Valuation essentials for CFOs.

• Author: Evans, Frank C.
• Position: Valuation - Asset and risk management

So much has been written about "value" and "creating value" that maximizing shareholder value is a primary concern at most public companies. But many financial executives must make calculations and decisions about value for entities for which no stock market price exists. Thinly traded public companies, divisions of public companies and all privately held companies operate year after year without senior executives knowing the answers to these basic questions:

* What is the company or business segment worth?

* What factors most affect the company's value?

* How much more would a strategic buyer pay to acquire it?

* What is the entity's real return on investment and rate of return?

* Does that return justify the risk?

* Are the owners better off selling and, if so, how, when and to whom?

As part of their broad responsibilities, financial executives become involved in merger and acquisition (M&A) decisions. While the media cover the mega M&A deals, the median transaction size in the United States last year was under $50 million, and about 60 percent of the sellers were private companies. So the real merger and acquisition action is in the middle market, where stock prices are unknown and little information is revealed to the public. For these very common deals, the following uncertainties abound:

* Do profits, usually expressed as EBIT or EBITDA, represent the company's true return?

* What is an appropriate rate of return or multiple considering the investment's risk?

* Has the seller properly prepared and packaged the company to get the right price?

* Has the buyer found the best target and accurately quantified potential synergies?

* Does the deal make sense at the quoted price?

Today's financial executives must possess fundamental valuation knowledge, and this should not be limited to price earnings multiples that apply to large public companies. Since most valuation decisions involve entities that lack a stock market price, a working knowledge of the following issues is critical.

Stand Alone Fair Market Value Versus Strategic Value -- While the worth of a company or business segment to its present owners -- fair market value -- is important to know, it's frequently more beneficial, particularly to value-oriented executives, to know what that business is worth to a strategic buyer. Companies should be investments held to generate a return to shareholders, but conditions may render a company uncompetitive. When this happens, on a stand-alone basis, the business possesses...