2 Ways to Determine an Energy or Environmental Company’s Value
Determining an energy or environmental company’s value is a critical piece of the acquisition process. And while there are many methods to determine its worth – none of which are exact – you can get reliable estimates using a couple methods.
One of the most popular is to perform a Discounted Cash Flow (DCF) valuation. Simply put, you project over a period of time of (usually at least 5 years) how much free cash flow the business will produce. The total free cash flow is then discounted to reflect the time value of money, costs of capital, consistency and predictability of cash flows, and premiums for risks involved with the investment.
So let’s say free cash flow over the next five years is projected at $1 million. You then calculate and/or negotiate an appropriate discount rate to get a possible price for that business.
Of course, the discount rate is often the sticking point on discounted cash flow valuations. As you might expect, buyers want a heavy discount, while sellers seek a premium to get the most money for the business.
So be ready to negotiate.
This is also true, in a different form, for the next valuation technique –the EBITDA multiple valuation. EBITDA stands for earnings before interest, taxes, depreciation and amortization.
Review a company’s EBITDA for the last few years to determine trends and consistency. If EBITDA shows steady growth or reduction, or is flat and consistent for a few years, then this method can be fairly reliable.
Conversely, high volatility in historical EBITDA can make this very difficult to use effectively. Determine an EBITDA figure you’re comfortable with – whether it’s last year’s EBITDA or an average of the last three years – depending on the trends.
The next step is assigning a multiple. Maybe it’s 3x or 5x. The multiple is usually determined by three factors:
- The industry in which the business operates
- Statistics specific to your business such as margins and growth rates
- Whether you can find multiples assigned in comparable (and recent) transactions
Again, like a discount rate, the multiple is often open for debate. Common non-financial factors that are considered include brand power, management’s future involvement, regulations that drive the business, legal problems, and other risks specific to the business’ future success.
If you need an easy industry to determine value, try construction. A construction company is generally worth what you can project in profit on remaining or existing backlog. Also account for assets on the balance sheet, subtract any debt owed on those assets and add that number to the projected backlog profit.
The result is a reasonably close number on what you might pay for a construction company.
Negotiating will happen, but this is a fairly standard formula for coming up with a value for a company where one-time contracts – instead of repeat business or products – create the revenue.
In almost all cases, multiple valuation techniques will be used as a form of checks and balances. No single method provides a complete picture on what a business might be worth.
As a seller, it’s important to have someone on your side of the table who knows proper valuation techniques so that you don’t sell yourself short or, more likely, scare off a buyer because you want more than the company is worth.