Getting Under the Hood of Company Valuations in M&A
Dr. Carsten Lehmann, Managing Director at IMAP Germany shares valuable insights into the key factors affecting company valuations in M&A, using the IT & Software sector as an example. Looking at the many different company segments in the digital industry, he outlines the criteria directly influencing M&A multiples, including sustainability, growth rates and the business model, and examines the increasing importance of conveying the right equity story.
“What can be digitized will be digitized!” – Products and services based on digital technologies increasingly determine the way we communicate and work. The entire industry has experienced an enormous upturn in recent years and is – compared to many sectors of the “old economy” – expected to see strong, above-average growth in the foreseeable future. This is reflected in company valuations that we observe both on the stock market and in M&A transactions. Many of the most valuable companies in the world are “digital companies” (Apple, Amazon, Microsoft, Alphabet, etc.) and their total share value has also risen significantly in relation to turnover and reported earnings.
What makes a company particularly successful? What are the key factors for high valuations? What criteria can be used to distinguish between companies valued higher or lower than others? These questions are just as relevant beyond the IT and software industry – both for investors and for shareholders of companies who are dealing with strategic issues such as raising equity or selling their company.
Valuation of Listed IT & Software Companies
There are numerous ways to segment companies in the digital industry. At IMAP Germany, we have opted for a segmentation that considers main differences in terms of business model, type of service or product, value chain position, and company size:
– Infrastructure and Cloud: Providers of hardware, software and/or services that operate IT networks and cloud infrastructures (e.g., Cisco, Citrix, VMware)
– Software as a Service (SaaS): Companies that sell software by means of a subscription model (e.g., Adobe, Dropbox, Zendesk)
– Application Software: Application software vendors, regardless of business model (e.g., Microsoft, SAP, Oracle)
– Software Development: Companies that develop application software on behalf of third parties and sometimes also provide their own technologies (e.g., Accenture, Cognizant, Infosys)
– IT-Service: IT service providers, e.g., consulting, implementation, managed services, and IT outsourcing (e.g., Atos, DXC, Cancom)
– Conglomerates: A selection of very large software and IT companies with a broader product range and a market capitalization greater than $100 billion (e.g., Microsoft, Alphabet, IBM)
Certainly, these six groups overlap to some extent and there are many other and more detailed ways to segment companies in the industry. For example, within the Application Software group, we could differentiate companies that have specialized in individual “verticals”, i.e., user industries, such as Healthcare, Financial Services, or the Construction industry. Nevertheless, even this rough segmentation shows significant differences in multiples as illustrated by the diagram below that shows median EV/sales and EV/EBITDA multiples in each of our digital technology segments for the years 2020 – 2022e.
We see three main criteria through which we can try to explain these differences:
Criterion 1: Sustainability and Strength of Cash Flows – the Role of the Business Model and Quality
First, we must differentiate between project and product businesses. Service companies, IT consulting firms, and software developers mainly operate on a project basis meaning that long-term revenue per customer is often relatively low. Good service providers partly compensate for this by offering great service to their most valuable customers. As such, these customers effectively outsource a significant part of their IT or software development budget to a service provider over the span of several years – in IT operations this is known as managed services or “outsourcing deals”. The “economies of experience” between employees of the service provider and employees of the client gain such significance that IT companies do indeed have long- term customer relationships and relatively predictable revenue streams. From an investor’s perspective, however, these business models remain fundamentally more susceptible to revenue fluctuations and customer loss, which is ultimately reflected in lower valuations.
Product companies, on the other hand, sell application software and often achieve long-term customer retention. Next to a superior offering, the sticky customer base results from the ability to “lock” clients into a process landscape from which separation can only be accomplished with great effort. Here, we must differentiate between the license sale model combined with maintenance contracts and the software-as-a- service (SaaS) model, in which software is billed either via a subscription or on a transaction basis. In the SaaS model, the software provider initially foregoes a part of the revenue that could alternatively be generated via a license but can achieve higher product margins over time if its product has strong USPs. For several years now, established SaaS companies have been achieving the highest market valuations as investors are most likely to associate them with stable, long- term cash flows and high margins.
Regardless of the business model, the quality of the IT service or the software product has a significant impact on the valuation of the company in question: The higher the quality and the more unique the product or service, the higher the margins and the more sustainable the business. Evidently, this holds true for all sectors.
Criterion 2: Growth Rates
Not only in the IT and software industry but across all sectors we observe: The higher the forecasted growth of a company, the higher its valuation (on average). We use SaaS companies as an example for this phenomenon (see page 19 in the pdf link below).
Criterion 3: Capital Intensity of the Business
When we compare Infrastructure & Cloud with SaaS or Application companies, we see that companies with capital-intensive business models (e.g., from the infrastructure environment) have lower valuations on an EBITDA basis than less capital-intensive firms. As opposed to capital-intensive company, the EBITDA of many software companies does not significantly deviate from EBIT, which is why it makes more sense to base the valuation on an earnings figure that showcases sustainable free cash flow after investments. Therefore, a comparison based on EV/EBIT multiples produces more accurate results than one on an EV/EBITDA basis. Just looking at EV/Revenue multiples one could assume that Infrastructure & Cloud companies have similar valuations to IT Service providers, even though they are valued significantly higher on a free cash flow after investments basis.
Story Telling & Positioning
Company valuation is not based solely on the mechanistic analysis of data or figures in financial models. To understand valuations on stock markets (but also in M&A transactions!), it has become increasingly important to understand and be able to convey the “equity story” of a company. How else can we explain that companies who have never turned a profit are valued in the billions? In his book Narratives & Numbers: The Value of Stories in Business, Aswath Damodaran, Professor of Finance at Columbia Business School in New York, argues that the right “story” drives corporate value by providing substance for the projected financial figures. Investors demand compelling arguments to assure themselves that the investment is worth taking the risk.
In recent years, the valuation levels of IT and software companies have risen continuously. The Corona pandemic has done nothing to change this. On the contrary, social distancing and global lockdowns have increased the importance of digital offerings (both in work scenarios and in private life) and have acted as accelerators of digitization. The valuations of large, listed application software providers are proof of this: Whilst the average EV/EBITDA value over the period of the last five years was just under 20x, we currently see values of over 30x (see page 17 in the pdf link below).
With compelling synergy potential and a well- organized, competitive sale process, significant strategic premiums can be realized.
Valuations in Mid-Market M&A Transactions
The three criteria that influence valuations, which have been outlined above can generally also be applied to investment and takeover situations of privately held companies. Moreover, we see three additional criteria that should be considered in the valuation of small- and medium size enterprises (SMEs).
1. Size of the Company: Smaller companies (generally, with sales of less than EUR 30 to 50 million or EBITDA of less than EUR 10 to 15 million) are more unstable than larger, listed enterprises and are often more susceptible to individual success factors (e.g., management, certain individuals, particular products, customers, or suppliers).
This leads us to believe that from an investor’s point of view, discounts of around 20 to 40 percent to valuations of listed firms appear to be appropriate.
2. Shareholding and Corporate Control: The takeover of the majority or entirety of shares in a company provides corporate control and therefore, may allow the acquirer to achieve synergies with existing activities. This can justify a significant premium over a “stand-alone” valuation of the target company, which is solely based on its own predicted cash flows. Inversely, minority interests with limited influence on corporate policy are often valued at a discount.
3. Lack of Short-term Liquidity: Shares in privately held companies cannot be actively traded on a stock exchange, requiring shareholders to have a long-term investment horizon. Should shareholders wish to sell their shares, they usually need to undergo a sale process that lasts several months and the success of which is dependent on numerous factors. These include, among others, company internal success and risk factors, general market developments and the professionalism with which the process is designed and executed. Given this lack of short-term marketability alone, investors deem a discount of approximately 10 to 30 percent appropriate when compared to the valuation levels of listed companies.
The net effect of these three factors on the value of a company in the case of a majority sale as part of a well- structured M&A transaction is difficult to estimate and is individual to each case. In most cases, factors one and three predominate. However, with compelling synergy potential and a well-organized, competitive sale process, significant strategic premiums can be realized.
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