The right buys Featured

7:00pm EDT January 26, 2010

Now that much of the smoke has cleared and the economy is slowly righting itself, the mergers and acquisitions (M&A) arena is beginning to pick up.

However, before beginning the bidding process for potential targets, acquiring firms must be aware of several business valuation pitfalls that might doom an acquisition.

“With mergers and acquisitions rising again within the U.S., it appears that the economy is on the mend,” says Adam Wadecki, manager of operations at Cendrowski Corporate Advisors LLC. “However, acquirers must be careful not to overpay for target firms as they begin the bidding process. The use of sound business valuation assumptions can help acquirers achieve this goal.”

Comprehensive business valuations can afford acquiring firms a relevant and reliable picture of a target’s growth, strengths and weaknesses, while providing a foundation that will help develop realistic post-acquisition strategic objectives.

Smart Business spoke with Wadecki about issues acquiring firms should look for in performing valuations and how to mitigate these issues.

What issues should acquirers watch for when pursuing target firms?

It’s vital for acquirers to understand how a potential target company earns its profit and to know if that earnings stream will continue. Sometimes, a highly profitable division may have been sold, or a competitor may have gained the upper hand in the marketplace with new technology.

If margins or revenue will be impacted in the future, an analyst won’t perceive that information by looking at past or current financial statements — it requires rather active due diligence. Acquirers also need to know if the target has a consistent, stable customer base, or if there have been one-time, large orders, inventory purchases, or nonoperational gains that have distorted earnings.

It’s highly important for acquiring firms to understand the true status of the firm’s operations absent any accounting or non-operational distortions. While financial ratios can tell part of the story, executives of the acquiring firm should examine first-hand the target firm’s operations and analyze its modus operandi. They should estimate the amount of time it will take to standardize accounting, inventory and finance systems across firms, as well as whether or not the firms’ cultures are compatible.

How might acquisition targets be valued?

There are generally three approaches to valuation: the income, market and asset-based approaches. The income-based approach encompasses discounted cash flow models and their many different forms. In a market-based approach, precedent transaction multiples are generally used, while an asset-based approach necessitates valuing all assets of a business separately, then aggregating them to arrive at a total value.

Valuation professionals look for convergence among several different approaches when valuing a business, most often using the income and market approaches.

When using the market approach, how should appropriate precedent transactions be selected?

Ideally, one would be able to find numerous ‘pure-play’ comparable companies when performing a market-based valuation. However, in some instances, pure-play companies may simply not exist. When this is the case, valuation professionals should select from a more diverse basket of comparable companies, including firms with similar revenue, cost structure, downstream customers, upstream suppliers and geographic locations.

This larger list of firms can then be filtered to arrive at an appropriate list of comparable companies.

When using the income approach, how should an appropriate cost of capital be determined?

When valuing a target, it’s important to use a cost of capital commensurate with the riskiness of the project itself; the acquiring firm’s cost of capital should not be used in the valuation. In order to estimate an appropriate cost of capital, the acquiring firm must estimate the target’s cost of debt and cost of equity capital.

The cost of debt can be estimated using interest rates obtained by the firm or firms with similar credit ratings. The cost of equity, however, is significantly more complex.

Professionals must be sure that they take into account the target’s liquidity, organizational structure, geographic location and other risk-dependent factors when deriving this figure.

How should potential synergies be incorporated into the valuation?

Ideally, an acquiring firm should not pay for synergies — it should only pay for the value of the target as a standalone entity. However, synergies should nonetheless be estimated in order to understand the benefits that the acquirer can reap from the target firm through the acquisition.

For publicly traded entities, it might also be advantageous to estimate the amount of pretax synergies necessary for the acquisition to be an accretive transaction rather than a dilutive one. Such an analysis can help public company managers ensure a potential acquisition will not negatively impact the firm’s stock price.

ADAM WADECKI is manager of operations for Cendrowski Corporate Advisors LLC. Reach him at aaw@cendsel.com or (866) 717-1607, or visit the company’s Web site at www.cca-advisors.com.