Valuations: Changing with the times

SUITS THE C-SUITE By Marie Stephanie C. Tan-Hamed

Business World (04/11/2016 – p.S1/2)

One of the most difficult aspects in closing a deal — whether the deal is an acquisition, divestment, or merger — is the valuation of the target asset. A key point in a deal is to agree to the amount to be exchanged for the asset between a willing buyer and seller in an arm’s length transaction.

The difference between the buyer’s value expectations and the seller’s value expectations is called the valuation gap, which, as reported in the recent EY Global Capital Confidence Barometer, is expected by most executives to widen in the current business environment. The report indicates, however, that the gap is only 10% to 25% and is expected to remain stable in the future. The same holds true for expectations on asset prices. The factors indicate that conditions are more conducive for deal making, which is consistent with the expectation of almost half of the surveyed executives that more deals will be closed in the foreseeable future.

Within an environment of robust Mergers and Acquisitions (M&A) activities where corporates and private equity firms compete for a healthy number of targets, the race to complete a transaction may be fraught with pitfalls. Apart from conducting due diligence, one way to reduce risks is to perform a proper Valuations and Modeling exercise that can bridge the price gap between the vendors and investors. Understandably, valuing targets is difficult, and it is made more complex in emerging countries, or in the cases of greenfield (where no previous companies or investments existed) projects and start-up companies, where no historical numbers can be relied on to estimate the performance in the next 3 to 5 years. Generally, value expectations are based on the opportunity for future growth where the potential is high, but historical bases are limited at best.

Take the case of the technology sector. Most technology executives surveyed indicated that valuation gaps between buyers and sellers are small (<10%) or only somewhat higher between 10% and 25%. More than 3/4 or 76% of technology respondents expect that valuation gaps will remain the same, and 81% expect asset prices to be stable. With these expectations, 67% of the executives surveyed said that they would actively pursue acquisitions in this sector. The main opportunities are driven by targets engaged in smart mobility, cloud computing, social networking, and big data analytics. This positive appetite for acquisitions has resulted in impressive numbers, specifically, $77.1 billion in disclosed-value deals and 981 deals in the first quarter of 2015 alone, according to EY’s Global technology M&A update. It is interesting to note that traditional valuation metrics based on current earnings on revenue multiples may not accurately capture the value of the future growth expectation in the technology sector. Take for example one of the most notable transactions in recent years, Facebook’s $19-billion acquisition of WhatsApp. WhatsApp reported revenue of only $20 million in 2013, but using our traditional Enterprise-Value-to-Sales (EV/Sales) multiple, it will yield a mind-boggling 950x of revenue. Applying traditional valuation metrics in this case would not have made sense and could have resulted in transactions falling through the cracks. Using traditional valuation metrics could cause companies to miss out on opportunities for growth through acquisitions. For the near term, understanding and estimating valuations such as these may require a different perspective which takes into account other key metrics such as the number of monthly active users/subscribers, coupled with the level of engagement of each user/subscriber. This is significant because as the level of user engagement increases, so does the value per user increase, says EY’s Jim Reinhart, Managing Director of EY Capital Advisors, LLC. This approach is increasingly being used particularly since technology start-ups focus on user growth first, then revenue generation, and ultimately profitability. It is also important to understand how users consume content, which makes active users more valuable than passive ones. However, this alternative valuation metric has to be augmented with an emphasis on rapid, sustainable growth. In a bid to better understand valuation in terms of price per monthly active user, EY developed a model that focuses on a company’s predicted future growth. EY analyzed 350 public companies that are generating revenue but not profits and, for 70 of these companies, was able to obtain forecasted revenue growth over the next three years and calculated its compounded annual growth rate (CAGR). The model worked out a more reasonable implied ratio where a 200% three-year CAGR has an implied EV multiple of 25x. This can be interpreted to mean that seemingly high valuations can seem more reasonable when considered with other valuation approaches. Jim Reinhart said that traditional valuation metrics start to make sense when we look at longer-term growth rates, but these growth predictions have to be scrutinized to see how realistic they are, including asking where revenues comes from; the predictability or uncertainty of sources; the technology company’s ability to expand to capture additional revenue-generating markets; and similar questions. Another sector that may require specific valuation metric is the telecommunications sector. Aside from using Enterprise-Value-to-Sales (EV/Sales) or Enterprise Value to earnings before interest, taxes, depreciation and amortization (EV/EBITDA), alternative measures would be Average Revenue Per User or ARPU, and EV/number of subscribers, respectively. For P/E, we can use EV/line installed as a proxy, and for P/B, we can look at Subscriber Acquisition Cost. When measuring beta coefficients, one can take a look at Subscriber Retention Cost. For valuation of a specific asset such as licenses, where information is scarce limiting the use of traditional valuation methods such as green-field method, alternative metrics such as Price/MHz, Price/Inhabitant, or Price/Mhz/Inhabitant can be used to value licenses. These alternative valuation metrics can give a better perspective on valuations of targets in a complex environment where traditional measures do not make sense. For many companies, M&A is a significant avenue for driving growth and keeping pace with changes in the market. Encountering difficulties in getting valuations right should not deter companies from undertaking transactions, since shying away from acquisitions due to challenges brought by valuations presents a risk of bargaining away future growth. Of course, at some point, there is a need to return to the traditional valuation metric based on earnings/profitability and cash flows. However, in an environment where growth potential is exponential, new and alternative valuation metrics are needed to capture the value of these targets. This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the author and do not necessarily represent the views of SGV & Co. Marie Stephanie C. Tan-Hamed is a Partner of SGV & Co.