Among the many forms of financial wizardry, valuing companies is a dark art. It combines complex financial skills with the ability to predict the future; it’s an unusual amalgam of statistics and crystal ball gazing.

The FTSE-100 building materials group, Wolseley, has a fair few practitioners of the dark art of valuation on its payroll. That’s because it aims to make half its growth every year from acquisitions, which translates into an improbable number of deals and an annual acquisition budget of close to half a billion pounds.

So far this year, the company has made 44 acquisitions. Buying this many companies each and every year means Wolseley has honed its valuation process to a wrinkle-free procedure, says its group finance director, Steve Webster.

“We have a rigorous, well-defined process that is applied to an acquisition whether it is large or small. We have a standard approach to valuing companies that includes a key return hurdle that has to be cleared for the acquisition to go ahead,” says Webster.

Wolseley tends to acquire small companies in a highly fragmented marketplace and so it rarely comes into competition with private equity firms.

But other publicly quoted companies are finding that they lock horns ever more frequently with private equity giants like Blackstone and KKR as their fiscal firepower has increased over the past decade.

Talk to any corporate finance practitioner and the message is resoundingly clear: private equity has shaken up almost every aspect of the M&A market, including the way that acquisitions and disposals are valued.

Doug McPhee, a partner at KPMG’s corporate finance division, says: “There has been a lot of ill-will from the big trade buyers towards private equity on two fronts: first, because private equity firms have been able to offer higher prices for acquisitions and, second, they are not affected by IFRS rules on goodwill treatment.”

New changes to IFRS means the company cannot simply lump all of the difference between the price it paid and the net asset value of its acquisition into goodwill.

Amortisation charges

The price now has to be apportioned to individual assets like brands and patents. These are then amortised, which has an impact on a company’s earnings per share. A private equity company has no public investors and rarely any profits left after interest charges so it is less concerned about the impact of amortisation charges.

Steve Taylor, head of UK valuations at Ernst & Young, isn't convinced that IFRS is having any real impact on pricing. “The new accounting rules haven’t changed the way deals are valued or priced, but companies are now thinking about the kind of accounting they will have to live with after an acquisition has been made,” he says.
The increasing might of the private equity sector has also had an influence on the kind of valuation methodologies that are used to assess what price to pay for another company.

Peter Clokey, partner of the valuation group at PricewaterhouseCoopers, says: “If you go back to the turn of this century, the typical purchaser was a trade buyer and they tended to value by P/E ratios and often had simple rules of thumb. I remember one major public company chairman who said: ‘I always pay one times turnover, it’s a rule that has worked for me throughout my business career.’”

Scroll on to today and the influence of private equity means that the M& A world has had to come to terms with the concept of valuing a company using EBITDA (earnings before interest, tax, deprecation and amortisation) in combination with enterprise value.

This is the tool of choice for private equity as it gives the best snapshot of the underlying value of the business, capturing its enterprise value rather than the worth of its equity. Private equity (belying its name) is highly leveraged, so much of its businesses’ operating profit will be swallowed up servicing interest charges. “This means that the net profits are often negligible and, therefore, older methodologies like P/E multiples are meaningless.”

Along with a focus on different methodologies, valuation techniques have also become increasingly sophisticated as more financiers have taken higher level qualifications, in part to meet the increasing demand by private equity for complex financial skills.

Clokey admits that even the most sophisticated valuation method does not change the fact that these tools are just trying to make an educated guess at the future. “A more sophisticated tool is only giving you a mildly better crystal ball,” he says.
But he still thinks it is important for finance directors to embrace the more complex valuation methodologies. “I think people criticise valuation tools like discounted cash flow because of the number of assumptions it involves. This overlooks the fact that those assumptions are4 implicit in a simpler multiples analysis. DCF is a useful tool because it makes you stop and think about those assumptions, forcing you to make a more in-depth analysis of the business.”

It’s been unemotional

For Webster, the key to Wolseley making a successful acquisition is to ensure that there is a step-by-step process from identifying a company as a potential acquisition target through to monitoring its integration within the firm several years after it has been bought.

“Part of the role of our central team is to take the emotion out of making acquisitions; it is very easy for people to fall in love with deals. You do need an independent check on that process,” says Webster.

Rather than being reliant on any one valuation methodology, Wolseley tries to work out what the performance of that company is likely to be under its ownership, says Webster. “It is very important that you are able to independently assess within the company what is the right acquisition and that you don’t rely too much on external advisers to give you that analysis.”

A key part of assessing what price a company can afford to pay for a particular company depends on how expensive it will be to finance a deal. Private equity has had a bigger impact on the way M&A deals are financed than on any other aspect of the market.

Nick Naylor, a director of corporate finance at the investment bank Noble, says: “Private equity is much more comfortable with higher levels of leverage and debt and, as a result, is often able to pay more. A lot of trade buyers feel uncomfortable when gearing levels get too high, especially at the levels that private equity operates.”

Trade buyers used to be able to beat private buyers when it came to a gloves-off battle for ownership of a company. The trade buyer could afford to pay a higher price for a company because the synergies from acquiring a company would offset any premium paid.

But private equity’s use of high levels of leverage and sophisticated financing means that it can often afford to pay more than trade buyers. Institutional investors have also become increasingly cynical about how much synergy can be extracted from an acquisition and questioned boards more sharply about the financial benefits of a deal.

In recent years, debt has become very cheap and public companies have faced another disadvantage with private equity ­ higher financing costs. The weighted average cost of capital a public company uses to fund an acquisition is composed of two components ­ the cost of the borrowing and the cost of equity.

David Bezem, managing director at Close Brothers corporate finance, says it is the cost of equity that makes a public company’s financing costs often higher than for a private equity firm. “The estimate of the cost of equity tends to be higher than the cost of debt finance because of equity’s risk premium to the normal market rate of return,” he says. As private equity uses more debt than equity, they have a lower cost of capital and so a lower hurdle rate.

“The most disciplined public companies have always had a clear view of their cost of capital and using that as a benchmark for the benefits of making a particular acquisition,” Bezem says.

Wolseley is one such highly disciplined company; it keeps its eye on a very specific return criteria. “For a smaller acquisition, we require a return on gross capital employed which is not less than 5% more than the pre-tax weighted average cost of capital within the first three years,” says Webster. The target is designed to make sure the company is adding sufficient shareholder value ­ sooner rather than later, so as to avoid so-called ‘hockey stick’ payback projections.

Fighting back

Despite having to adhere to such a strict return policy and being prepared to walk away from deals if prices get pushed too high, Webster says that trade companies can fight back against the dominance of private equity in the M&A market. “We probably compete three or four times a year with private equity for a company,” he says.

The market may be sceptical about just how high a level of synergies can be extracted from a merger, but Webster says that a trade buyer is much better placed to shake out the highest level of benefit from an acquisition. “It is also much easier to create value from buying a smaller company because there is immediate integration and no cultural conflict,” he says.

Wolseley also gets round the issue of higher financing costs by using its financial strength to get access to low-cost debt and using that rather than equity to finance its deals. This puts it on a level playing field with private equity.

There can also be advantages to being a trade buyer. “The owners or the managers of the business that we are looking to acquire sometimes prefer to be bought by a trade buyer. We understand the industry and they know they can learn from other people in the same sector.” That can also help Wolseley to get better value from the acquisition as the management then feels highly motivated to improve the sales and the profitability of the business.

Help for the trade buyer competing against private equity may also be on hand from the financial markets: the recent wobbles in the debt markets mean that the days of cheap debt financing for private equity may be numbered. Now could be the time for the financial wizards at public companies to get out there and once again practise the dark art of valuation.