Do you immediately skip to the back of the CIM and start working through the company’s financials? You’re not alone. Confidential information memorandums (CIMs) can be onerous documents, often more than 100 pages of text, charts, and figures.
It’s tempting to skim most of it. But by taking more time to read about the company, its operations and its industry, you may find a story that can help you better determine the value of the company.
When MergerMarket, in partnership with Firmex, interviewed senior executives involved in M&A, 40 per cent chose “relying too much on the financials and ignoring the intangibles of a target” as the most dangerous bias in valuation. Clearly, practitioners see the value of looking beyond the financials.
“The funny thing about ‘hard numbers’ is that they can give a false sense of security,” says prominent venture capitalist Bill Gurley in a piece about valuing Uber, in which he demonstrated the importance of narrative in the valuation of a company.
Gurley argued that, in order to properly value Uber, you had to consider network effects. As Uber’s business grew, it would experience higher usage, faster pickup times, and greater coverage density. These factors would make its services more valuable, causing an increase in the total available market for its services. This increase in market size resulting from the growth of Uber itself needed to be factored into its valuation.
Aside from influencing the numbers used for valuation, a narrative can help determine if an acquisition will be a good fit for a strategic buyer and help evaluate the story being told by a target company and its bankers. WeWork, for example, described itself as a disruptive technology company that would change the way people work. But in reality, it’s a space-as-a-service firm.
Uncovering the Company Narrative
The CIM provides your first detailed look at a target company. How can you uncover the company narrative from the CIM? What is it telling you that may need to be considered when you crunch the numbers?
As you read through the CIM, it can be helpful to think about the potential stories that might affect valuation. Aswath Damodaran, a professor of finance at NYU Stern, identifies seven business stories in his seminal book Narrative and Numbers: The Value of Stories in Business.
These stories include: the “bully” that steamrolls the competition; the underdog that might compete by providing more personalized service; the “eureka moment” company that finds and fills an unmet need in the market; the better mousetrap; the disruptor; the low-cost player; and the “missionary” that values more than just profit and makes money while doing good.
Damodaran suggests looking at whether the company is sticking to the established business model in its industry or if it’s a disruptor. Does the firm have a finite life, such as some family-owned companies or resource firms, or is it a going concern like a publicly traded company?
And you need to think about where the company lies on the growth spectrum. Is it a startup or a mature firm that might even be in a declining industry? What drives profitability, growth, and risk in the industry and for the target firm? You should also look at what types of investments are needed for growth in the industry and how the target firm is investing compared to the most successful firms in the industry.
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Looking for Sustainable Competitive Advantage
There are five competitive forces that determine industry profitability, according to Michael E. Porter in his book Competitive Advantage: Creating and Sustaining Superior Performance, which provides a framework for examining companies and industries. These are the rivalry among existing firms, the bargaining power of buyers, the bargaining power of suppliers, the threat of potential entrants and the threat of substitutes for the product or service.
“The fundamental basis of above-average performance in the long run is sustainable competitive advantage,” says Porter. This happens when a firm deals with competitive forces better than its rivals to create a cost advantage or differentiation either broadly across its industry or in a focused segment of its industry.
Consider the level of differentiation of the target firm from its rivals, whether it’s dependent on one or a few customers or suppliers, and whether it has a broad customer base and access to alternative suppliers. Determine the strength of barriers to entry and the degree to which the firm can keep customers from moving to a substitute product or service.
And finally, to the relief of the number-crunchers out there, sometimes the numbers themselves are the narrative. While narrative is often important for young companies, for more mature companies in stable industries with a long history of solid financials, numbers might in fact be the story.
It’s important to understand whether there’s a narrative that can drive the outperformance or underperformance of the target company. The CIM provides a resource to start to develop this story—if you take the time to look for it.
Illustration by Christy Lundy
