You’ve spent weeks building the perfect valuation model. You’ve included growth forecasts, estimated costs, calculated discount rates, and determined a valuation range you’re confident in. But now comes the hard part – determining the right price for the business. How do you bridge the gap between your valuation and a price that will resonate with the market?
If you price too high, potential investors could lose interest resulting in an unsuccessful transaction. Too low, and you leave money on the table or struggle to fund operations or growth. The key is finding a price that balances your valuation with investors’ demand and willingness to pay. It requires both art and science. In this article, we’ll walk through strategies to help get your valuation closer to pricing.
Understanding the difference between Valuation and Pricing
You’ve built a solid valuation model and are confident in the numbers. However, these numbers differ from the number on which the buyer and seller shake hands. What gives? Which is the accurate number? As the seasoned investor Warren Buffet puts it, “Price is what you pay, value is what you get”. Valuation calculates what a business is worth based on its assets, growth and earnings potential and risk. On the other hand, pricing refers to what buyers and sellers agree to exchange the company for in the real world. There are several reasons why a valuation and final price can diverge:
- Lack of information: Buyers and sellers may value a company differently if they have access to different data or projections;
- Market conditions and demand: Valuation is often based on fundamental factors such as financial performance and growth prospects. However, pricing is influenced by market conditions, including supply and demand dynamics. If there is high demand for businesses in a particular industry or market, pricing may be driven up;
- Current events: External events like economic shifts, political changes or technological disruptions can impact pricing but not affect the business’s intrinsic value;
- Synergies and strategic values: In certain transactions, buyers may perceive additional value beyond the financial metrics of the business. This may influence the pricing above the intrinsic value of the business. A company may be willing to pay a premium if an acquisition is critical to its business strategy or growth plan;
- Negotiation and subjective factors: The party with more leverage in negotiations may get a price that suits them. Emotional factors, group thinking, and investors’ perception about an industry or business could also influence the pricing.
Bridging the Gap
While most of the factors that cause the valuation and pricing numbers to diverge are external and largely unpredictable, it is important for any modeler to get their valuation as close as possible to pricing to strengthen their negotiation. Some of the approaches to bridge the gap include:
- Focus on the future, not the past. Buyers care about future potential, so base your valuation on realistic future cash flow projections, not just historical financials;
- Use multiple methods: Don’t rely on just one approach like DCF. Also, look at comparable companies and precedent transactions to triangulate a value range. This provides a more defensible number;
- Identify comparable businesses: Using comparable transactions and companies accounts for the market perception of the business under valuation. Therefore, it is important to pick the best comparable business in regard to the industry, size & scale, geographic factors, growth potential, risk factors etc.;
- Adjust for differences with the comparable firm: It is difficult to find a comparable business that is perfectly similar to the business under valuation. Allow for the comparable differences in risk profile, geographical location, market share, liquidity etc., in your valuation;
- Use industry-specific multiples: Different industries have unique metrics that are more relevant for valuation. For example, the technology industry might focus more on EV/EBITDA, while the price-to-book ratio in the banking sector is more appropriate.
- Consider market conditions: Extraordinary events or temporary market distortions could impact the multiples of certain companies. Adjustments may be necessary to account for abnormal market conditions that do not reflect the true valuation environment;
- Make reasonable assumptions. It’s easy to be too optimistic, but unrealistic assumptions will undermine your credibility. Challenge your assumptions and make sure they are backed by industry trends and historical data;
- Be transparent. Clearly show your work by documenting all assumptions and the methodology used. This allows others to understand how you arrived at the valuation, even if they disagree with the final number;
You’ll establish a grounded and compelling valuation with a balanced, well-supported approach that accounts for the market perception and conditions. And one that moves you closer to a price you and the buyer can agree on.
Negotiating the Best Deal
When all is said and done, pricing is still an art, and we cannot ignore the place of negotiations in arriving at a price. A few pointers as you go into the negotiations:
- Own your numbers: Be ready to explain clearly how you arrived at your estimate in a confident yet flexible manner. Know where there’s room for negotiation and where your numbers are firm;
- Do your homework: Come prepared with data and examples to support your position. Point to comparable businesses that recently sold for similar multiples. Reference industry benchmarks or metrics that support your valuation. The more evidence you have, the stronger your case will be;
- Focus on the Future: Frame the discussion around future potential. Explain how the business or asset can generate more value over time with investment, development, or operational changes. Help the other party see the possible upside by laying out a vision for long-term growth;
So there you have it. The key to bridging the gap between your valuation and real-world pricing is factoring in the market perception. Carefully pick comparable businesses, use industry-specific multiples and account for market conditions. And remember, pricing is an art as well as a science. The final price depends on more than just the fundamentals. It comes down to the motivations and perceptions of the buyers and sellers. With diligence and an eye for the human elements of the deal, you’ll be negotiating with confidence, knowing your valuation is as close to the mark as it can be.
At InVhestia Africa Ltd, we have a skilled team with extensive experience conducting valuation across various sectors for both sell and buy-side clients. Our experience in leading negotiations with investors and entrepreneurs will ensure you get the best price for your business.
By Kimali Simon, Associate InVhestia Africa Limited