Valuation in M&A

Why is valuation important ?

Right

reasons

Right

information

Right

price

Right

implementation

Strategy Due diligence Valuation Integration

The keys to successful M&A

Valuation elements in M&A

There are five ‘value’ elements involved in determining the price that

is paid for an acquisition:

• The ‘as is’ value of the target’s equity

• The minimum control premium that needs to be offered to the

target’s shareholders

• The value of the net synergies that can be derived from the

combination

• The costs incurred in prosecuting the acquisition

• The standalone value of the acquirer’s equity (only relevant when shares are offered as payment for the target’s equity)

The M&A valuation task – the negotiating range

Synergy

leakage

Negotiating

Range

Standalone value

of the target

Value of the target

to the acquirer

Minimum

control

premium

Costs

Net

synergies

• Multiples

• Market multiples - comparable publicly traded companies – this

analysis indicates how the stock markets are valuing companies

that are similar to the target

• Transaction multiples - precedent comparable transaction

analysis – this analysis indicates the valuations at which prior M&A

transactions have been done in the same industry as that of the

target.

• Discounted cash flow - DCF analysis – is one of the most

important valuation techniques – it can be used to determine

standalone value and value of synergies

• Sum-of-the-parts analysis – If a target has more than one line of

business, the financial adviser will value each business separately.

Therefore, each “part” might have its own market multiples, transaction

multiples and DCF (with different WACCs for each part). The total

value is the sum of the parts.

Common techniques used in M&A valuations

• Multiples

• multiples yield measures of relative value

• market multiples give an estimate of the standalone value of the firm

relative to other similar

• Transaction multiples estimate what the deal price would be relative to

other similar deals that have occurred in the marketplace.

• Discounted cash flow

• DCF analysis is a way of estimating ‘fundamental’ or ‘economic’ value

• It does not refer to how other firms are valued

• It determines value from first principles

• What cash flows will the firm’s assets be able to generate in the future?

• What will the firm’s cost of capital be in the future?

• Etc., etc.

Essential difference between multiple and DCF methods

Investment by

debt holders (interest bearing debt)

Investment by

share holders (equity)

• Enterprise value is the value of the

whole firm – the value of debt plus

the value of equity

• Equity value is the value of what

remains after debt investors claims

have been satisfied

• Debt usually means interest bearing

liabilities in this context

• Sometimes equity value is estimated

directly and sometimes indirectly.

• Equity value = enterprise value –

value of debt

Enterprise Value

What is to be valued – the equity or the whole firm?

• To purchase a business the acquirer

generally pays equity value (but also

inherits the debts of the acquired

business)

What do multiples measure?

• What value are multiples measuring?

• Are we always measuring just the value of equity?

• Or do we sometimes measure the value of debt and equity?

• Some measure Equity value:

• PE ratio

• PB ratio

• Some measure Enterprise Value (EV):

• EV/Sales

• EV/EBIT

• EV/EBITDA

• Note - if using EV must deduct the value of debt to estimate equity

What are price multiples?

• A price (or valuation) multiple is a combination of two things

• a value driver and

• a market price

• Value drivers

• can be anything the valuer considers appropriate

• revenue, profit (in all its forms), earnings per share, book value etc.

• The price used must be consistent with the value driver

• The price of equity (market capitalisation) or

• The price of debt and equity (enterprise value)

• This combination can then be expressed as a multiple – for example

the PE ratio (or price earnings multiple), or EBITDA multiple

Using the multiple method

Multiples work by:

• Choosing a value driver on which to base the valuation • Determining a sustainable or maintainable (normal) amount of that

value driver

• How do we estimate that number?

• Applying a multiple to that sustainable amount of the value driver • Multiples are generally chosen from a comparable firm (or a set of

firms)

• What constitutes a comparable firm?

• How do we arrive at a list?

• A great deal of judgement is used to get answers

Value = Sustainable amount of value driver x Chosen multiple

Types of multiple – market multiples

• Market multiples estimate standalone value

• A market multiple is determined by comparing the current trading

level of a Company to its peer group of companies

• The peer group is a set of companies that are most similar to the

target in terms of business mix and strategy, geographic risks(same

country), margins, size etc.

• To find a good peer group start broad and then narrow the list to the

most comparable peers. Refer to equity research reports, industry

reports, the company releases

• The goal of the analysis is to understand how the market is valuing

the peer group in terms of your chosen multiple or multiples

• So market multiples are a measure of relative value – this company

should trade at the same level as its peers

• If you want to estimate the real economic value of the equity or firm

you must use discounted cash flow (fundamental economic value)

Common market multiples

Equity Multiples:

• PE ratio

MPS or Market capitalisation

EPS Earnings after interest and tax

Note that the Earnings need to be after Preferred Dividends so that they are earnings that

are available to ordinary shareholders

• PB ratio

Price per share Market capitalisation

BV of equity per share BV of ordinary shareholders equity

Enterprise Value Multiples:

• EV/Revenue

• EV/ EBITDA

• EV/EBIT

• The goal here is to understand the multiples at which

transactions in the target’s industry sector have been announced

or completed. The importance difference with market multiples is

that in this case, a control premium is built into the offer price and

therefore the multiples.

• Specifically, determine the pricing of past deals as compared to

the target’s financial performance and unaffected (pre-

announcement) market value

• Transactions selected should be as comparable to our proposed

transaction as possible, so one should look for recent deals,

where a company with highly similar business was acquired, in the

same country as the target etc.

• Transaction multiples include the premium paid (offer price

premium are often expressed as % of 1-day, 1-week and 4-week

pre-announcement trading prices - VWAPs).

Transaction multiples

Valuation using discounted cash flow

• DCF models approach valuation by considering what drives

economic value – often called fundamental valuation

• An asset, a firm, or its equity is worth the value today of all its

future net cash flows

• Valuation by discounted cash flow requires combination of

three finance concepts

• Time value of money

• Free cash flow

• Cost of capital

• DCF models range from the very simple to the quite complex

Discounted Cash Flow basic formula

The value of equity or of the firm (debt + equity or enterprise

value) is best measured by the discounted value of future cash

flows.

NPV = FCF1 + FCF2 + FCF3 + …. + FCFn

(1 + r) (1 + r)2 (1 + r)3 (1 + r)n

where: FCF = free cash flow

r = discount rate

PV = present value of equity or the firm

Present value

$365 m

Present value

Year 5 to ∞ $10,927 m

Value today

(Present value)

$13,338 m Present value

$722 m Present value

$681 m Present value

$643 m + + + =

The cost of waiting (WACC = 8.7%) reduces the value of the free cash flow

+

The concept of Time Value of Money

Nominal value

$397 m

Nominal value

$853m

Nominal value

$875 m

Nominal value

$898 m

Nominal value

Year 5 to ∞ $13,640 m

Toda

y

$16,663m

Applying DCF

DCF may be applied in many ways from the very simple to a

‘complete’ method. The difference is how future estimate are made.

The simplest method – a perpetuity – FCF1

r - g

The ‘complete’ method – discount year on year estimates

for a nominated period and use an assumed constant growth

rate thereafter

Intermediate methods – use constant growth rates for

nominated ‘step periods and an assumed constant growth

rate thereafter

The ‘Complete’ DCF method

Forecast period FCF1 FCF2 FCF3 FCFt-1 FCFt g x x x x x x sum V enterprise value less D market value of debt

equals E value of equity

divide N number of shares

equals P value per share

V = FCF1 + FCF2 + … + FCFt-1 + FCFt (1+r)-(t-1)

(1 + r) (1 + r)2 (1 + r)t-1 (r - g)

Terminal

year

Steps in ‘Complete’ DCF calculation

• Determine specific forecast period and terminal year

• Forecast free cash flow for specific period

• Forecast free cash flow for terminal year and beyond

• Determine discount rate (must be consistent with 2 and 3)

• Determine present value of free cash flows

• Determine enterprise value

• Deduct market value of debt to derive equity value

• Determine number of shares

• Determine value per share

• Businesses generate cash flows from operations

• Free cash flow to the enterprise is the after-tax cash flow from

operations that is “free” to be paid back to equity and debt holders

• Investors base their assessment of value on the cash flows they

could receive

• They “receive” these cash flows either directly through dividends or

through capital gains

• The value of the business is equal to the value of all the future free

cash flows

The concept of Free Cash Flow

Equity capital

Debt

capital

Working Capital

Net Assets

Non-current

Assets

Free Cash Flow to

the Enterprise

Free Cash Flow to the Enterprise

The amount of cash flow available to debt and equity investors after

investment in working capital and capital expenditure

Free Cash Flow to Equity

Free Cash Flow to Debt

Basis for

valuing

Equity

Basis for

valuing

Enterprise

Cash from

operations

The concept of Free Cash Flow

Calculating Free Cash Flow

There are two common approaches:

• an indirect approach from the Income Statement

or alternatively

• a direct approach it from the Cash Flow Statement

The indirect method

From the Income Statement:

Net Profit (earnings after interest and tax)

+ Interest

+ Tax

= EBIT (earnings before interest and tax)

- EBIT x Corporate tax rate

+ Depreciation and Amortisation (non-cash expenses)

+/- Change in working capital

= Net cash flow

- Net Capital expenditure (Capex)

= Free cash flows available to debt and equity holders (FCFd+e)

The direct method

From the Cash Flow Statement

Net cash flow from operations

+ Interest x (1 – corporate tax rate)

- Net Capital expenditure (Capex)

= Free cash flows available to debt and equity holders (FCFd+e)

Choosing the forecast period

The forecast period should reflect how long it will take for free

cash flows to become ‘normal’ (grow at a constant rate

thereafter).

This time period is indicated by:

• When you no longer have a competitive advantage

• The duration of the economic cycle for firms in cyclical industries.

• All predictable significant events are impounded.

• The degree of confidence in forecasts of future events.

Estimating future growth in FCF

During the forecast period:

• Each year must be considered individually

• The best results will be obtained through ‘line-by-line’

forecasting

• Generally avoid highly simplifying assumptions

The terminal year and beyond:

• Generally the estimated long term growth rate in

the economy is used because you can’t

outperform for ever

Estimating the Cost of Capital

Weighted average cost of capital under CAPM :

WACC (r) = re . E + rd (1-t) . D

V V

where: re = rf + b(rm - rf)

rd = interest rate

t = corporate tax rate

E = market value of equity

D = market value of debt

V = market value of the firm

The most popular method of estimating the cost of capital is

the Capital Asset Pricing Model (CAPM) …

Methods used in Australia

Source:

Most popular

method

Australian Journal of Management June 2008

Estimating Net Capital Investment

• Capital Investment represents the amount invested to maintain and

grow the business

• Can think of capex in two parts:

• replacement capex

• growth capex

• Where possible base estimates on actual capex forecasts

• If forecast data isn’t available cash flow statement approach is

most straight forward

• Consider ‘normal capex’; don’t include irregular capex or one off

events

• Also consider any inflows from realising old investments – hence

the reference to net capital investment

Length of forecast period

• It is assumed the business cannot grow faster than the economy

indefinitely

• However, a monopoly can last a long time

• Patents have long lives

• Brand superiority can be enduring

• How long superior growth rates can be maintained depends on the

sustainability of competitive advantage

Industry Value Growth Durations Value Growth Duration

Industry (Using Straight Perpetuity)

Banking 1-5 years

Food Products 3-10 years

Fast Foods 3-15 years

Pharmaceutical 15+ years

Beer and Wine 2-20 years

Airlines 3-10 years

Home Building 3-6 years

Source: LEK

* Chile’s Grill & Bar, Ramano’s Macaroni Grill, Maggiano’s, etc.

** PepsiCo spin off of KFC, Pizza Hut, Taco Bell

Source : Value Line, L.E.K Analysis

2124

29

90

7976

71

10

-

20

40

60

80

100

Wendy's Brinker Int'l* McDonald's Tricon**

Percent

Percent of Enterprise Value Attributable to Residual value

First 5 Years

After 5 Years

Terminal value – how important?

Example of an intermediate method

• Clearly the ‘complete’ DCF model is complex and time-consuming.

• Many shortcut methods exist: an example

• Forecast free cash flows in three steps; two initial constant growth

periods of , say, five years each with a constant growth rate

thereafter forever.

FCF growth

rate (%)

10

5

3

5 10 Years

Non-operating items

• Valuation may be simplified by removing the net cash inflows from

non-operating or non-core assets from the determination of annual

free cash flows.

• If this is done the present value of free cash flows will omit the value

of those assets.

• Hence, after calculation of the present value of the free cash flows

the market value of the non-operating assets must be added.

• This variation of the model relies on the assumption that the current

market value of such assets represents the present value of the net

cash flows that would be derived from the asset in the future.

• Excess cash can be treated in this way.

Judgement

• It is apparent that a great many judgements have to be made in

every element

• Good idea to check how sensitive the answer is to changes in key

variables

• What the DCF model does is to ensure you make judgements

about the things that drive value

• So your answers are not right, just the best you can do

• That’s why it is a good idea to check, using alternative method(s)

whether your answer is reasonable

End note one

Remember

you take responsibility for the debt

but you only pay for the equity

End note two

Suggestion

If you’re doing a valuation that really

matters

GET AN EXPERT

But check their results….

…..….because……...

End note three