By Karen Sibayan | November 3, 2015
Skyrocketing valuations are the topic du jour both from a buyer’s and a seller’s point of view.
For buyers, whether strategic or private equity, the current high values mean having to pay up for quality assets. From the sellers’ standpoint, timing is everything as they market their companies and prepare their financials to get to a desirable price point.
At the recent Axial Concord 2015, panelists discussed the state of company valuations today and what they mean for CEOs, investors, and M&A advisors.
The ABCs of Valuations
Before examining the implications of these elevated valuations, it’s worth looking at how companies get to the magic number.
Tom Courtney, president and managing director at The Courtney Group, says people use primarily five methodologies to determine a valuation: discounted cash flow analysis, publicly traded comparable companies, comparable merger & acquisition transactions, LBO analysis, and liquidation analysis. The most used in practice is the discounted cash flow analysis, projecting and discounting future cash flows by using the weighted average cost of capital.
Although the valuation of a company is most commonly based on discounted cash flow, when buyers look at the enterprise value in a specific transaction, it is actually determined by several factors.
One of these is the rising number of participants in the bidding process. Eighteen to 24 months ago, valuations in auctions coming in for businesses had a “high-low bid range of roughly 1X,“ says Adams Price, managing director at The Forbes M+A Group. “I would see offers coming in between 5X and 6X with five, six, maybe seven participants in the auction. But, over the last eight months, we have seen closer to 15 to 20 groups that are bidding on the companies we are representing. The range of low-bid to high-bid can be 2X to 2.5X — there are really big ranges out there.”
The defining difference between those ranges is the level of risk. For instance, there might be a lot more risk in a company with a higher enterprise value compared to a firm with a lower one. “It really comes down to the specific transaction and what risk apportionment you are able to accomplish,” Price says.
Fits Like a Glove
Aside from considerations that include risk, strategic fit also matters. Sam Thompson, a senior managing director at Progress Ventures, says that a company can garner a high valuation when there is a strong alignment to a product team. “A lot of the pre-transaction planning that we’re working on is about getting into and understanding who the target market is for that ultimate exit,” says Thompson.
The end result might not be a sale, but the process is more about firms “getting on the map and making sure that a product or management team has awareness of what the product is in the market, and how it differentiates itself. More often than not, there are multiple partnerships in the marketplace and when there are multiple acquirers, companies can start to dial up the valuation number.”
Industry Multiples
Panelists also discussed multiples in various industries. It is no surprise that the technology sector was singled out for having elevated multiples.
“If you look at overall multiples across the board, they peaked out in the fourth quarter in the 7Xs, and now have backed off and gone into the 6.5Xs,” says Forbes’ Price. “They are still pretty high for multiples, but they vary greatly between industries.” He describes the technology space as “very strong” with recent multiples getting up into the double digits. “I’m not talking about the unicorns and companies that are growing at 200%. I’m talking about good companies that have consistent and high quality earnings, consistent growth over an extended period of time, and strong customer relationships with low churn.”
Price says even private equity firms would sometimes allow their return rates to drop down into the single digits to be able to win these auctions. “That’s an example of an area that is very robust if not frothy.”
Thompson agreed that technology companies will likely see some of the higher multiples, particularly those that have Software as a Service (SaaS) platforms. “A lot of the companies that we’ve seen in the marketing technology services side, for instance, are looking at how they can switch over into a SaaS software platform to get themselves into a higher multiple range,” he says. However, it can be hard for firms to drive their multiples higher in the crowded technology marketplace. “Momentum is a big factor when it comes to multiples. Businesses we’ve been working with a flat growth trajectory find it hard to get the multiples up higher even if they are a fairly profitable business. Buyers want to see that there’s a hungry customer base that wants more of this technology and platform.”
Performance in the public market can drive valuations upward. “Publicly traded companies can use their stock as a currency,” Courtney says. “So there’s a big difference if a company trades for 10X or 30X earnings.”
Aside from industry differences, in this case, size also matters. For instance, companies with over $10 million of EBITDA are seeing higher multiples than those with less. “That’s the concept of EBITDA arbitrage,” says Forbes’ Price. “There are bands of EBITDA and as a company works its way up, the multiples go up as well. I’ve seen many private equity groups that rationalize it in their minds that they can use the arbitrage to get paid up on the backend. “
Efficient Capital
Supply and demand factors are key to how high valuations are going to be. “What it comes down to, more than anything, is supply and demand of capital in the market versus those companies that are available to invest in,” Price says. He cites the large amount of cash reserves on corporate balance sheets both domestically and internationally as well as the historically high private equity overhang. “There’s just a tremendous amount of money available in the marketplace and banks are also extremely aggressive right now in deploying money.”
Capital is deployed in an increasingly orderly fashion so that how much investors get back can be considered independently from valuations. “There is an increasing efficiency to the capital markets in organizing different tranches of capital so each of those has a different risk profile and rate of return requirement,” Courtney says. “As capital raising becomes more and more tranched out, I think there may be an opportunity to have investment coming in at lower rates of return that could yield higher multiples overall. In a sense, this would be getting closer to the efficient frontier of the capital markets.”
Prudence is King
Despite the abundance of money and a welcoming capital market, buyers are more discerning about the targets that they seek. Unlike previous boom periods, “we are finding that it’s pretty prudent money, particularly for companies that are in the middle-market and lower middle-market. It’s really more about having a very clear vision of where the company is going, and how that dovetails with the buyer’s opportunity,“ Price says. Acquirers might use an aggressive cash flow model, “but it’s a model that they tear down several times before they invest, particularly on the private equity side. So we tell our clients to articulate a clear message of growth that’s going to warrant the multiple they are trying to get.”
In short: Buyers are looking for quality. “When you hear about those big valuations, it is for those companies that are perfect,” Price says. These firms are great performers and can also “support, in the long term, the leverage necessary to be purchased at those higher valuations.”
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