Most Common Mistakes When Valuing an Acquisition

M&A activity has started to pick up again. Just last week, Applied Industrial Technologies, Cleveland, OH, announced two acquisitions – one in Canada and one based in Cleveland. We also heard recently about acquisitions from Stanley Black & Decker and Arrow Electronics, and the potential acquisition of building products distributor BlueLinx Holdings by a private equity firm.

I spoke this week with Jon Skelly, managing director at investment banking firm Vetus Partners, about the current state of the M&A market. "There is a strong market and appetite for high-quality distributors and an active market for distressed distributors," he said. "There is not much of a market at all in between."

In this excerpt from our discussion, read what Skelly says acquirers should keep in mind when valuing a business in today's markets:

MDM: What are the average multiples right now for a good company in the distribution industry? Are there differences between sectors?

Skelly: Good companies in distribution today are selling for 6X–8X EBITDA. Most of the companies being sold at these valuations are more MRO-focused (less cyclical so they performed better than the market during the downturn) or in other sectors that tend to be more resilient during recessions, such as health care and food. There is less activity in sectors related to construction and industrial projects, and the valuations are lower in these sectors.

It is important to note that only the best distribution businesses are selling in the 6X-8X range, and the market is not very receptive for average businesses.

MDM: What are the key elements to keep in mind when determining what to pay for a business?

Skelly: You want to look closely at performance over historical cycles to understand how the business performs in various markets. Understand potential commodity price impacts on the business. Understand the company's value proposition, competitive advantages, use of technology and key risks. You want to focus on the projected financial performance of the business – you are not buying the past, you are buying the future.

MDM: When looking at future performance, what are the most common mistakes companies make?

Skelly: I would say the No. 1 problem is that people get too aggressive with projected growth. To make the model work, they assign growth rates going forward that are potentially a little too rosy and allow them to justify a valuation they need to justify getting a deal done. But what's behind that justification? What's your plan look like to hit those numbers? If I see a 10 percent growth rate across the board for the next five years, I want to see how you're going to hit those numbers. I want to see the end-markets you're in and the statistics behind those markets. If a research firm tells me that end-market is going to grow at 4 percent and you say you're going to grow at 8, I want to understand what is going to allow you to take market share and outpace overall industry growth.

Almost every strategic buyer is going to use the Discounted Cash Flow analysis as one of the pillars of their evaluation. Diligence is centered on understanding and justifying the growth projections built into that model.

MDM: We are hearing there is still a disconnect between buyer and seller. Are you still seeing this?

Skelly: Yes. Owners still have vivid memories of how profitable their business was before the downturn, and the potential valuation associated with the business at that time. Most of those individuals are highly confident entrepreneurs who believe they have what it takes to return their business to historical levels. So if they are to consider a sale today, they want some credit for the rebound they see coming in the future while buyers want to anchor around today's performance. This has caused a valuation gap.

The rest of my conversation with Skelly will be published in the Aug. 25, 2010, issue of MDM Premium.