The price of a company

The price of a company

When talking about the price of a company, one of the main elements of the contract for the sale and purchase of companies that differentiates it from other sales and purchases of goods and justifies its complexity, is that its object is a flow-generating business in operation, which means that its valuation differs from one day to the next. Hence, in the course of the negotiations of a sale and purchase, it is impossible for the parties to determine exactly what the valuation of the company will be at the time the transfer is executed.

The solution, then, is for the parties to establish a point in time at which to look at the company’s financial information (for example, the latest audited financial statements) and, on the basis of these, to establish a provisional price that will be adjusted and become definitive as soon as the parties can verify the actual valuation of the company on the date on which the transfer of risk from the seller to the buyer takes place, i.e. at the closing (with the exception of the Locked Box mechanism, which we will discuss in this section).

The valuation of the company being bought and sold is the starting point for determining its price.

The price of a company, as we shall see, does not necessarily coincide with the valuation assigned to it (and normally they do not) for the simple reason that company valuation methods incorporate parameters such as the company’s expected future growth and the additional value created by the integration of the acquired company into the buyer’s business, and do not usually pay attention to the company’s existing capital structure (debt and cash).

Hence, two businesses with identical valuation, i.e. with identical future profit generation capacity in the eyes of the same buyer, may have, for this buyer, different prices due to a different capital structure, i.e. a higher or lower net debt, understood as the difference between debt and cash.

The main valuation methods used in the practice of the sale and purchase of companies are two, the method based on the generation of cash flows and the comparative methods with the application of multiples, among which the EBITDA multiples stand out.

Price of a company: the discounted future cash flow method

The discounted future cash flow method is based on the present value rule which states that the value of any financial asset is the present value of its future cash flows. The free cash flows (after taxes, but without taking into account indebtedness) of the company projected over a given period of years are calculated.

The residual value of the company is then calculated (which functions as the final cash flow at the end of the period considered) and a certain discount rate is chosen to reflect the risk of the investment. The discounted sum of the sum of the free cash flows and the residual value calculated by applying this rate will be the value of the company.

The EBITDA multiples method

EBITDA is the company’s earnings before interest, taxes, depreciation and amortization and is a good measure for company valuation as it eliminates the items that can give rise to the greatest distortion in a company’s results, namely the capital structure (debt), the tax burden (taxes) and the accounting expenses linked to the ownership of fixed assets (depreciation and amortization). This allows you to make fair comparisons between companies, regardless of jurisdiction.

The result of the application of the valuation method is not the value of the shares or, in other words, the equity value, but the enterprise value. The underlying reason is that neither EBITDA nor the free cash flow concept pays attention to the capital structure of the company (net debt), but focuses on the company’s capacity to generate future profits or cash flows. Therefore, it can be inferred from the above that:

• The enterprise value is the value of the company assuming zero cash and zero debt (debt-free/cash-free)
• The equity value is the enterprise value minus the net financial debt, this being the difference between debt and cash.

Once the enterprise value of the company is reached, the buyer will look at the snapshot that has been agreed with the buyer as a reference for the calculation of the provisional price (the latest audited financial statements), subtract the debt and cash therein (as well as other debt and cash items that the buyer has detected during the due diligence process) and obtain the equity value that will be paid to the seller at closing.

At Letslaw, our team of commercial lawyers will help you with any doubts in this sector. Do not hesitate and contact us.