With US M&A still going strong both domestically and internationally, bias inherent in traditional valuation methods can lead to incorrect assumptions. Hence it is time to take a new approach to valuation. Or so say the authors of a new M&A methodology out in the Harvard Business Review.
Alexander van Putten— principal at Cameron & Associates and affiliate faculty member at the University of Pennsylvania's Wharton Business School— Mehrdad Baghai—managing director of boutique advisory firm Alchemy Growth Partners—and Ian MacMillan—principal at Cameron & Associates and Ambani Professor of Innovation and Entrepreneurship at Wharton—have come up with a twist on traditional methods for valuing a potential acquisition target that they say reduces false positives in the M&A process.
It makes use of McKinsey & Company’s Three Horizon model and bolts on what they call Opportunity Engineering (OE) to look at value in a new way.
The Three Horizon model looks at asset valuation in three horizons: the first being core operations that produce cash flow for daily operations and future growth; the second being fast-growth revenue streams; and the third being future growth opportunities. Under the model, you assign the target’s assets across the three horizons to see how they add value.
But, say the authors, each horizon represents different levels of uncertainty, which must be managed and valued in its own way—hence the need for another dimension to the valuation process, namely Opportunity Engineering.
The main theme here is that net present value (NPV) of those assets does not create a full picture of the value of individual assets, but rather you need to look at opportunity value (OV)—or ability to capture the potential value—of assets along with NPV.
Finally, you must evaluate the abandonment value (AV) of an asset, which, according to the authors: “Results from having the flexibility but not the obligation to sell all, or any part of the acquisition in the future if it is not working out as hoped. This creates real value because the cash can be redeployed elsewhere.” They say this is often overlooked in valuations, but that it can be approximated with simple option pricing models.
Which creates the equation: Target Value = NPV + OV + AV
By using this broader valuation model, it creates a clearer picture of the real value of a potential target, say the authors.