Generally, when valuing a company, there are two different ways to

approach the valuation of the company: the first is the liquidation

value of the company, and the second is the value of the company
as a going concern. Most often in a mergers and acquisitions
transaction, the target business will be valued as a going concern,
unless the target company is in distress and the acquiring company
is purchasing it to strip it down and sell the assets, or to remove it
from the market as a competitor. The liquidation value is most
accurate for distressed companies, or companies that require
restructuring. When a company is valued as a going concern, the
assumption is made that the company will continue operating
throughout the foreseeable future, adding to its value beyond just
the sum of its assets.
When undergoing valuations for companies that are being valued as
a going concern, the acquiring company will be looking at the
earning power of the business, as well the cash generation
capability of all of the assets that make up the operations of the
target company. When the target company is valued as a going
concern, rather than through liquidation value, non-operating or
intangible assets will be included in the valuation, including such
items as: brands, trademarks, patents, interests in other companies,
customer and supplier relations, skill of management and expertise,
technology, industry know-how, infrastructure, etc.
The following will include some of the ways to approach valuations
in the mergers and acquisitions setting, as well as some of their
strengths and weaknesses.
Price-Earnings Ratio (P/E Ratio)
The P/E Ratio is the comparison of the companys current share
price to its per-share earnings. The P/E Ratio is expressed as follows:
Market Value per Share / Earnings per Share (EPS). Usually, the EPS
is calculated from the last four quarters of the companys

performance, but can also be calculated by estimating the

companys earnings over the next four quarters, or a combination of
the previous two quarters and the estimates for the next two
quarters.
A higher P/E ratio signals an expectation by investors for a high
earnings growth in the future compared to those companies that
have a lower P/E ratio. When valuing a companys P/E Ratio, it is
most useful to compare to the ratios of companies in the same
industry, or against the companys historical P/E Ratio. The P/E
Ratio also signals how much investors are willing to pay per dollar of
earnings. P/E Ratios can be easily manipulated via a companys
accounting practices however, so it is important to not depend on
this method alone.
Enterprise-Value-to-Sales Ratio (EV/Sales)
This ratio is a valuation measure comparing a companys enterprise
value to the sales of a company. This ratio is used by investors to
get a base estimate of the price it would cost to buy the companys
sales, and generally, the lower the EV to Sales ratio is the more
attractive or undervalued the company is believed to be by possible
acquiring parties. A company can essentially be bough by its own
cash if the EV/Sales measure is negative meaning that the cash in
the company is greater than the market capitalization and debt
structure. EV/Sales is often more accurate than the price-to-sales
valuation method (which uses the market capitalization rather than
the enterprise value of the company), due to the fact that market
capitalization does not incorporate the level of debt a company has
as well as the enterprise value of the company does. EV/Sales
measurements are not always telling of the companys position,
however, as a high ratio could mean that investors believe future
sales could greatly increase, and a lower ratio may even signal
unattractive future sales prospects.

The EV/Sales Ratio equation is expressed as follows:

(Market Capitalization + Debt + Preferred Shares Cash and Cash
Equivalents) / Annual Sales
Book Value
Valuation based off of the book value method works best for those
firms that do not have intangible assets, and important assets such
as intellectual property, trade secrets, brand value, and the
competency of the managers and officers are ignored in the
valuation. The book value will also depend on which of the varying
accounting practices the company uses. Liabilities are often in
dispute when negotiating a valuation in a mergers and acquisitions
transaction when using book value.
Liquidation Value
Liquidation value is the value of the sale of assets at a certain point
in time via the use of an appraiser or appraisers. Usually this
method will be utilized for firms in financial distress, or have an
uncertain future. Often, it is difficult to get a consensus between the
parties as liquidation values tend fluctuate with the appraiser, and
such factors need to be taken into consideration such as the
physical condition of the assets, or in some cases, the age of the
assets. Furthermore, some appraisers may ignore the value of
certain intangible assets.
Market Value (of Securities)
The market value of traded securities is most often used to assess
the value of the companys equity by taking the stock price and
multiplying it by the outstanding shares. Another way to value an
enterprise is by further adding the market value of debt as the price
per bond multiplied by the number of bonds outstanding. The book

value is frequently close to the market price of a bond, and as such,

the book value of debt can be used as a reasonable proxy for its
market value. In the opposite, book value per share of equity is
rarely close enough to its market price to be a reasonably good
estimate.
For this method to be used accurately, it is necessary for the stock
to be publicly traded and analyzed by securities analysts, and is not
available for privately held companies. This is further based on the
efficient market hypothesis, and that all necessary materially
important information is reflected in the price of the equity.
When negotiating a mergers and acquisitions transaction, the
company selling its equity (and the equity holders) will generally
receive what is called a control premium. A control premium is
often around 30% to 50% more than the price of the equity one day
before the merger or acquisition announcement. The control
premiums are due to the equity holders of the target company not
being willing to sell unless they benefit more from such a sale, such
a control premium is a way of making it more beneficial to the
selling equity holders than not selling the company. The control
premium is further based on the rarity of assets, including the
intangible assets, and the saturation of the companys assets within
the market and owned by competing businesses, the financial
resources of the company making the bid, or over-inflated market
prices.
Replacement Cost Method
This method is based off of the cost of replacing the target
company. This method is not used as often anymore, and as such
the discussion on this method will not be as detailed. The
replacement cost method works on a most basic level by the
acquiring company forcing the target company to sell at the price of
its equipment and staffing costs, or else the acquiring company will

form a competitor for the same price and force the target company
out of business. This method is least effective when merging or
acquiring a service industry based business.
Discounted-Cash-Flow Method
The principle behind this type of valuation is that a businesss value
is based on that companys ability to generate and grow its cash
flow for the providers of the capital. In mergers and acquisitions
transactions, this method is used to determine the enterprise value
by estimating future cash flows over the horizon period (explained
later), calculating the terminal value at the end of that period, then
the forecasted free cash flows and terminal value are discounted to
the present value of the companys weighted average cost of
capital. Free cash flow is the cash generated by the business
available to be distributed to all providers of capital to the business.
The terminal value is the value at the end of the free cash flow
projection period (also known as the horizon period), and the
discount rate is the rate used to discount the projected future cash
flows and terminal value to their present values.
If done correctly this method is one of the most valuable tools when
valuing the enterprise value of a company, due to this method
being: forward-looking and less dependent on historical results;
inward-looking and less influenced by external factors; based on
cash flow and less affected by accounting practices and
assumptions; operating strategies able to be factored into the
valuation; and allowing different components of a business to be
valued separately. However, one must be wary when using this
method as the quality of the assumptions made when calculating
the free cash flow, terminal value, and discount rates are integral in
assuring an accurate valuation.
This is only a basic review of each some of the ways to value a
business, and is by no means exhaustive. It is important to

remember that your individual circumstances dictate what is best

for you and your company, and it is highly recommended that you
consult with an experienced business law attorney to ensure your
transaction is handled correctly and effectively. Contact Lee Shome
& Kennedy today to schedule a free one-hour consultation with one
of our experienced business law attorneys.
http://www.lskfirm.com/blog/valuations-methods-in-mergers-acquisitionstransactions
http://www.uni-stuttgart.de/infotech/pdf/bma13/BMA13_Mergers.pdf
Business Valuation / Mergers & Acquisition / Post Merger Integration