What are the risks of using different deal closure valuation methods?

While considered to be an important approach, especially for income generating properties, it is important to bear in mind that this approach may not reflect the true value of the property, especially for tangible assets, which are under-utilized / super-adequate / have spare-capacity, or due to characteristics of the property that are not intrinsically linked to the income generating capability (e.g. location and or physical condition, future development potential etc). The future cash flow projections need to be carefully evaluated, and adjusted for market conditions and ongoing changing scenario. Management efficiency also has bearing on the income generating capacity of the property.

One time at work: Utilizing the DCF method for deal closure underscored the importance of thorough due diligence. While it offers insights into intrinsic value, navigating uncertainties and subjective assumptions demands meticulous analysis to mitigate risks effectively. On my experience: DCF provides a comprehensive view, its reliance on assumptions necessitates a balanced approach, combining quantitative rigor with qualitative insights to mitigate potential discrepancies. One thing I found helpful: DCF highlights the need for robust sensitivity analysis. By stress-testing key assumptions and scenarios, stakeholders can better understand the potential impact of uncertainties, enhancing decision-making and deal negotiations.

In my experience, The DCF (Discounted Cash Flow) method is a widely used valuation method that estimates the present value of a company based on its future cash flows. However, it has inherent risks due to assumptions of growth rates, terminal values, and discount rates which leads to uncertainty and subjectivity into the valuation process, potentially causing over or underestimation of the company's value. To mitigate the risks of assumptions due diligence is crucial. This involves validating and analyzing the assumptions by considering the company's historical performance, market conditions, and industry trends. Further, conducting sensitivity analyses can help identify potential variations in valuation based on changes in assumptions.

The DCF method can be a powerful tool, but it's crucial to tread carefully. In today's dynamic business environment, those assumptions about growth rates, terminal values, and discount rates can be especially tricky. Economic conditions, market disruptions, and even unexpected events like a pandemic can throw a curveball into those projections. So, staying adaptable and regularly revisiting your assumptions is key to ensuring an accurate valuation.

If you need DCF to evaluate the deal, you’re in a super conservative private equity sector or one with highly predictable cash flows like huge infrastructure businesses! It’s a tool I suspect is used more in listed company M&A or in PE purely for quarterly comparable reporting. Majority of deal flow is between PE funds, they are working on a similar basis. It can be useful to take the DCF as a benchmark and then model the impact of different drivers within the business. I very much doubt there are many in PE using it to value though, it’s a multiples business (albeit they are in themselves often reflections of DCF at a basic level!) It will be used for modelling, but typically at the point of thesis for a particular strategy in a sector.

The comparable multiples method, while straightforward, comes with risks like comparability issues, market volatility, and the impact of outliers. Proper adjustment and consideration of these factors are crucial to avoid distorted or misleading company valuations.

Multiple based valuation is very challenging, and especially in private equity where true deal price and terms are often not understood (unlike public market deals) for comparables. Maybe 8x multiple would seem high for a business only doing ￡900k EBIT. If that business is high growth (40% YoY) with all recurring revenue streams & a strong second tier management, suddenly that 8x might not seem too bad. E.g. It might be preferable to a ￡2m EBIT at 6x with little to no growth YoY & being run lean. Earnings and capital value in the first example could easily outpace the 2nd in a few short years. High growth businesses with predictable cash flows attract the best multiples for good reason, but it’s highly specific to each business.

To mitigate these risks, practitioners should conduct thorough due diligence, carefully select comparable companies based on relevant criteria, adjust for differences in business fundamentals and market conditions, and complement the Comparable Multiples Method with other valuation approaches to triangulate the target's valuation. Additionally, sensitivity analysis and scenario testing can help assess the impact of key assumptions and mitigate valuation uncertainty.

Relying solely on comparable multiples for valuations is akin to navigating with an outdated map. While it provides a quick benchmark, it often overlooks the unique attributes and future potential of a target. It's vital to not just look at the numbers but to understand the stories behind them—why a multiple might be higher or lower for a similar company, and what that means for the one you're evaluating. Diving deeper into operational efficiencies, market positioning, and growth prospects gives a fuller picture, mitigating risks and leading to more informed decisions.

Based on my experience, The transaction multiples method involves analyzing prices paid for similar companies in recent transactions and applying a multiple to a financial metric. However, this method carries some risks. Comparable transactions may be scarce, making it challenging to find accurate valuation benchmarks. Timing and context must be considered to account for market fluctuations and economic conditions. Data quality is crucial, as flawed or incomplete data can lead to misleading valuations. To mitigate these risks, detailed due diligence is important. Careful selection of comparable transactions, validation of data can lead to a more accurate valuation.

See above my comment on comparable multiples, it’s the same issue. Deal values are often not represented correctly or known in private equity. So the very starting point is flawed. Add to that the highly specific nature of the target business. Geographies, horizontal sectors to the comparable, efficiency and free cash flow, IP, quality of the team etc etc. It’s far too basic a method. I take the generic multiples I know will apply to that type of business size and sales led vs recurring or repeat revenue and then add or subtract using my own reference of key value drivers and then weight them. And even that is just a ‘discovery call’ model; ultimately it’s about the quality, predictability & scale of free cash flow plus YoY growth model.

(a) Risk - Using multiple methods increases the complexity of due diligence and can extend deal closure timelines. Mitigation - Streamline due diligence by prioritizing the most relevant valuation methods for each deal (b) Risk - Inconsistent valuation practices can erode investor confidence and trust in your fund. Mitigation - Communicate your valuation methodology clearly to investors and demonstrate a commitment to best practices (c) Risk - Differing valuation methods may affect the alignment of exit strategies with initial investment goals. Mitigation - Regularly review and adjust your exit strategy based on the most appropriate valuation method for each investment.

Regardless of the valuation method involved, if I can’t see how to make capital growth on the equity at the very least, within 3years I walk away. The multiple might be high, but if the growth factor is good and you can enhance value through the efficiency of ops and make the future revenue stickier - you can increase the multiple and EBIT during the period and dispose. Helping the target understand what drives the values and our decisions is a key part of the negotiation. Often you’re combatting inflated generic appraisals of the value by a third party with differing levels of experience. You have to balance the risk and reward view from both your side and the other side. You have to take them on a journey in both the figures and emotion.

Stay informed about industry trends, market conditions, and macroeconomic factors that may impact valuation multiples. Consider the cyclicality, seasonality, and long-term growth prospects of the target industry when interpreting valuation metrics. Conduct sensitivity analysis to assess the impact of changes in key assumptions (e.g., growth rates, discount rates) on the valuation outcome. Identify critical variables and scenarios that may affect the reliability of the valuation and evaluate their implications.

Conduct comprehensive due diligence on both the target company and the selected comparable companies. Evaluate key financial metrics, growth prospects, competitive positioning, and industry dynamics to ensure comparability. Choose comparable companies that closely resemble the target in terms of business model, size, growth trajectory, and industry dynamics. Make appropriate adjustments to the valuation multiples to account for differences between the target and the comparable companies. Adjustments may be needed for factors such as growth rates, profitability margins, capital structure, risk profile, and market conditions.

(a) Used for companies with complex capital structures or contingent assets, this method's risk lies in its reliance on volatile market variables and assumptions about future volatility. An investment in a company with significant patent potential I was involved with highlighted how changes in market sentiment dramatically affected the perceived value of its options, leading to valuation volatility (b) Valuing assets based on contingent outcomes (e.g., milestones, regulatory approvals) can introduce significant uncertainty. A biotech firm we evaluated faced this issue when future cash flows from a drug under development were overly optimistic, not fully accounting for the regulatory and clinical trial risks.

Valuations in the lower mid-market (￡1-5m EBIT) are as much about emotion as valuation, especially if the original founder is still involved. Their focus might be how quickly they can exit, the earn-out structure, how well their team/clients/suppliers are looked after etc etc, as much as price. I always speak to shareholders about price and terms being inverse. You can have one side of the equation, but not the other unless you are very special indeed (and not likely one of my targets). If you want a certain price and it’s not outrageous, then you need to let me dictate terms (less up front, longer deferred etc). If you want the best terms, maybe 80% day 1 and a years deferred then the price is mine and it’ll be lower end of the scale.