Corporate valuations: For what it's worth

Among the many forms of financial wizardry, valuing
companies is a dark art. It combines complex financial skills with the ability
to predict the future; it’s an unusual amalgam of statistics and crystal ball
gazing.

The FTSE-100 building materials group, Wolseley, has a fair few practitioners
of the dark art of valuation on its payroll. That’s because it aims to make half
its growth every year from acquisitions, which translates into an improbable
number of deals and an annual acquisition budget of close to half a billion
pounds.

So far this year, the company has made 44 acquisitions. Buying this many
companies each and every year means Wolseley has honed its valuation process to
a wrinkle-free procedure, says its group finance director, Steve Webster.

“We have a rigorous, well-defined process that is applied to an acquisition
whether it is large or small. We have a standard approach to valuing companies
that includes a key return hurdle that has to be cleared for the acquisition to
go ahead,” says Webster.

Wolseley tends to acquire small companies in a highly fragmented marketplace
and so it rarely comes into competition with private equity firms.

But other publicly quoted companies are finding that they lock horns ever
more frequently with private equity giants like Blackstone and KKR as their
fiscal firepower has increased over the past decade.

Talk to any corporate finance practitioner and the message is resoundingly
clear: private equity has shaken up almost every aspect of the M&A market,
including the way that acquisitions and disposals are valued.

Doug McPhee, a partner at KPMG’s corporate finance division, says: “There has
been a lot of ill-will from the big trade buyers towards private equity on two
fronts: first, because private equity firms have been able to offer higher
prices for acquisitions and, second, they are not affected by IFRS rules on
goodwill treatment.”

New changes to IFRS means the company cannot simply lump all of the
difference between the price it paid and the net asset value of its acquisition
into goodwill.

Amortisation charges

The price now has to be apportioned to individual assets like brands and
patents. These are then amortised, which has an impact on a company’s earnings
per share. A private equity company has no public investors and rarely any
profits left after interest charges so it is less concerned about the impact of
amortisation charges.

Steve Taylor, head of UK valuations at Ernst & Young, isn’t convinced
that IFRS is having any real impact on pricing. “The new accounting rules
haven’t changed the way deals are valued or priced, but companies are now
thinking about the kind of accounting they will have to live with after an
acquisition has been made,” he says.
The increasing might of the private equity sector has also had an influence on
the kind of valuation methodologies that are used to assess what price to pay
for another company.

Peter Clokey, partner of the valuation group at PricewaterhouseCoopers, says:
“If you go back to the turn of this century, the typical purchaser was a trade
buyer and they tended to value by P/E ratios and often had simple rules of
thumb. I remember one major public company chairman who said: ‘I always pay one
times turnover, it’s a rule that has worked for me throughout my business
career.’”

Scroll on to today and the influence of private equity means that the M&
A world has had to come to terms with the concept of valuing a company using
EBITDA (earnings before interest, tax, deprecation and amortisation) in
combination with enterprise value.

This is the tool of choice for private equity as it gives the best snapshot
of the underlying value of the business, capturing its enterprise value rather
than the worth of its equity. Private equity (belying its name) is highly
leveraged, so much of its businesses’ operating profit will be swallowed up
servicing interest charges. “This means that the net profits are often
negligible and, therefore, older methodologies like P/E multiples are
meaningless.”

Along with a focus on different methodologies, valuation techniques have also
become increasingly sophisticated as more financiers have taken higher level
qualifications, in part to meet the increasing demand by private equity for
complex financial skills.

Clokey admits that even the most sophisticated valuation method does not
change the fact that these tools are just trying to make an educated guess at
the future. “A more sophisticated tool is only giving you a mildly better
crystal ball,” he says.
But he still thinks it is important for finance directors to embrace the more
complex valuation methodologies. “I think people criticise valuation tools like
discounted cash flow because of the number of assumptions it involves. This
overlooks the fact that those assumptions are4 implicit in a simpler multiples
analysis. DCF is a useful tool because it makes you stop and think about those
assumptions, forcing you to make a more in-depth analysis of the business.”

It’s been unemotional

For Webster, the key to Wolseley making a successful acquisition is to ensure
that there is a step-by-step process from identifying a company as a potential
acquisition target through to monitoring its integration within the firm several
years after it has been bought.

“Part of the role of our central team is to take the emotion out of making
acquisitions; it is very easy for people to fall in love with deals. You do need
an independent check on that process,” says Webster.

Rather than being reliant on any one valuation methodology, Wolseley tries to
work out what the performance of that company is likely to be under its
ownership, says Webster. “It is very important that you are able to
independently assess within the company what is the right acquisition and that
you don’t rely too much on external advisers to give you that analysis.”

A key part of assessing what price a company can afford to pay for a
particular company depends on how expensive it will be to finance a deal.
Private equity has had a bigger impact on the way M&A deals are financed
than on any other aspect of the market.

Nick Naylor, a director of corporate finance at the investment bank Noble,
says: “Private equity is much more comfortable with higher levels of leverage
and debt and, as a result, is often able to pay more. A lot of trade buyers feel
uncomfortable when gearing levels get too high, especially at the levels that
private equity operates.”

Trade buyers used to be able to beat private buyers when it came to a
gloves-off battle for ownership of a company. The trade buyer could afford to
pay a higher price for a company because the synergies from acquiring a company
would offset any premium paid.

But private equity’s use of high levels of leverage and sophisticated
financing means that it can often afford to pay more than trade buyers.
Institutional investors have also become increasingly cynical about how much
synergy can be extracted from an acquisition and questioned boards more sharply
about the financial benefits of a deal.

In recent years, debt has become very cheap and public companies have faced
another disadvantage with private equity ­ higher financing costs. The weighted
average cost of capital a public company uses to fund an acquisition is composed
of two components ­ the cost of the borrowing and the cost of equity.

David Bezem, managing director at Close Brothers corporate finance, says it
is the cost of equity that makes a public company’s financing costs often higher
than for a private equity firm. “The estimate of the cost of equity tends to be
higher than the cost of debt finance because of equity’s risk premium to the
normal market rate of return,” he says. As private equity uses more debt than
equity, they have a lower cost of capital and so a lower hurdle rate.

“The most disciplined public companies have always had a clear view of their
cost of capital and using that as a benchmark for the benefits of making a
particular acquisition,” Bezem says.

Wolseley is one such highly disciplined company; it keeps its eye on a very
specific return criteria. “For a smaller acquisition, we require a return on
gross capital employed which is not less than 5% more than the pre-tax weighted
average cost of capital within the first three years,” says Webster. The target
is designed to make sure the company is adding sufficient shareholder value ­
sooner rather than later, so as to avoid so-called ‘hockey stick’ payback
projections.

Fighting back

Despite having to adhere to such a strict return policy and being prepared to
walk away from deals if prices get pushed too high, Webster says that trade
companies can fight back against the dominance of private equity in the M&A
market. “We probably compete three or four times a year with private equity for
a company,” he says.

The market may be sceptical about just how high a level of synergies can be
extracted from a merger, but Webster says that a trade buyer is much better
placed to shake out the highest level of benefit from an acquisition. “It is
also much easier to create value from buying a smaller company because there is
immediate integration and no cultural conflict,” he says.

Wolseley also gets round the issue of higher financing costs by using its
financial strength to get access to low-cost debt and using that rather than
equity to finance its deals. This puts it on a level playing field with private
equity.

There can also be advantages to being a trade buyer. “The owners or the
managers of the business that we are looking to acquire sometimes prefer to be
bought by a trade buyer. We understand the industry and they know they can learn
from other people in the same sector.” That can also help Wolseley to get better
value from the acquisition as the management then feels highly motivated to
improve the sales and the profitability of the business.

Help for the trade buyer competing against private equity may also be on hand
from the financial markets: the recent wobbles in the debt markets mean that the
days of cheap debt financing for private equity may be numbered. Now could be
the time for the financial wizards at public companies to get out there and once
again practise the dark art of valuation.