Determining value is the primary goal of an investment strategy. For transactions based on physical assets, the valuation process is straightforward - analyzing the cash value of real estate, equipment, and inventory, and subtracting outstanding liabilities. For mergers and acquisitions, private equity transactions, and other types of investments, the process becomes more complex and can use multiple methodologies to come up with a single price.
Determining valuation begins with the due diligence process. Many of these are revenue KPIs, but for a successful merger, due diligence must also address the culture of the target company, as indicated by Customer and Employee KPIs. As experienced investors and CEOs know, most - 70 to 90 percent - of M&A deals fail, so rigorous due diligence must go beyond the numbers to provide a clear picture of a target company’s health.
In this article, we explore some of the key metrics commonly used in valuing and analyzing deals.
Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA)
EBITDA is a commonly used metric in deal analysis, as it provides a clear indication of a company's operating performance, independent of its capital structure and accounting practices. EBITDA is calculated by taking a company's net income and adding back interest, taxes, depreciation, and amortization expenses. EBITDA is a useful metric because it can be used to compare the performance of companies with different capital structures or accounting practices.
Price-to-Earnings Ratio (P/E Ratio)
The P/E ratio is a commonly used valuation metric that measures a company's stock price relative to its earnings per share. The P/E ratio is calculated by dividing a company's stock price by its earnings per share. A high P/E ratio can indicate that a company's stock is overvalued, while a low P/E ratio can indicate that a company's stock is undervalued.
Return on Equity (ROE)
ROE is a metric that measures a company's profitability relative to its shareholders' equity. ROE is calculated by dividing a company's net income by its shareholders' equity. A high ROE can indicate that a company is generating strong profits relative to the amount of equity invested by its shareholders.
Debt-to-Equity Ratio (D/E Ratio)
The D/E ratio is a metric that measures a company's leverage, or the amount of debt it has relative to its equity. The D/E ratio is calculated by dividing a company's total debt by its shareholders' equity. A high D/E ratio can indicate that a company is highly leveraged, which can be a risk factor for investors.
Free Cash Flow (FCF)
FCF is a metric that measures a company's cash flow, or the amount of cash it generates from its operations, after accounting for capital expenditures. FCF is calculated by subtracting a company's capital expenditures from its operating cash flow. FCF is a useful metric because it provides insight into a company's ability to generate cash, which is a key driver of long-term value.
Enterprise Value (EV)
EV is a metric that represents the total value of a company, taking into account both its equity and debt. EV is calculated by adding a company's market capitalization (the value of its outstanding shares) to its total debt and subtracting its cash and cash equivalents. EV is a useful metric in deal analysis because it provides a comprehensive picture of a company's value, including its capital structure and cash holdings.
Gross Margin
Gross margin is a metric that measures a company's profitability relative to its revenue. Gross margin is calculated by subtracting a company's cost of goods sold from its revenue, and dividing the result by its revenue. Gross margin is a useful metric because it provides insight into a company's ability to generate profits from its core business operations.
Market Share
Two companies within the same industry vertical and with roughly the same market size can differ significantly when market share is considered. Is the company an established market leader, or an upstart? What percentage of total sales does the company have in their industry, and is their customer base broad, or niche? Calculate this metric by taking the company’s sales for a given period and dividing by total industry sales for the same period.
Reinvestment
In today’s world, successful companies are investing a share of revenues in new equipment, people, and programs. Some such reinvestments are announced in new ventures, like Meta’s “Metaverse” VR headsets or Apple’s Titan car manufacturing venture. Others can be measured by productivity: a company’s average gross and operating margins for the last three years compared to its industry vertical standards, which provides insight into the management of headcounts vs. sales.
Customer Satisfaction
Due diligence should reveal customer satisfaction, as measured in KPIs like Customer Satisfaction Score (CSAT) or Net Promoter Scores (NPS).
Retention of Top Talent
Retaining talent is critical in tech and other industries that require advanced skill sets or are beset by labor shortages, like transportation, healthcare, hospitality and food services. A stable and happy workforce is not only a financial asset, but also bodes well for the merger of different cultures. A good metric to uncover in due diligence is Employee Net Promoter Score (eNPS), which is the results of employee surveys that measure staff engagement and loyalty.
Attention to Security Risks
A good investment opportunity is a company that has security built into its DNA. Security research firm Getastra reports that cybercrime accounted for $6 trillion in damages in 2022, a number they predict will grow by 15 percent a year starting in 2023.
A company’s financial records and trade secrets are prime targets. Today’s hackers use AI-enhanced algorithms to seek out vulnerabilities in unencrypted archived records, data banks, and confidential documents shared in emails, consumer-grade file sharing apps, and other underprotected online environments.
A good indication that a company is smart about security is to determine if it is using a virtual data room (VDR) for storing and sharing confidential information. A VDR from a quality provider like ShareVault provides a full array of safeguards: all documents in the VDR are automatically encrypted, and access to documents is limited to an authorized list of users who gain access using a two-factor password. Even those who have access have defined permissions for use, such as save, print, copy, or view only, and expiration dates on access. Documents can be remotely “shredded”, even for files that have already been downloaded.
ShareVault, a company with more than 15 years of experience in working with banks, investment and private equity firms, and other financial institutions, also understands the pressure-cooker atmosphere in finance dealmaking, so they provide protections for every authorized user, allowing fully encrypted document sharing from any browser or device, at any time, from anywhere, including those in remote locations. ShareVault protected access and document sharing can also be extended to analysts, accountants, the legal team, regulatory experts and other third parties.
ShareVault’s built-in software includes document management tools like drag-and-drop uploads, a powerful full-text search engine, inter-document hyperlinking, and easy integration with DocuSign and other file-sharing apps.
At the appropriate time, a bank or investment firm can invite investors into the protected ShareVault VDR. By following the same security protocols, these current and prospective customers can enjoy fully protected document sharing.
Smart Metrics Are Key to a Successful Investment
Each of the metrics uncovered in due diligence provide perspective on a company's financial performance and potential. The challenge is to develop a comprehensive understanding of a target company and its industry, including its role in the industry and its appeal to its customers and employees. This “big picture” view provides the best chance for investment success.