is achieving synergies, or at the very least improving the operations of the acquired company in order to boost profitability. There are many different types of synergies.

Revenue synergies

If, for instance, the acquired company has an attractive range of products but has trouble bringing them to market due to a limited distribution network, the acquirer could use its own distribution network to increase the sales volume of those products. This would be an example of revenue synergies. Value is created through an increase in revenues and the achievement of profit once the acquired company has been integrated with the buyer’s company.

Cost synergies

The acquirer may also be able to reduce the acquired company’s operating costs. This would be an example of cost synergies. Value is created through an increase in the acquired company’s profits. Ideally, these synergies should benefit the buyer, without having to be accounted for in the purchase price. Synergies can be created by having companies operating in the same sector. The profitability of the acquired company can also be increased by streamlining its management to reduce costs and improve productivity. These reductions are examples of cost synergies.

If no synergies are foreseeable, you should think twice about pursuing an acquisition. True, some financial buyers will acquire this type of company in order to restructure it or improve operations in the hope of ultimately deriving a profit. But in such cases, major changes must often be made to put a struggling company back on its feet. This is the main reason why it’s best to target complementary businesses.

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