In general, scrutiny of potential prospects will include a close look at a company’s strengths and weaknesses as well as market analysis and due diligence. Within this will be reviews of past and present financial statements, as well as projected financial results. And this is just the beginning. In this article, we explore some of the most common and crucial factors weighed up by potential buyers.
The price/earnings ratio is one of the oldest, most trusted and most frequently used metrics when valuing companies. The ratio of a firm’s stock price to its earnings per share (EPS), there are a number of versions of the P/E ratio.
At first glance, the P/E ratio is simple to calculate but, particularly given there are different forms, it can be hard to interpret. From a ‘forward P/E’ (using estimated future net earnings) to a ‘trailing P/E’ (a formula which employs recent net income, typically calculated using EPS from the past 12 months), assessing the profitability of a target firm can be arrived at in a number of ways. There’s another method too which uses the sum of the last two quarters and the estimates of the next two quarters.
Once the maths has been completed, a buyer has a clearer idea of what to expect and can determine whether the shares are correctly valued. For example, if the current share price is £10 and the EPS is £1, then the P/E ratio is ten. Put simply, this calculation tells the buyer how long it would take them to recoup their initial investment in the target firm if it continues to generate the same earnings. And it’s a better indicator of the value of a stock than the market price alone.
Enterprise value/sales is a financial ratio that compares the total value of a firm to its sales.
It works like this: the enterprise value is the sum of a company’s market capitalisation and its net debt while the sales figure is usually arrived at by taking the most recent four quarters. By comparing the two you arrive at a valuation ratio. It sounds relatively straightforward but it can be slightly misleading. While some buyers prefer high multiples, others believe that a lower EV/Sales means the company is undervalued and therefore attractive. It’s essential to compare like-with-like here and scrutinise the EV/Sales of other firms in the industry. And remember that the sales figure gives no indication of cash flow or profitability.
Discounted Cash Flow
Discounted cash flow – DCF – is a method of assessing how much a share is worth based on the present or discounted value of projected future cash flows. In essence, this valuation estimates the appeal of a target company and its potential for investment as it centres on what the entire firm is worth.
While the concept of the DCF is fairly simple (a stock’s worth is equal to the present value of all its estimated future cash flows), actually valuing a stock is fraught with difficulty, and DCF can be a complex way to value stocks.
In this article, we’ve only just begun to explain the myriad of measures employed by buyers on the acquisition trail. There are many more to consider. For the moment, however, business owners would do well to remember that every situation is different, not least due to economic conditions, industry risks and shifting motivations. In fact, an ideal way to obtain a good price for your business is to grow its profitability and let others argue about valuations later.