Establishing the purchase price for a company transaction

Ahead of a company takeover, regardless whether you are buying or selling, one of the core questions is, what is a suitable purchase price, and how you can derive this from the figures of the entity being sold. The variety of approaches to finding a reasonable purchase price often range from the value of the equity, value of the material assets (net asset value), application of the future income stream method or a discounted cash flow method, to a market-oriented purchase price estimate using multipliers (or "multiples"). Especially these last two methods (discounted cash flow method and application of multiples) have become common in the mergers and acquisition market, and are now the most commonly used in Germany. Both methods initially involve the calculation of a company value, although this very rarely corresponds to the final cash purchase price.
In this article, we take a brief look at the theoretical approaches of these two valuation methods, before briefly explaining what adjustments are usually made to the company value in order to reach the final purchase price.

Discounted cash flow

The discounted cash flow (DCF) method calculates the company value by discounting the free cash flows. When applying the DCF method, a fundamental distinction is made between two calculation approaches: the gross method and the net method.

In the gross method, the company value is calculated in two steps. In the first step, the entire company value is determined by discounting the free cash flows arising in each of the individual planning years. As a second step, the value of equity is then calculated. In practice, the distinction between enterprise and equity value is elementary, and often leads to misunderstandings.
Unlike the gross procedure, when using the net method, the company value is calculated in a single step. For this calculation, the cash flows, which are received by the owners of the equity, are discounted to a present reference date. The discount rate used is the interest rate which the equity holders use to compare returns on equity for investment alternatives.

Multiple valuation

In the case of a multiple valuation, typical KPIs from the company's figures are collected and compared with those from a peer group. Valuation multiples can, for example, refer to the ratio of company value to turnover, or the ratio of the company value to the EBITDA or EBIT. Sales volumes are often used in situations in which companies are not yet profitable. The approach used most frequently in the market is the EBITDA multiple valuation, since EBITDA represents the closest value to cash from the profit and loss account, and is independent of the financing and tax structure. The multiples used are either derived from listed companies or by looking at comparable transactions.

As already indicated, the company value calculated by means of the procedures described above will only, in the rarest cases, turn out to be the final purchase price. This poor match results especially from two mechanisms that are also taken into account when determining a purchase price: the cash free debt free basis, and the working capital basis.

Cash free debt free basis

For the cash free debt free basis the liquid items (cash) of the entity being sold are netted off against its (interest-bearing) liabilities (debt). The sum of both items ("Net Debt" or "Net Cash" depending on the net balance) is deducted from or added to the company value. The definition of Net Debt and Net Cash often leads to heated discussions between sellers and buyers (see also the September 2019 issue of the M&A Dialogue newsletter).

Working capital basis

The working capital basis ensures that the timing of the sale/purchase does not play a role. It is agreed that the entity being sold should be transferred with the average working capital (current assets) required for operations.
 

If the working capital is lower than the average required on the transaction date, the purchase price is reduced by the difference between the reference date and the average, or is otherwise increased.

Conclusion

There are various valuation methods that can be used in establishing a purchase price. Irrespective of the method selected, it is important to understand that adjustments are frequently applied to the calculated company value, and buyers/sellers should come to an agreement about these at an early stage.