Rethinking Valuation So You Don’t Miss a Good Deal

The odds of a successful acquisition are long — something research has proven time and again — yet executives show no signs of losing interest in M&A. Even Dell, famous for eschewing acquisitions in favor of organic growth, has thrown in the towel with its $5 billion acquisition of Perot Systems. Most commonly noted in hindsight analysis of M&As are the effects of what we will call false positives, where in the fullness of hindsight it becomes clear that an acquisition effort was flawed from the start. But what may be equally important concern is the issue of false negatives — where constructive acquisitions are lost due to low bids constrained by outdated valuation methodologies. We have constructed a framework that allows an acquiring company to avoid the bias in valuation that often leads to wrong conclusions. To do this, we combine two separate frameworks: the first is the Three Horizon strategic model developed by McKinsey. The other is a process called Opportunity Engineering (OE) that instills a different way to look at value. The 3 Horizons model breaks down strategy into three parts. Horizon 1 (H1) represents the current core operations of a company that produce the cash flow needed to sustain operations, to meet investor expectations, and to invest in future growth. Horizon 2 (H2) represents businesses that are generating fast-growing revenue streams. These may not be making as great a contribution to profitability or cash flow at this point, but they show promise to do so in two to three years. Horizon 3 (H3) represents opportunities for future growth that may take the form of new products, services, capabilities, and perhaps extensions into non-adjacencies that show great promise but are highly uncertain. To define the full value of acquisitions analyze the target’s assets and assign them across the Three Horizons of the acquirer to understand how they add value. In general, the more horizons that a target’s assets reach, the stronger and more valuable the acquisition is. Since the Three Horizons represent different levels of uncertainty, they need to be managed and valued differently. This is where Opportunity Engineering comes into play. The higher level of uncertainty associated with H2 and H3 necessitates an updated valuation methodology that takes into account more than the net present value (NPV) of the target. We call this the Opportunity Value (OV) of an asset. Think of OV as capturing the potential value of the target’s H2 and H3 assets if they become successful. The two together, NPV + OV, provide an inclusive but not inflated valuation. In discussions with managers we find that even experienced acquirers do not consider anything beyond the H1 assets of a target when arriving at a bid price. The third component of opportunity engineering is what we call Abandonment Value [AV]. AV results from having the flexibility but not the obligation to sell all, or any part of the acquisition in the future if it is not working out as hoped. This creates real value because the cash can be redeployed elsewhere. We find that this is rarely considered because it cannot be captured through a NPV analysis that is based on a linear set of projections, but an approximation of AV can often be captured using simple option pricing models. The three sources of value combined provide a different and powerful way to look at acquisitions where: Target Value = NPV + OV + AV. Let’s consider the example of an actual banking company that was chasing an important acquisition that it had valued at $800 million using the NPV analysis. It lost the acquisition to an archrival that bid $840 million. The target had both H2 and H3 assets that were never valued because they were not generating cash flow and therefore added nothing to the NPV. Had the company considered AV it would have been able to bid up to $866 million because the option to regain $700 million of the price two years later, a disaster scenario, would have generated $66 million of value using simple option pricing. Make sure you don’t miss your next good deal by thinking too narrowly about how to value it!

Rethinking Valuation So You Don’t Miss a Good Deal

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