The values of private companies are expressed as a multiple of EBITDA (earnings before interest taxes depreciation and amortization). Several variables, both internal and external, effect the multiple and thus the fair value of a private company. This article highlights those factors MCM considers most influential in our evaluation of a potential acquisition candidate. Although this article will discuss each of these individually, these factors are inter-related and must be taken as a whole in assessing value.
Internal factors are those indigenous to the company that shareholders and management have the most control over. These include: strength and breadth of the management team, financial track record, competitive advantages, and customer concentration.
- Strength and breadth of management team. As investors and board members MCM believes we add value to our portfolio companies, but ultimately the success or failure of any investment is dependant on the skill of the management team. Thus, MCM’s investment analysis always starts with an assessment of the CEO and overall strength of the management team. Although the CEO is the key driver in any business, our evaluation includes an assessment of executives in the key functional areas of sales, engineering, operations and finance. The stronger and deeper the management team, the more inclined we will be to assign a premium valuation to the Company.
- Financial track record. This rather broad variable covers several areas of specific interest including the company’s historical levels of profitability, sales and earnings growth, and cash flow from operations. MCM uses these historical financial measures to assess the current management team’s capability and as an indicator of expected future financial performance. A private company with a strong record of profitability and growth will command a higher multiple of operating earnings than an average performer.
- Competitive advantages. A company’s competitive advantages will be considered in the process of determining value. These competitive advantages can take many forms including, but not limited to, superior brand recognition, proprietary products or processes, rapid turnaround times, broad product lines, unusually strong distribution, and extremely efficient operations.
- Customer concentration. Companies with higher levels of customer concentration will tend to command lower multiples for the simple fact the business is more likely to be materially affected by the loss of a prominent customer.
External factors also play a role in determining fair value. Those we deem most relevant include the growth and cyclicality of the target’s industry and the existing supply of acquisition capital.
- Growth and Cyclicality of Industry. Companies, which compete in growing, less cyclical markets will command a higher multiple than a company which operates in a mature cyclical industry. This is particularly true if the market perceives the industry cycle is at or near its peak. For example, MCM reviewed a heavy duty truck component supplier which had experienced steady growth in sales and earnings for the prior five years, had a solid, experienced management team and had a excellent reputation in the marketplace. These factors would seem to dictate the Company receive a premium multiple of earnings, however, the Company competes in a highly cycle industry which, according to a number of analysts and supported by certain forward indicators, had peaked and was softening. As a consequence, we proposed a valuation and capital structure designed to weather the impending industry downturn. Certainly, these same attributes can be seen in the public markets that value cyclical stocks more conservatively than, for example, growth stocks. Specifically, steel, automotive, and construction related companies generally command average multiples, which are typically more conservative than the prevailing average market multiples.
- Supply of Equity & Debt Capital. The private equity markets are subject to the laws of supply and demand. Thus, the supply of capital, relative to the supply of potential transactions, will impact company valuations. Record amounts of private equity capital has been raised over the course of the prior few years with 2006 posting another record of capital raised totalling $150 billion.
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