This is just one of the stories from our I’ve Always Wondered series, where we address all your questions about the business world, no matter how big or small. Have you ever wondered if it’s recycling? it’s worth it? Or how you save brands pile up against brand names? See more from the series here.
Listener Stephanie Gilliam of Florence, Alabama, asks:
How are businesses evaluated? For example, when one company buys another, who sets the price? What does the cost include? I assume the price includes any assets, but how much of the price is for the brand itself and future profits?
There is no magic equation to estimate the true value of a company. If there is such a thing as “true value,” it can be much more or less than a company’s sale price.
“It’s more art than science. It would be nice if there was some kind of formula that you could just plug in and have confidence that this is how a business is valued,” said Brian Quinn, a professor at Boston College Law School. “But you’ll see that any time someone values a business, they’re going to take multiple approaches and then make a lot of assumptions about the future. Then they draw a line in the sand and that’s where they stand.”
These valuations are also tied to whether the company is publicly traded versus being a private business, according to financial experts.
Publicly traded companies
When it comes to publicly traded companies, value starts with its stock price, which is determined by the buyers and sellers who trade the stock on a daily basis, Quinn explained. The share price multiplied by the number of shares is what determines the value of the company at any given moment, and the trading process keeps that value fluctuating.
The stock price tells you how the market values that company. But to convince a company’s managers and major shareholders to sell to a buyer, the buyer usually has to offer more than market value, a so-called takeover premium.
“This essentially becomes the beginning of a negotiation,” Quinn said. “And negotiations really come down to: ‘The market says your company is worth X. How much more than X do I have to pay you to give up what you think the company is really worth?’
Twitter Case: “Elon Math”
Elon Musk’s infamous attempt to buy Twitter has been one of the highest-profile business negotiations of the past year. He initially offered to buy the company for $54.20 per share in a deal valued at $44 billion. He has since tried to abandon the deal, arguing that Twitter did not provide enough information about the number of spam and fake accounts on the platform.
A few weeks before Twitter announced the deal, the stock had closed at $38 a share.
Quinn said Musk likely arrived at that price because he had asked his bankers, or perhaps himself: What’s a number above Twitter’s current stock price that will make Twitter say yes and end up at 420? (A weed joke, in other words.)
“My guess is that he basically came up with that number,” he said. “Because if he gave them 42, they would say, ‘We’re trading at 38 and that’s not enough.’ The next increase in Elon Musk’s math is $54.20.”
And because Twitter was trading above $70 a share at several points last year, the company may have asked itself, “‘What is the prospect, given what we think is the future, that we’re going to trade again? by $70 in the next few years?’ “, Quinn said. “And they probably concluded that the outlook is low.”
This is a case where arriving at the stock price was “the opposite of science,” Quinn said. “These are just increases in Elon’s math.”
Private equity buyers
Each type of buyer will have a different approach. Private equity buyers, for example, will try to figure out how much debt they should take on when considering what price to offer, according to Quinn. PE firms are usually focused on acquiring investment shares in public companies or often buying them outright.
“They’re very focused on what’s required to pay off the debt because they don’t want to pay too much for a company and then put themselves in a position where the company doesn’t generate enough revenue to pay off the debt.” he said. “So if you look at private equity in general, the buyers there tend not to generate wild valuations because they’re very tied to their models and their financial needs.”
However, he noted that very low interest rates for much of the past decade have enabled private equity buyers to pay higher prices, but as interest rates rise, Quinn expects PE players keep a tighter grip on their checkbooks.
In private companies, there are no share prices, making it even more difficult to assess their value.
The purchase price of a private company would normally be based on key factors such as the historical profitability of the business, the industry and markets the company is in, and projections of its ability to grow earnings in the future, according to Brian Price, president and chief operating officer of Mesirow Investment Banking. Intangibles like a company’s image and brand are a big part of its potential success.
Price added that private companies will generally market themselves to potential buyers confidentially. If the owners are interested in selling, they may have a price in mind, but it’s up to the market to meet that price or not, he explained.
Sometimes, a private company ends up being worth much more than its sale price. Take Instagram, which Facebook bought in 2012, Quinn said.
“When Facebook bought Instagram for $1 billion, Instagram had 11 employees and no profits,” he pointed out.
However, Instagram co-founder Kevin Systrom asked Facebook’s Mark Zuckerberg for $2 billion during their negotiations. Zuckerberg, however, was able to reduce the amount to $1 billion and sign the deal.
Six years later, Instagram, becoming a vital part of the world’s largest social media company, was valued at more than $100 billion.
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