Valuation Master Class: Q&A with Alexandra Lajoux

In the world of mergers and acquisitions, few issues are more vexing than valuation. M&A professionals know all too well that clash of valuation views can be one of the most common obstacles in negotiating an M&A deal. It’s a topic that Firmex, in partnership with MergerMarket, tackled in the report M&A Valuation: Trends, Challenges and Horror Stories. We sat down with Alexandra Lajoux, founding principal of Capital Expert Services, LLC (CapEx), to explore the views in her books. She is the coauthor of all nine books in the McGraw-Hill Art of M&A series, including a title on M&A Valuation and Modeling (McGraw-Hill Education, 2015); and coauthor of Corporate Valuation for Portfolio Investment (Wiley: 2010)

You literally wrote the book – two, actually! – on M&A valuation. What’s the hardest concept for people to grasp about valuing companies?

It’s calibrating the interplay between the known facts of the past and the unknown promise of the future. You need to balance both, but it is not easy.

So much depends on context. The McGraw-Hill book I coauthored with investment bankers Peter and Elizabeth Nesvold presented valuation and modeling in an M&A deal context, focusing on comparative transactions and discounted cash flow. According to Peter and Liz, who are very experienced in this area, these are the only two approaches fully trusted by investment bankers.

By contrast, the Wiley book I did with Robert A. G. (Bob) Monks had a much broader perspective on valuation. Our subtitle was “analyzing assets, earnings, cash flow, stock price, governance, and special situations,” and many of the approaches we presented could be considered “hybrid” methods for valuation. We listed 14 methods. Interestingly, they all included some of all of the same six basic components:

  1. Earnings
  2. Cash flow
  3. Market value
  4. Invested capital
  5. Cost of capital
  6. Some measure for return on capital

Other elements in models include cash on hand, debt, book value of equity, and market value.

In your experience, what is the number one hurdle M&A practitioners face when determining a valuation?

Information—who has it when.

If the company is privately held, the number one hurdle is lack of transparency. Private companies do not publish their financials. Yet the buyer has questions. What are its sales and profits? What level of contribution to each comes from specific products and services?  Who are the main customers for the company and is there any risk of losing a significant one (a major client)? What other risks does the company have? All this information matters for valuation but it is not disclosed in a private company. The potential acquirer may not know the answers unless and until it tips its hand and lets it be known that it wants to acquire the company.

If the company is publicly held, the number one hurdle is just the opposite – it is transparency! Everything that the company publishes in its 10-K is known to all – including other companies that may want to acquire. And at a certain point in negotiations, the target company may be required under federal securities law to disclose that negotiations are underway, giving competitors notice.

Everyone in the industry has a valuation horror story. What’s an example of a recent valuation disaster, in your opinion, and what can it teach us?

I won’t call it a valuation disaster, but I will call it a valuation gamble. It was when Comcast paid $39 billion for 61 percent of U.K. satellite operator Sky on September 22. The deal was financed largely through $29 billion in unsecured bonds—and more debt will be added if it buys the rest of Sky which at this point is very likely. At that point, it will be carrying more than $100 billion in debt. Other large telecomms have such high debt but it is risky, and the market knows it. The day before the announcement Comcast stock was trading at $37.90 per share and following the announcement it dropped and as of this day it has not yet recovered (it’s been in the mid-30s). At an analysts call broadcast on the company’s website on October 25, 2018, Comcast CEO Brian Roberts spent an extra 30 minutes addressing the deal, explaining that the company is banking on “scale.”

M&A professionals have access to better analytical technologies than ever before. Has technology helped make valuation more precise and prevent common blunders?

I would say that technology has enabled dealmakers to consider a greater number of valuation scenarios more quickly, but nothing can make valuation precise or error-free. There will always be a wide range for values and there will always exist the possibility of bets gone wrong.

Models with increasing sophistication can take on more variables and can compute more quickly. Through machine learning, they can also start giving answers based on variables that are not supplied by human programmers, but are learned by the machine in a kind of “black box” impervious to analysis.

These technologies have given dealmakers greater power to model the future. But as Kang and coauthors have noted in the January 2018 issue of the Journal of Organization Design, “M&A values are sometimes endogenously created as a result of the method that firms use to evaluate deals.” In many cases, “the deal does not exist a priori” with an underlying value. Rather, that value can “emerge through the valuation process.”

So technology should be seen and used as an enabler to decisions, and never the source of right answers. Dealmakers must always be ready to explain the reason for their valuation.

M&A practitioners know that it isn’t all about the numbers: mental biases can impact a target’s valuation. In your opinion, what is the most dangerous of these human or cognitive biases, and how can it be overcome?

I like the list featured in the Firmex & MergerMarket survey, starting with the first item mentioned there—over-reliance on financial statements (let’s call it the GAAP trap). As the PE pro cited there said so well, it’s vital to consider “other important factors such as product or service mix, competition, and operational details.” The survey also mentioned anchoring (it worked before, why not now), halo effect (so and so can do no wrong), bandwagon (everyone else is doing it), and groupthink (everyone else is thinking it). I agree that these can distort valuations.

When Bob Monks and I wrote our book on valuation during the last financial crisis we were keenly aware of behavioral finance. Global stock markets lost half their value and then doubled their value during the two years we were writing!

Our appendix in that book had some of these, plus many others, along with valuation tips. I’ll mention some of them here.

Attribution bias
Past successes tend to generate overconfidence. People take too much credit for successes and too little blame for failures; they attribute successes to their own prowess but failures to forces beyond their control.
Don’t assume that, because a company has done well in the past, it will do well in the future; differentiate between the root causes of success and flukes.
Cognitive dissonance
This is a state of mind in which contradictory ideas and/or actions coexist.
Make sure your valuation decisions match your valuation findings.
Confirmatory bias
People have a tendency to overweigh data confirming prior beliefs while dismissing data contradicting prior beliefs.
When you select formulas or variables for valuation, be willing to go against the grain of your own past approaches. Don’t pick only the indicators that make your investment choice look good.
People to change their behavior as a result of pressure from others—similar to the bandwagon mentioned earlier.
Don’t pick a particular valuation approach, or adjust a value within that approach, just because others are doing so.
Control illusion
Many suffer from the false belief that they have control over something uncontrollable. Conformists are likely to rationalize.
When creating a valuation formula, remember to factor in uncertainty.
Disposition effect
When an investor overvalues a company and refuses to sell its stock even though its pricing is steadily declining, this irrational behavior is called the disposition effect.
If a company’s securities keep losing value, recheck your valuation assumptions (e.g., strength of earnings, discount rate for future cash flow, etc.) and consider downgrading them.
Emotional attachment
Sometimes emotional attachment to an investment position masquerades as the exercise of discretionary judgment. One study showed that investors who fared best during a recent market downturn had restrictive rules that prevented them from holding on to stocks (for emotional or other motives) that did not meet the criteria.
If your gut instinct always results in faulty valuation (and hence faulty investment choices), try using and sticking to stricter criteria.
Group thinking
Different answers given by individuals converge to a single answer when the individuals are in a group.  Also, individuals sometimes give wrong answers in order to conform to group norms.
When valuing company worth, keep marching to the beat of your own drum.
People are generally optimistic. In one study, undergraduates were asked to relate how likely various life events were to happen to them. The result: students systematically thought that good events were likely to happen to them while bad events were more likely to happen to other students.
When you like an industry or company, be especially careful not to minimize weak areas and downsides.
Cognitive dissonance causes people to rationalize actions that differ from their own preferences. Conformists are more likely to rationalize.
If you find yourself making too many exceptions to your valuation rules, check your motives.
Self-serving biases
People reach conclusions about reality (including their own skills) that favor them.
As you set a value, ask yourself, what’s in it for me? If there is something in it for you, make an adjustment to eliminate the bias.

There are also a great number of fallacies in logical reasoning that we listed, which are too numerous to mention.

It’s called the IKEA effect – the tendency to place a disproportionately high value on things that you build yourself. How can M&A advisors manage unrealistic valuation expectations from sellers who have spent years building their business?

First of all, they can acknowledge the value that the founder has added to the products, services, and culture, adding to the brand value of the company. Buyers can point out that the price they are paying is much higher than liquidation value, which would be X (calculate this and show your math).  So make the point that you are paying for entrepreneurial genius and sacrifice. Show the margin of difference in a big, accurate number. That will set the stage for positive dialogue.

Dialogue is very important, and the following points may or may not be appropriate to raise, but are certainly valid points:

  1. The founder did make sacrifices but, at the same time, the journey was its own reward and has clearly been successful.
  2. Just because the founder spent X amount of money (and/or Y years) building the business does not mean that it is worth that money and time. Business conditions change and what cost X or Y to build in the past may not cost that today.
  3. If the founder is so confident that the business is worth a large premium (over the fair market value that the acquirer is proposing) then would the founder consent to be paid a down payment now and then receive contingency payments on the future, based on sales?

Recently, we’ve seen tech valuations go through the roof. Why do you think this is happening and is the hype in this hot sector warranted?

This is just a hunch, but I believe that large tech stocks are overvalued, as are the prices they are paying for small tech companies that they take over. The only undervaluations are occurring in mid-cap companies that are making high-value adaptive use of a substantial tech component but are not pure tech companies.

I say this because I foresee future antitrust regulation against large tech that will chip at their profits and hamper their pure tech dealmaking. This will create market space for mid-cap.

Is it more difficult to arrive at a valuation in a strategic deal rather than in a strictly financial one?

Yes, because one is valuing two or more companies in combination, not just one freestanding company with a new cash infusion. Also, in the typical case, outcomes depend on the quality of integration, which is difficult to manage and therefore predict. Remember: When you set a value on a deal you are never just evaluating the deal, you are predicting the future.

Alexandra Reed Lajoux is chief knowledge officer emeritus at the National Association of Corporate Directors and founding principal of Capital Expert Services, LLC. She has served as editor of Directors & BoardsMergers & AcquisitionsExport Today, and Director’s Monthly, and is coauthor of all books in the McGraw-Hill Art of M&A series, with titles on strategy, valuation, financing, structuring, due diligence, integration, bank M&A, and distressed M&A. Dr. Lajoux, who serves on several advisory boards, holds a B.A. from Bennington College, a Ph.D. in comparative literature from Princeton University, and an M.B.A. from Loyola University in Maryland.


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