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M&A - Calculating the purchase price for acquiring a company

Written by Andrew Collins | Jun 17, 2024 9:53:15 AM

Calculating the purchase price for acquiring a company involves several valuation methods and financial analyses. Here's a detailed guide on how to calculate the purchase price, incorporating various approaches and considering multiple factors to arrive at a fair and accurate valuation.

Step 1: Understand the Valuation Approaches

There are three primary valuation approaches used to determine the purchase price of a company:

  1. Income Approach
  2. Market Approach
  3. Asset-Based Approach

Step 2: Income Approach

The income approach values a company based on its ability to generate future cash flows. The most common method under this approach is the Discounted Cash Flow (DCF) analysis.

Discounted Cash Flow (DCF) Analysis

Forecast Free Cash Flows (FCF):

  • Revenue Projections: Estimate future revenues based on historical performance and market analysis.
  • Operating Costs: Deduct operating expenses, taxes, and changes in working capital.
  • Capital Expenditures: Subtract capital expenditures needed to maintain or grow operations.

Example:

  • Revenue Growth Rate: Assume a 5% annual growth.
  • Operating Margin: Historical average of 20%.
  • Capital Expenditures: 10% of annual revenue.
FCF = Revenue * Operating Margin - Capital Expenditures

Determine the Discount Rate:

  • Calculate the Weighted Average Cost of Capital (WACC), which reflects the company's cost of equity and debt.

Example:

  • Cost of Equity: 10%
  • Cost of Debt: 5%
  • Equity to Debt Ratio: 70:30
WACC = (Cost of Equity * Weight of Equity) + (Cost of Debt * Weight of Debt * (1 - Tax Rate))

Calculate the Present Value of FCF:

  • Discount the forecasted FCFs to their present value using the WACC.

Example:

  • Year 1 FCF: €5 million
  • Year 2 FCF: €5.25 million
PV_FCF_Year1 = FCF_Year1 / (1 + WACC)
PV_FCF_Year2 = FCF_Year2 / (1 + WACC)^2

Estimate Terminal Value:

  • Calculate the terminal value, which represents the value of the company beyond the forecast period.

Example:

  • Terminal Growth Rate: 3%
Terminal Value = (FCF * (1 + Terminal Growth Rate)) / (WACC - Terminal Growth Rate)

Sum the Present Values:

  • Add the present value of the forecasted FCFs and the present value of the terminal value to get the total enterprise value.
Enterprise Value = Sum(PV_FCF_Years) + PV_Terminal_Value

Step 3: Market Approach

The market approach values a company based on how similar companies are valued in the market. The most common methods are Comparable Company Analysis and Precedent Transactions.

Comparable Company Analysis (CCA)

  1. Identify Comparable Companies:

    • Select publicly traded companies similar in size, industry, and market.

  2. Calculate Valuation Multiples:

    • Common multiples include Price/Earnings (P/E), Enterprise Value/EBITDA (EV/EBITDA), and Price/Sales (P/S).

    Example:

    • Comparable Company P/E Ratio: 15x
    • Comparable Company EV/EBITDA Ratio: 10x
    • Target Company Earnings: €10 million
    • Target Company EBITDA: €15 million

      Apply Multiples to the Target Company:

      • Use the multiples to value the target company.

      Example:

  3. Target Company Value (P/E) = Target Company Earnings * Comparable P/E Ratio
    Target Company Value (EV/EBITDA) = Target Company EBITDA * Comparable EV/EBITDA Ratio

Precedent Transactions Analysis (PTA)

  1. Identify Similar Transactions:

    • Look for recent acquisitions of similar companies.

  2. Calculate Transaction Multiples:

    • Determine the multiples paid in those transactions.

    Example:

    • Transaction EV/EBITDA Ratio: 12x
    • Target Company EBITDA: €15 million

      Apply Multiples to the Target Company:

      • Use these multiples to estimate the purchase price.

      Example:

  3. Target Company Value (Transaction) = Target Company EBITDA * Transaction EV/EBITDA Ratio

Step 4: Asset-Based Approach

The asset-based approach values a company based on its net asset value (NAV).

Net Asset Value (NAV) Calculation

  1. Calculate Total Assets:

    • Sum the fair market value of all the company's assets.
    • Total Assets: €50 million
    • Total Liabilities: €20 million

      Subtract Total Liabilities:

      • Deduct all liabilities from the total assets.

      Example:

  2. NAV = Total Assets - Total Liabilities

Step 5: Reconcile Different Valuations

  1. Compare Valuations:

    • Compare the results from the income, market, and asset-based approaches.
    • Income Approach Weight: 50%
    • Market Approach Weight: 30%
    • Asset-Based Approach Weight: 20%

      Weight the Valuations:

      • Assign weights to each valuation method based on relevance and reliability.

      Example:

  2. Final Valuation = (Income Approach Value * 0.5) + (Market Approach Value * 0.3) + (Asset-Based Approach Value * 0.2)

Step 6: Final Purchase Price

The final purchase price can be negotiated based on the reconciled valuation, considering strategic factors, negotiation dynamics, and the seller's expectations.

Example

  • Income Approach Value: €45 million
  • Market Approach Value: €50 million
  • Asset-Based Approach Value: €40 million
Final Purchase Price = (€45 million * 0.5) + (€50 million * 0.3) + (€40 million * 0.2)
Final Purchase Price = €22.5 million + €15 million + €8 million
Final Purchase Price = €45.5 million
 

Considerations and Adjustments

  1. Synergies:

    • Adjust the valuation to account for potential synergies from the acquisition.

  2. Negotiation Leverage:

    • Consider the relative negotiation power of both parties.

  3. Market Conditions:

    • Adjust for current market conditions and trends.

Final Example

Assume after detailed calculations and adjustments, the fair value is determined to be €45.5 million. Negotiations might then adjust this figure up or down based on additional factors such as strategic fit, urgency, and competitive bids.

By following these steps and employing a combination of valuation methods, you can arrive at a well-supported purchase price for acquiring a company in the Netherlands. What would for example a company based in the Netherlands with a yearly turnover of 2 million and a profit of 100K and they are in IT tech focused on Telecom.

Example Valuation for a Dutch IT Tech Company in Telecom

Let's walk through the valuation process for an IT tech company in the Netherlands with a yearly turnover of €2 million and a profit of €100,000. This company operates in the telecom sector.

Step 1: Understand the Valuation Approaches

We'll use three primary valuation approaches to determine the purchase price:

  1. Income Approach
  2. Market Approach
  3. Asset-Based Approach

Step 2: Income Approach

Discounted Cash Flow (DCF) Analysis

  1. Forecast Free Cash Flows (FCF):

    Assume the company will continue to grow. For this example, we'll project growth over the next 5 years.

    • Revenue Growth Rate: Assume a 10% annual growth rate.
    • Operating Margin: Historical operating margin is 5% (€100,000 profit on €2 million revenue).
    • Capital Expenditures: Assume 5% of revenue.
     
    Year 1: Revenue = €2 million * 1.10 = €2.2 million
    Operating Profit = €2.2 million * 0.05 = €110,000
    Capital Expenditures = €2.2 million * 0.05 = €110,000
    FCF = €110,000 - €110,000 = €0

    Year 2: Revenue = €2.2 million * 1.10 = €2.42 million
    Operating Profit = €2.42 million * 0.05 = €121,000
    Capital Expenditures = €2.42 million * 0.05 = €121,000
    FCF = €121,000 - €121,000 = €0

    Year 3: Revenue = €2.42 million * 1.10 = €2.662 million
    Operating Profit = €2.662 million * 0.05 = €133,100
    Capital Expenditures = €2.662 million * 0.05 = €133,100
    FCF = €133,100 - €133,100 = €0

    This simplified example assumes no significant free cash flow in the initial years due to capital expenditures equaling the operating profit.

    • Cost of Equity: Assume 10%
    • Cost of Debt: Assume 5%
    • Equity to Debt Ratio: 70:30

      Determine the Discount Rate:

  2. WACC = (0.10 * 0.7) + (0.05 * 0.3 * (1 - 0.25))
    WACC ≈ 0.085 = 8.5%

  3. Calculate the Present Value of FCF:

    Due to the FCF being €0 in the first three years, we'll focus on the terminal value.

  4. Estimate Terminal Value:

    Assume a terminal growth rate of 2%.

    Terminal Value = (FCF * (1 + Terminal Growth Rate)) / (WACC - Terminal Growth Rate)
    Terminal Value = (€133,100 * 1.02) / (0.085 - 0.02)
    Terminal Value ≈ €2.1 million

  5. Sum the Present Values:

    Since the FCFs for the first three years are zero, the total enterprise value will primarily come from the terminal value.

    Present Value of Terminal Value = Terminal Value / (1 + WACC)^3
    Present Value of Terminal Value ≈ €2.1 million / (1.085)^3
    Present Value of Terminal Value ≈ €1.68 million

Step 3: Market Approach

Comparable Company Analysis (CCA)

  1. Identify Comparable Companies:

    Find similar companies in the IT tech and telecom sector with known multiples.

  2. Calculate Valuation Multiples:

    Assume the comparable companies have an average EV/EBITDA ratio of 10x and a P/E ratio of 15x.

    • EBITDA: Assume EBITDA is similar to operating profit due to minimal depreciation/amortization. Thus, EBITDA ≈ €100,000.

      Apply Multiples to the Target Company:

  3. Company Value (EV/EBITDA) = €100,000 * 10 = €1 million
    • Earnings: €100,000
     
    Company Value (P/E) = €100,000 * 15 = €1.5 million

Step 4: Asset-Based Approach

  1. Calculate Total Assets:

    • Assume the company’s assets include equipment, software, and working capital, totaling €500,000.

  2. Subtract Total Liabilities:

    • Assume liabilities amount to €200,000.
     
    NAV = €500,000 - €200,000 = €300,000

Step 5: Reconcile Different Valuations

  1. Compare Valuations:

    • Income Approach (DCF): €1.68 million
    • Market Approach (EV/EBITDA): €1 million
    • Market Approach (P/E): €1.5 million
    • Asset-Based Approach (NAV): €300,000

  2. Weight the Valuations:

    Assign weights based on relevance and reliability:

    Final Valuation = (DCF * 0.5) + (EV/EBITDA * 0.2) + (P/E * 0.2) + (NAV * 0.1)
    Final Valuation = (€1.68 million * 0.5) + (€1 million * 0.2) + (€1.5 million * 0.2) + (€300,000 * 0.1)
    Final Valuation = €0.84 million + €0.2 million + €0.3 million + €0.03 million
    Final Valuation ≈ €1.37 million

Step 6: Final Purchase Price

The final purchase price should consider strategic factors, negotiation dynamics, and potential synergies. If significant synergies are expected from the acquisition, the buyer might be willing to pay a premium.

Example

Assuming moderate synergies worth €200,000, the final offer might be:

Final Purchase Price = €1.37 million + €200,000 = €1.57 million

 

Conclusion

In this example, after considering various valuation methods and strategic factors, a fair purchase price for the Dutch IT tech company focused on telecom would be approximately €1.57 million. This calculation incorporates projected cash flows, market comparisons, and the company's net asset value, ensuring a comprehensive valuation approach.
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