Dealing with Inorganic Growth in Valuations Based on Market Approach

It is a challenge to apply the market-based approach while valuing companies showcasing high inorganic growth or participating in an acquisitive industry. Analysts should be mindful of the accuracy of market information, fairness of precedent transactions, projections of the subject company, and transaction economics of the acquisition pipeline.

Most organizations target evolution and expansion as long-term objectives. While some tread the organic route to achieve these aims, others may follow an inorganic growth plan. Companies operating in an acquisitive industry (for example, the US cannabis industry, which features frequent, multiple acquisitions) have created a need for business valuations as well as complexities in such valuations.

In business valuations, market-based and income-based are the most common approaches. Valuations using the market-based approach are achieved by comparing similar assets. Valuations using the income-based approach estimate a value based on projected future cash flows or earnings. Both approaches have their strengths and weaknesses.

In acquisitive industries, it is exceedingly difficult to predict cash flows and their timing as every transaction brings a step change in the company’s operating performance. In such cases, an income-based valuation becomes speculative. It may therefore not be the best way to value companies in industries with high inorganic growth. Meanwhile, valuations of precedent transactions or publicly listed companies can be considered as reliable benchmarks when applying the market-based approach. However, analysts should be careful when applying this approach.

Current/historical multiples may not result in fair valuation
Historical financial performance of companies with a high rate of inorganic growth may not be a fair representative of their potential. As these companies are acquisitive, their revenue and profitability would change materially. Many are still at the growth stage and, therefore, have limited or negative profitability, which could bring about meaningless multiples. In such cases, historical performance will also not be indicative of future growth opportunities. Hence, it is logical to use forward multiples, instead of relying on historical multiples.

Ensure accuracy of market multiples
In the market-based approach, valuations are calculated by benchmarking multiples or ratios of similar assets. Therefore, it is necessary that the multiples exhibit apple-to-apple comparison between the numerator and the denominator. In an acquisitive industry, companies frequently close or cancel acquisitions. Analysts should therefore ensure that the effect of the transaction has been considered accurately in both components of the multiples. In stock deals, the enterprise value is estimated after considering market capitalization, which in turn depends on outstanding shares and share price. Once an acquisition is announced, analysts often add the target company’s revenue to the acquiring company’s revenue estimates, without making adjustments for outstanding stock. In other words, revenues are reflected in the enterprise value (EV)/revenue multiple, but shares to be issued after the transaction are not. Consequently, market capitalization of the acquirer is understated, resulting in inaccurate multiples.

Adjust valuations for consideration to be paid for ongoing acquisitions captured in projections
While valuing companies with high inorganic growth, it is important to ascertain the consideration to be paid for transactions continuing beyond the valuation date. As the benefits of the acquisition would be captured in the multiplier, it is imperative to adjust the valuation for any pending consideration or earn-outs. For instance, if the valuation is based on EV/revenue multiples and the revenues considered for calculation include the amounts of ongoing acquisitions, the valuation arrived at is after the benefits of the transaction accrue. So, any payments to be made at a future date should be deducted from the EV estimated thus. The principle followed here is like that of arriving at pre-money valuation from post-money valuation, where the amount of funding raised is deducted.

Understand acquisition motive and, thereby, synergies
The most common motives for acquisition are expansion or growth. Understanding the motive of the transaction helps estimate and value synergies accurately. Other motives for acquisition may include a company’s need to increase product lines, acquire resources, benefit from government schemes, and to diversify. Synergy is the incremental value generated when two companies combine. Hence, it is essential to incorporate these synergies into the valuation by adjusting the multiple or multiplier reasonably.

Ensure precedent transactions are not overvalued
In an acquisitive or sunrise (read inorganic-growth-led) industry, there is much demand to acquire other companies. Due to this high demand, paying a premium is common in such transactions. In such industries, there is also a possibility of transactions being based on market sentiment, instead of rigorous fundamental analysis. In such cases, the fairness of the transaction is questionable. For instance, there have been several acquisitions in the cannabis industry over the past few years. In this industry, the popular mode of consideration is stock. However, cannabis companies’ stock prices have been volatile in the past couple of years. Consequently, it is probable that some acquisition transactions were overpriced. Analysts should therefore be careful while shortlisting precedent transactions in an industry featuring high inorganic growth. An incorrect pricing of these transactions could lead to unreliable valuation results.

Ensure minority interests are considered in valuation
While valuing companies with a pipeline of acquisitions, analysts should review the economics of ongoing transactions. They should scrutinize areas where the subject company would not be acquiring a 100% stake, but only a controlling one. In such cases, if the financial estimates of the subject company include a 100% contribution from the expected transaction, an adjustment for the minority interest is necessary. Analysts should separately calculate the value of the minority interest and deduct it from the value estimated otherwise.

Conclusion
The fundamentals of companies engaged in a high inorganic growth industry may differ significantly from those in other traditional or mature industries. Traditional methods of valuation, if applied without right judgement, may not result in a meaningful analysis for companies in a high growth stage. Thus, appraisers need to apply significant professional judgement and industry expertise while valuing businesses taking the inorganic route to growth.