In my last blog, I discussed the ways in which a valuation expert might able to justify the $19 billion purchase price in Facebook’s acquisition of WhatsApp. While it is rather difficult to support such a price with any degree of certainty, there are scenarios where one can see significant potential value in this acquisition. I felt that a deeper discussion of the types of adjustments and assumptions that underlie these scenarios would be helpful in understanding how companies are valued in the context of an acquisition.
The process of valuing a company involves an analysis whereby the cash flows of the business are “normalized”. In the context of profits and cash flows, this normalizing analysis converts historical results to expected, repeatable levels. Simply, this analysis helps quantify the cash flows that the buyer is expected to receive after completion of the hypothetical purchase.
Because of this buyer-centric viewpoint, it is critical to understand the characteristics of the buyer. In many of our engagements, we are asked to ascribe a value under a “fair market value” assumption.
Fair market value, as opposed to strategic value, assumes that the buyer is hypothetical in nature and is generally a financial buyer, not a specific buyer that may be able to generate synergies as a result of the acquisition. A financial buyer (e.g. Warren Buffett’s Berkshire Hathaway) evaluates a company on its ability to generate a return on investment through organic methods, such as improvement of operational performance and the addition of customers. Therefore, when developing normalizing adjustments in a fair market value scenario, there is generally more “science” than “art” to quantifying the adjustments. In a fair market value context, normalizing adjustments generally fall into one of the following categories:
- Adjustments for discretionary items – Such adjustments are often found in evaluating owner compensation, where the owner may be taking more (and, on some occasions, less) salary that the fair market value of the services he or she provides to the company. Other examples of adjustments that fall into this category might be rent paid to a related party at other than market levels or excess perquisites (e.g. personal auto, travel or entertainment expenses).
- Adjustments for non-recurring items – These adjustments are the results of one-time income or expense items that are typically identified through analysis of trends in the historical income statements. Examples of non-recurring items might be a one-time charge for a litigation settlement, relocation expenses required to lure a key employee, or transaction costs associated with the purchase of a company.
Now, contrast these adjustments to those that I spoke of previously in the context of strategic value. Items such as cross-selling opportunities and staff redundancies possess a much larger “art” aspect to them when compared to those discussed above. While a valuator can certainly estimate the impact of such strategic items or adjustments on the company’s cash flows, there are a two major issues that hurt the reliability of the resultant value.
First, these items can be very speculative in nature (see my example of increasing the subscription price of WhatsApp from $1 to $5). This speculation creates considerable uncertainty in the likelihood of the future cash flows, and in turn increasing the risk of those cash flows. As a result, it becomes increasingly challenging to fit these facts into traditional valuation metrics and methods.
Second, as I noted in my last entry, it is unlikely that the entire market of buyers can capitalize upon these synergies. Rather, this value might only be available to a select few buyers – or perhaps a single buyer. Thus, when a valuation expert is preparing a valuation based on a fair market value (or fair value) premise (such as for the IRS, a judge or jury, or a financial statement auditor), the inclusion of such synergistic adjustments to cash flows is generally inappropriate. However, in a case where the prospective buyer is known and potential synergies can be estimated, an analysis prepared under a strategic value premise can be valuable to the seller as he or she enters into negotiations and attempts to secure the best price possible for his or her business.
Do you have questions about the value of your business? Our Valuation and Litigation Advisory professionals are happy to help. Feel free to leave a comment below or call Dan Golish, CPA/ABV, CVA, CFF at 440-449-6800.
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