VideoAll too often since the 1980s gave birth to America's historic "merger mania," the story has been the same. The initial champagne celebration gives way to a major hangover once the final cost of the deal is tallied. In fact, taken as a whole, mergers and acquisitions in recent years have produced a disheartening negative 12 percent return on investment.
It may come as a surprise, then, that among the clearest areas of progress during the past two decades has been company valuation — the art of figuring how much a target is worth, so that the offering price can include the smallest premium necessary to win the prize.
"We know much more about a target company today that we ever did 20 years ago," says David Harding, a senior partner with Bain & Co. and co-author of Mastering the Merger (Harvard Business School Publishing, 2004). "It's the difference between examining a patient with a stethoscope or with a CAT scan."
Indeed, acquirers have found the financial data to create good models ever more readily available, resulting in the increased reliability of discounted cash flow (DCF) estimates, and leading to the refinement of all kinds of valuation techniques. On top of that, companies have adopted far more rigorous due-diligence practices, drawing many of them from the entrepreneurial private-equity sector.
Subtracting the Multiple
While many factors have contributed to the improvement in valuation techniques, perhaps the most important of them flow from new technologies — often summoned through the magic of the Internet. Consider how complicated and time-consuming it was in 1985 merely to obtain all the needed public financial statements.
"We used to have to send guys from our D.C. office [over] to the [Securities and Exchange Commission] to copy 10-Ks for a nickel a page — and even then you often couldn't get all the filings," recalls Robert Reilly, managing director of Chicago-based valuation consultancy Willamette Management Associates. Now public filings are available online. In addition, such operations as FactSet Mergerstat LLC and Ibbotson Associates provide a constant flow of M&A transaction data and cost-of-capital statistics.
When the numbers are right, that can make the task of calculating the right discount rate a relative breeze. "You can now get every input you want for the capital asset pricing model [CAPM] for every industry and every time frame," says Reilly, referring to the model commonly used to determine the risk-adjusted cost of equity. "Our ability to be more precise in the application of CAPM has improved a lot in the past 20 years."
Adding to the improvement have been advanced cost-of-capital methodologies, notes Jay B. Abrams, president and CEO of North Hollywood, California-based Abrams Valuation Group Inc. For instance, analysts can now adjust discount models for special cases, such as nonpublic companies and smaller targets. "Large firms are more stable and small firms more volatile," says Abrams. "So for smaller firms, you should be using much higher discount rates" than the CAPM would yield. Newer methods, such as the Fama-French three-factor model, do a better job of capturing such subtleties.
The improvement in DCF calculations has ushered out, in many cases, the once-dominant role of such less-exact methods as historic market multiples. And for many finance executives, it's been good riddance.
"It used to be that market multiples were all anybody looked at," says Robert Holthausen, an accounting and finance professor at the University of Pennsylvania's Wharton School, "in part because discounted cash flows were so hard to do."
Not that multiples have lost their clout entirely; the calculations remain a standard tool — particularly for private-equity firms — because they offer a helpful means of comparing what others have paid in similar transactions. And they are still the main way of pricing deals in the technology sector. Rocky Pimentel, executive vice president and CFO of San Mateo, California-based game software maker Sorrent Inc., and a veteran of many high-tech mergers, says that most of the deals he has worked on, including Microsoft Corp.'s acquisition of WebTV, were largely based on multiples. "When you are in a high-growth industry, you are usually more willing to pay more for future revenue growth, and are less focused on the cost structure," he says.
Among the companies that came to rely more on discounted cash flows and cost of capital was New York-based Colgate-Palmolive Co. By the late 1980s, the company's management had gone through a period of diversification, and had decided to focus the business and to increase efficiencies. That meant adopting a formal approach to investments globally — from capital spending to acquisitions — based on DCF and cost of capital.
"We had used other approaches over the years, like sales growth and profitability trends," says now-retired Colgate CFO Robert Agate, who headed finance for the consumer-products giant from 1987 to 1996. "But when looking at high- and low-inflation countries or different types of businesses, it was apparent that we needed a method that would provide a dollar-based common denominator for viewing the various transactions." The approach also called for management to determine the likely upside and downside of its projections, which has the virtue of encouraging a focus on business assumptions rather than on methodology.
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