This is just one of the stories from our “I’ve Always Wondered” series, where we tackle all of your questions about the world of business, no matter how big or small. Ever wondered if recycling is worth it? Or how store brands stack up against name brands? Check out more from the series here.
Listener Stephanie Gilliam from Florence, Alabama, asks:
How are businesses valued? For instance, when one company buys another, who sets the price? What does the cost include? I assume that the price includes any assets, but how much of the price is for the brand itself and future profits?
There’s no magic equation to assess the true value of a company. If there is such a thing as “true value,” it can be far 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 be confident that that’s how a business gets valued,” said Brian Quinn, a professor at Boston College Law School. “But you’ll see that anytime anyone values a business, they’ll take multiple approaches and then make lots 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, the value starts with its stock price, which is set by buyers and sellers trading shares on a daily basis, Quinn explained. The price of the stock multiplied by the number of shares is what defines the company’s value at any particular moment, and the process of trading keeps that value fluctuating.
The stock price tells you how the market values that company. But to persuade a company’s managers and large shareholders to sell to an acquirer, the buyer typically has to offer more than market value, a so-called takeover premium.
“That becomes basically the beginning of a negotiation,” Quinn said. “And the negotiation really falls 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 actually worth?’”
The case of Twitter: “Elon math”
Elon Musk’s infamous attempted acquisition of Twitter has been one of the highest-profile business negotiations of the past year. He initially offered to buy the company for $54.20 a share in a deal worth $44 billion. Since then, he’s been trying to abandon the agreement, arguing that Twitter did not provide enough information about the number of spam and fake accounts on the platform.
A few weeks prior to Twitter’s announcement of the deal, the stock had closed at $38 a share.
Quinn said Musk likely landed on that price because he’d asked his bankers, or maybe himself: What’s a number above Twitter’s current stock price that will get Twitter to say yes and ends in 420? (A weed joke, in other words.)
“My guess is that’s basically how he came up with that number,” he said. “Because if he gave them 42, they’d say, ‘We’re trading at 38, and that’s not enough.’ The next increment in Elon Musk math is $54.20.”
And because Twitter was trading above $70 a share at some points last year, the company may have asked itself: “‘What’s the prospect, given what we think the future is, that we will trade again at $70 in the next few years?’” Quinn said. “And they probably came to the conclusion that the prospect is low.”
This is a case where arriving at the stock price was “the opposite of science,” Quinn said. “That’s just Elon math increments.”
Private-equity buyers
Each type of buyer will have a different approach. Private-equity buyers, for instance, will try to figure out how much debt they have to take on when they’re thinking of what price to offer, according to Quinn. PE firms are typically focused on taking investment stakes in public companies or often buying them outright.
“They’re highly focused on what’s required to pay the debt back 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 across private equity generally, the buyers there tend not to generate outrageous valuations, because they’re so tied to their models and their financing needs.”
He noted, though, that very low interest rates for most of the last decade have enabled private-equity buyers to pay higher prices, but with interest rates going up, Quinn expects PE players to keep a tighter grip on their checkbooks.
Private companies
With private companies, there are no stock prices, making it even more difficult to assess their value.
The buyout price of a private company would normally be based on key drivers such as the historical profitability of the business, the industry and markets the company is in and forecasts of its ability to grow earnings in the future, according to Brian Price, president and chief operating officer of Mesirow Investment Banking. Intangibles like the company’s image and brand are a big part of its potential success.
Price added that private companies generally will market themselves to possible acquirers confidentially. If the owners are interested in selling, they might have a price in mind, but it’s up to the market to meet or not meet that price, he explained.
Sometimes, a private company ends up being worth much more than its selling price. Take Instagram, which Facebook purchased in 2012, Quinn said.
“When Facebook bought Instagram for $1 billion, Instagram had 11 employees and no profits,” he pointed out.
Nevertheless, Instagram co-founder Kevin Systrom asked Facebook’s Mark Zuckerberg for $2 billion during their negotiations. Zuckerberg, though, was able to push the amount down to $1 billion and seal the deal.
Six years later, Instagram, having become a vital part of the world’s biggest social media company, was valued at more than $100 billion.
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