Training The Street s Pre-Reading Materials Corporate Valuation Workshop Valuation Primers

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1 Training The Street s Pre-Reading Materials Corporate Valuation Workshop Valuation Primers Preparing Financial Professionals for Success Training The Street, Inc.

2 Table of Contents A Primer on Public Comparables Analysis... 3 A Primer on Acquisition Comparables Analysis A Primer on Discounted Cash Flow Analysis A Primer on Merger Consequences Analysis A Primer on Leveraged Buyouts Training The Street, Inc. Page 2 of 28

3 A Primer on Public Comparables Analysis Training The Street, Inc. Page 3 of 28

4 A Primer on Public Comparables Analysis Overview Public comparables analysis is a relative valuation approach used by practitioners to evaluate how the equity markets are valuing a group of companies that are similar to the target company. The public comparables analysis operates on the basis that all things being equal, similar companies should have similar valuation multiples. The two most important measures used in the relative valuation exercise are: (i) the valuation measure (i.e. price per share) and (ii) the performance measure (i.e. earnings per share or EPS). Each of them conveys information about the company s value or performance. But the real power of these metrics lies in combining them to calculate a multiple. Hence, every relative valuation multiple has the following fundamental structure: Valuation Measure Value Performance Measure Value Driver Company multiples are likely to diverge due to several factors, including but not limited to, each company s degree of financial risk, profitability & margins, growth prospects and takeover speculation for either of the companies in the peer group. By analyzing the key multiples for each of the companies in the peer group, it is possible for practitioners to estimate how the public equity markets would value the target company. More importantly, this analysis allows practitioners to form an opinion as to whether a target company is overvalued, fairly valued, or undervalued relative to its peers using benchmark valuation multiples. This approach is usually the first valuation methodology used by practitioners when undertaking a valuation analysis of a target company. There are a number of steps involved in doing a public comparables analysis. They include: 1) Selecting a comparable peer group (comps universe) 2) Gathering the appropriate information 3) Calculate valuation measures 4) Calculate performance measures 5) Calculate the multiples 6) Analyze the results and derive a range Selecting a comparable peer group Selecting a peer group to include in a relative valuation analysis can be challenging. Therefore, it is important that practitioners understand the target company's business beforehand. Ideally companies that are to comprise the peer group should have similar operational and financial characteristics as those of the target company. While the list of common characteristics below is not exhaustive, it provides a broad overview of the practice and includes suggested sources commonly used by practitioners to create a peer group: Operational Financial Suggested sources for finding comparables 1) Industry/Sector 2) Products & services 3) Markets (geography base) 4) Business structure (i.e., manufacturer, distributor) 5) Customers 6) Seasonality 1) Size (i.e. Revenue, market capitalization) 2) Growth prospects 3) Profitability / Margins 4) Financial leverage 5) Liquidity 6) Shareholder base 7) Business outlook (i.e. maturity, restructurings) The target's annual report, 10-K (especially the section on competition equivalent to an annual report and specific to US companies), or prospectus Proxy statements in which the target compares its stock price performance with a that of peers Previous analysis from in-house professionals Analyst research reports S&P Capital IQ, Value Line, and Moody's company reports Recent news focus on market moving headlines A meaningful comparison in a relative valuation analysis may only occur when the companies in the peer group have similar products, profitability figures, financial leverage, prospects for growth, etc. as the target company. However, such a scenario is often difficult to realize as practitioners can rarely find companies that have the exact same operational and financial characteristics. Depending on the size of the peer group, practitioners may create company subgroups to better understand and analyze the multiples Training The Street, Inc. Page 4 of 28

5 Gathering the appropriate information Practitioners typically gather several documents for each company included in the peer group. Gathering the public information to complete this analysis can be time consuming and there are some items on the information list that require a premium service subscription in order to be accessed. Below is a list of items required to begin the exercise of calculating valuation multiples. 1) 10-K (US) or annual report (non-us) for the most recent fiscal year Obtained from a subscription-based database service, or freely available on the company s website (usually under investor relations or a similar section). 2) 10-Q (US) or interim report (non-us) for the most recent period Obtained from a subscription-based database service, or freely available on the company s website (usually under investor relations or a similar section). 3) News announcements since the most recent filing Obtained from the company s website, a news provider s website, or a subscription service. Focus on newsworthy items that could have an impact on the company s share performance since the filling of the latest interim or annual results. 4) Financial statistics estimates Typically, practitioners use consensus estimates for revenues, EBITDA, EPS and so on. An example of an aggregator service would be S&P Capital IQ. However, a subscription may be required. Choose one research report for all estimates. A subscription may be required. 5) Most recent closing share price (and most recent dividend per share) Obtained from a subscription-based database, or freely available on a company s website or another finance website (such as Yahoo! Finance or Google Finance) Training The Street, Inc. Page 5 of 28

6 Calculate valuation measures The two commonly used measures of a company s value are: (i) Equity Value and (ii) Enterprise Value. These two values form the basis for business valuation and are defined below in more detail. NCI * Preferred Stock Net Debt Enterprise Value Equity Value Price x diluted shares outstanding Also know as: Market Cap. or Market Value Also know as: Firm Value. or Aggregate Value * NCI = noncontrolling interest. It is also referred to as minority interest. It represents the interest of a noncontrolling shareholder in the net assets of a company. Equity Value Reflects the market value of the shareholders' residual interest after repaying all senior claims such as debt, minority interest and preferred stock. Calculation Considerations Diluted shares outstanding reflect any and all shares from options, restricted awards, warrants and convertible securities. These instruments are commonly referred to as dilutive securities. Practitioners need to know what the total number of shares outstanding would be if all of these instruments were converted into shares. Enterprise Value A measure reflecting the market value of an entire company, comprising the sum of claims of all claimants. In other words, it measures the company s market value from the viewpoint of all it financing sources. Calculation Considerations Use the latest balance sheet information Net Debt is equal to total debt less cash and equivalents. Include both the current portion of long-term debt and long-term debt as well as short term debt when calculating total debt. Preferred stock that is not convertible into common stock is treated as a financial liability equal to its liquidation value. Liquidation value is the amount the firm must pay to eliminate the obligation. Noncontrolling interest, formerly known as minority interest, represents the interest of a noncontrolling shareholder in the net assets of a company Training The Street, Inc. Page 6 of 28

7 Calculate performance measures Some performance measures are more universal in their application, while others are more industry-specific. The key is to match the performance measure with the appropriate valuation measure. For the purpose of this primer, the focus will be on the most common performance measures used across a majority of industries. With most financial performance measures, it is not possible to eliminate all accounting differences between companies. Therefore, practitioners generally use key performance measures that are least likely to be distorted because of the company s capital structure or the adoption of new accounting rules. The standard financial performance measures (and select industry-specific ones) are summarized below: 1) Revenue - referred to as a suitable basis for valuation on the premise that it is largely comparable across different accounting standards. However, it is an incomplete measure of performance given its lack of focus on profitability and cash flow. As a consequence, revenue as a performance measure and basis for valuation should only be considered if more relevant profit measures are unavailable. 2) Earnings Before Interest, Taxes, (aka EBIT) and; 3) Earnings Before Interest, Taxes, Depreciation and Amortisation (aka EBITDA) EBIT and EBITDA capture the "intrinsic operational performance" of a business. In other words, the performance when all costs that do not occur in the normal course of business (i.e., restructuring costs, impairment charges, advisory fees) are ignored. We refer to these as normalized results if any of the aforementioned items have been excluded from the reported results. 4) Earnings Per Share (aka) EPS: The portion of a company's net income allocated to each outstanding share of common stock. Usually, a forward median or average consensus estimate is used. 5) Some industry-specific performance measures include: Same store sales growth rate: compares the sales of stores that have been open for at least one year. Allows practitioners to assess the portion of new sales derived from sales growth and the portion that can be attributed to the opening of new stores. Commonly used within the retail sector. Average revenue per unit (ARPU): allows for the analysis of a company's revenue generation and growth at the per-unit level. Often used in the telecommunications sector. Depreciation & amortization are noncash recurring operating expenses that are added to EBIT to arrive at EBITDA Training The Street, Inc. Page 7 of 28

8 Calculate the multiples Valuation multiples attempt to capture a firm's operating and financial characteristics in a single number. In other words, a multiple captures the relationship between a valuation measure and performance measure. To be meaningful, the performance measure Revenues, EBITDA, EPS or some other measure must bear a logical relationship to the valuation measure being observed. The basic formula to calculate a multiple is: Valuation Measure Value Performance Measure Value Driver There are two categories of valuation multiples that form the basis of the relative value analysis: (i) Enterprise Value multiples and (ii) Equity Value multiples. Enterprise Value Multiples Equity Value Multiples Enterprise Value / Revenue Enterprise Value / EBITDA * Enterprise Value / EBIT * Eqity Value / Net Income * Share Price / Earnings Per Share (E.P.S.) * P E / Annual EPS Growth Rate (PEG Ratio) ** * Reported results adjusted to exclude any extraordinary items and one-time occurrences (e.g., restructuring charges). ** The price/earnings to growth (PEG) ratio is used to determine a stock's value while taking the company's EPS growth rate into account. It is considered to provide a more complete picture than the P/E ratio, and the EPS growth rate is based on consensus estimates. Once the multiples for the peer group have been calculated, the practitioner will use their best judgment when choosing the valuation metrics that will serve as the basis for reaching a conclusion on how the target company trades relative to its peers. The selection of a multiple is purely subjective and it is likely to be based upon various data points. The public comparable analysis can also raise questions when significant discrepancies exist between the trading multiples of the target company and those of its closest peers. In this instance, the practitioner is likely to undertake additional research to better understand the discrepancy which may result in some companies being excluded from the analysis. Research reports and news articles are good sources to review. In summary, the practitioner needs to provide compelling arguments to support their conclusions Training The Street, Inc. Page 8 of 28

9 Analyze the results and derive a valuation range Market Multiples Analysis of Selected Technology Companies (Figures in millions, except per share data) Companies are organized in alphabetical order Enterprise Value as a Multiple of: Price / LTM Projected Market Value Enterprise Sales EBITDA EBIT CY+1 EBITDA EPS PEG Company Stock Price of Equity Value (a) LTM LTM LTM EPS Margin Growth Ratio Apple Inc , , % 18.4% 0.7 CA Technologies , , % 8.9% 1.4 Cisco Systems, Inc , , % 7.8% 1.4 Google Inc. 1, , , % 17.1% 1.3 Intel Corporation , , % 10.9% 1.2 International Business Machine , , % 9.8% 1.1 Hewlett-Packard Company , , % 3.8% 2.1 Oracle Corporation , , % 10.3% 1.3 Samsung Electronics Co. Ltd. 1, , , % 12.3% 0.6 SAP AG , , % 9.1% 1.8 VMware, Inc , , % 19.7% 1.4 Yahoo! Inc , , % 10.0% 2.4 There are few companies similar to MSFT in terms of products sold and size. Therefore we have kept the parameters broad to capture more companies. Most recent closing share price High 7.87x 24.4x 30.7x 27.2x 43.5% 19.7% 2.4x Average % 11.7% 1.4 Median % 10.3% 1.3 Low % 3.8% 0.6 Microsoft Corporation $38.31 $318,000.7 $258, x 8.1x 9.2x 14.0x 38.1% 8.7% 1.6x (a) Calculated as Market Value of Equity plus total debt, non-controling interest and preferred stock, less cash & equivalents. (b) Financial data provided by S&P Capital IQ as of Feb Common to show the following values. Include High/Average/ Median/Low multiples and operating statistics to allow for comparison. Consider excluding outliers. Show standard Enterprise and Equity multiples. Common to include both historical (Latest twelve months LTM ) and forward looking multiples that are based off consensus estimates. Helpful to show margins to help with interpretation of the multiples. Also include industry specific multiples if known. Footnotes are used for clarifying difficult formulas or unusual terminology A valuation range illustration To demonstrate the application of deriving an equity value range let s consider the following. A practitioner concludes after narrowing the peer group, that a reasonable for a forward P/E multiple is 12.0x 15.5x. To calculate an equity value range, the next step is to apply the P/E multiple ranges to MSFT s forward EPS consensus estimate of $2.74. The calculation of the equity value ranges are shown below: Consensus EPS estimate $2.74 Consensus EPS estimate $2.74 x P / E multiple 12.0x - x P / E multiple 15.5x = Implied share price $32.88 = Implied share price $42.47 Based on the current share price of $38.31 for MSFT, the company appears to trade at the high end of the range. The practitioner will defend their conclusion on MSFT being overvalued, fairly valued, or undervalued by performing a detailed qualitative and quantitative analysis of MSFT against companies in the peer group. Conclusion It is important to compare a target company's multiples to those of its peer group in order to bring the comparative analysis into context. To perform a relative value analysis effectively, practitioners must identify the performance measures and be able to explain why the multiples trade at different levels. In order to do this, practitioners must have a fundamental understanding of the business being analyzed and the sector in which it operates. There are a variety of dynamics that could influence a company s market multiple including, but not limited to, market factors, size, financial & business risk and growth prospects. The relative value analysis approach is very subjective and will inherently result in differing valuation ranges, which is why practitioners often refer to valuation as being part art and part science. To help validate and build confidence around the valuation ranges, practitioners are likely to perform a Discounted Cash Flow (intrinsic value) analysis to determine if the intrinsic value falls within the range of those implied under the relative valuation approach as well as review stock price targets established by equity research analysts that cover the company. Due to the subjective nature of this exercise, a company s valuation is rarely quoted as just one value, but rather a range of values. Remember, a goal of the analysis is to understand how the market is valuing the target company relative to the peer group. It is important for practitioners to understand what has been priced into the stock of the target company or that of its peers. For example, it is important to note if a merger premium has been built into the share price of the target company or a peer. Analyzing market multiples allows practitioners to form an opinion as to whether or not the target company is overvalued, fairly valued or undervalued relative to its peers Training The Street, Inc. Page 9 of 28

10 A Primer on Acquisition Comparables Analysis Training The Street, Inc. Page 10 of 28

11 A Primer on Acquisition Comparables Analysis Overview Acquisition comparables or precedent transaction analysis is another relative valuation technique that is used by practitioners to derive an implied value of a target company in a M&A context. This valuation approach is based on the premise that the implied value of a target company can be estimated using historical transaction multiples and premiums paid by acquirers for comparable companies under similar circumstances (i.e. timing, takeover environment, etc.). Examining prior transaction multiples and premiums allows practitioners to assess what may be necessary in the current situation to gain full or majority control of a target company or what the target company s shareholders could expect to receive in an acquisition. There are a number of steps involved in doing a precedent transaction analysis. They include: 7) Determining the transaction list and information sources 8) Calculate the valuation measures 9) Calculate the multiples 10) Compute premiums paid 11) Analyze the results and derive a valuation range Determining the Transaction List and Information Sources Selected precedent transactions should be as comparable to the proposed transaction as possible. Perhaps the easiest way to screen for historical transactions is by performing a database search using an online subscription service such as S&P Capital IQ. Since no two companies or transactions are exactly the same, the most similar companies and transactions are sought. Practitioners aim to screen for precedent transactions in which a variety of similarities exist. Ideally, the target companies (precedent and contemplated target) should have similar profiles (i.e. business activities, geographical location and profitability profile), and characteristics including, but not limited to, the following: Industry and financial characteristics Similar Sales, EPS growth and operating margins Size of the deal as measured by offer and transaction value Nature of the transaction - Hostile, friendly and did multiple bidders exist. Full or majority control Buyer type: Strategic vs. financial buyer Transaction-specific characteristics Domestic vs. cross-border, full auction vs. negotiated deal, underlying market conditions Timing The more recent the data, the more relevant the benchmark. Good to identify any significant industry wide events occurring at the time (i.e. wave of consolidation) The precedent transaction analysis requires practitioners to study various documents and extract the relevant information required to calculate the transaction multiples. Finding appropriate information for this analysis is akin to putting together pieces of a puzzle using various information sources (i.e. merger agreement, investor presentations, and regulatory filings). Research reports and industry magazines provide useful background innformation on things like the strategic rationale for the transaction etc Training The Street, Inc. Page 11 of 28

12 Calculate the Valuation Measures When practitioners reference value in an M&A context, the following terms are used: NCI * Preferred Stock Net Debt Transaction Value Offer Value Offer Price x diluted shares outstanding * NCI = noncontrolling interest. It is also referred to as minority interest. It represents the % of equity in a consolidated subsidiary that is owned by someone else. Offer Value Reflects the amount an acquirer agrees to pay for all outstanding shares of the target company and any security that can be converted into shares. This is collectively referred to as total potential shares outstanding. Practitioners apply the proceeds from in-the-money options to reduce the amount needed to calculate at the offer value. Calculation Considerations Offer Value Gross Up - There may be instances when less than 100% of the target equity is acquired. In order to perform a precedent transaction analysis under this scenario, the offer value will need to be adjusted to reflect the value of the transaction as if 100% of the target company s equity was acquired. This is important since the offer value is being compared against a performance measure (i.e. Sales or EBITDA) that is wholly attributable to the target. To correct the above inconsistency, practitioners adjust the offer value (and, as a result, the transaction value) for each deal to assume a 100% acquisition using the gross up formula below: Implied 100% Offer Value = Offer Value / % Acquired Transaction Value A measure reflecting the true cost of the transaction to the acquirer. It includes not only the offer value, but also the target s net debt obligations (net of cash), including obligations to preferred stockholders and noncontrolling interest holders as of the most recent balance sheet date. The acquirer cannot just acquire the equity of the target and not the other components of the capital structure, as these obligations are likely to contain change-of-control provisions with specific terms of liquidation. Calculation Considerations Use the latest balance sheet information Net Debt is equal to total debt less cash and equivalents. Include both the current portion of long-term debt and long-term debt as well as short term debt when calculating total debt. Preferred stock that is not convertible into common stock is treated as a financial liability equal to its liquidation value. Liquidation value is the amount the firm must pay to eliminate the obligation. Noncontrolling interest, formerly known as minority interest, represents the interest of noncontrolling shareholder in the net assets of a company. It is worth noting that the premium paid in a transaction resulting in less than a 100% ownership stake may not be the same as the premium the acquirer might have paid to gain full control of the company. Therefore, it is important to highlight transactions of this type in the analysis. With the grossed up offer value calculated, the next step is to calculate the transaction value Training The Street, Inc. Page 12 of 28

13 Calculate the Multiples A goal of the acqusition comparables analysis is to interpret the price paid by the acquirer to gain control of the cash generating assets of a target company. One of the ways this can be achieved is by calculating transaction value multiples. A transaction multiple compares the relationship between a valuation measures (i.e. transaction value) and a performance measure (i.e. Sales, EBITDA, EBIT). That mathematical equation can be expressed as follows: Valuation Measure Value Performance Measure Value Driver The illustration below depicts the standard multipes that are calculated using the offer and transaction value: Offer Value Multiples Transaction Value Multiples Offer Value / Net Income * Transaction Value / Revenue Offer Value / Equity Book Value Transaction Value / EBITDA * Offer Price / Earnings Per Share (EPS) * ** Transaction Value / EBIT * * Reported results adjusted to exclude any extraordinary items and one-time occurrences (e.g., restructuring charges). Premiums Paid Analysis An acquisition premium is the difference between the estimated fair value of a company and the actual price paid to acquire the target company. An acquirer usually pays a premium above the current share price in order to compensate for the control it is receiving over the target company. The premium also reflects the buyer s expectation that the merger will yield positive synergies (i.e. cost savings) once the two companies are combined, resulting in higher earnings on a combined versus a standalone basis. Shareholders of the target company recognize this and want to be paid upfront for it. So in effect, the premium represents the price paid for control of the company and for the expected resulting synergies. Because of the inherent price inflation, this analysis typically leads to a higher valuation range in comparison to those derived from public comparables analysis. The acquisition premium is calculated using the following formula: Acquisition Premium (%) = Offer Price / Target Company Share Price * 1 * Based on the closing price of the target company prior to the announcement of a business combination Because information leaks in these kinds of transactions can occur, sudden target company share price increases may not necessarily reflect improving underlying company fundamentals. Such a share price increase would ultimately affect the premium paid which is to be used in the precedent transaction analysis. Under this scenario, practitioners seek to calculate the premium using the company s unaffected share price. To do so, the share price at various time periods (i.e. one week prior to announcement) are used to calculate a true premium Training The Street, Inc. Page 13 of 28

14 Analyze the Results and Derive a Valuation Range To compute an implied transaction or offer value for the target company, the multiples from precedent transactions are applied to the relevant performance measure of the target company. There are several ways practitioners select the transaction multiples to be used in this analysis. For simplicity, a practitioner may use the average / median transaction multiple or the lowest and highest multiples and premiums. However, the aforementioned has several shortcomings. Alternatively, the practitioner could create a subset incorporating transactions that occurred in similar market conditions, involved companies with similar products and services, the companies exhibited similar growth prospects, operating margins and financial risk. The most appropriate method will depend on the perspective (target or acquirer) and the situation. A valuation illustration To demonstrate the application of deriving an implied transaction and offer value, let s consider the following. A practitioner concludes, after a review of precedent transactions, a transaction value multiple of 18.0x 19.5x and premium of 30% - 40% are reasonable acquisition parameters to expect under the current situation. Using the performance measures of the target company and transaction value multiple ranges, the practitioner will calculate the following transaction and offer values: Select Financial Information & Valuation Analysis (amounts in millions unless otherwise indicated, except per share data) Sales $1,200.0 Net debt (175.0) EBITDA Diluted shares outstanding % Margin 13.8% Consensus CY EPS estimates $1.35 EBITDA $165.0 EBITDA $165.0 x Transaction multiple 18.0x x Transaction multiple 19.5x = Transaction value $2,970.0 = Transaction value $3, Net debt (175.0) - Net debt (175.0) = Offer value $2,795.0 = Offer value $3,042.5 Diluted shares outstanding Diluted shares outstanding = Offer price per share $19.28 = Offer price per share $20.98 Current share price $14.38 Current share price $14.38 = Offer Premium 34.0% = Offer Premium 45.9% Consensus CY EPS estimates $1.35 Consensus CY EPS estimates $1.35 Offer price per share / CY EPS 14.3x Offer price per share / CY EPS 15.5x Notes: The one year forward EPS estimate is based on a calendar year (CY) fiscal year end. Offer Premium (%) = Offer price per share / Current share price Training The Street, Inc. Page 14 of 28

15 Sample Summary of Acquisition Comparables Select Apparel and Retail-Jewelry Transactions (Figures in millions, except per share data) Multiples Analysis of Selected Precedent Apparel and Retail-Jewelry of the Transactions multiples. (Figures in millions, except Common per share data) to show the legal names of the Target first then Acquiror Aggregate value of 100% of the target's diluted common equity Multiples calculated based of the target s performance measures and transaction value. Helpful to show margins to help with interpretation PRE-SYNERGIES: Calculate premium over different time periods in order to arrive at the true premium paid Offer Value / Transaction Value / LTM Premiums Paid Date Offer Value Transaction LTM Book LTM LTM EBITDA 1 Day 1 Week 1 Month Target / Acquiror Announced of Equity Value (a) CY EPS Value Sales EBITDA Margin Prior Prior Prior Harry Winston Luxury Brand Segment / Swatch Group 01/14/13 $750.0 $1,000.0 NA NM 2.34x 24.4x 9.6% Warnaco Group / PVH Corp. 10/31/12 2, , x 2.6x % 34.5% 31.1% 33.4% Benetton Group SpA / Edizione S.r.l. 02/01/12 1, , % 13.6% 45.6% 47.5% The Timberland Company / VF Corporation 06/13/11 2, , % 43.4% 45.8% 28.9% Jimmy Choo / Labelux 05/22/ NA NM % Gruppo Coin SpA / BC Partners 05/09/11 1, ,023.5 NA % 1.4% 0.0% 8.3% Volcom, Inc. / PPR SA 05/02/ NA % 24.2% 31.9% 32.9% Bulgari SpA / LVMH 03/07/11 5, , % 61.4% 59.5% 59.6% J Crew Group, Inc. / Leonard Green & Partners 11/23/10 2, , % 15.5% 23.1% 37.3% Tommy Hilfiger B.V. / Phillips-Van Heusen Corp. 03/15/10 3, ,167.1 NA % Bailey Banks & Biddle / Finlay Enterprises, Inc. 09/27/ NA % Oakley, Inc. / Luxottica Group S.p.A. 06/20/07 2, , % 16.1% 20.9% 20.5% Hugo Boss AG / Permira Advisors Ltd. 06/01/07 2, ,432.5 NA % 7.6% 4.9% 6.1% Valentino Fashion Group / Permira Advisors Ltd. 05/16/07 3, , % 8.0% 9.9% 13.6% Puma AG Rudolf Dassler Sport / PPR SA 04/10/07 7, , % 4.8% 18.3% 22.5% Organised in chronological order, all financial data should be as of the announcement date. Reflects all information known to the acquirer at the time. Include High/Average/ Median/Low multiples and operating statistics to allow for benchmarking High 39.5x 186.1x 3.93x 27.2x 23.3% 61.4% 59.5% 59.6% Average % 20.9% 26.4% 28.3% Median % 15.5% 23.1% 28.9% Low % 1.4% 0.0% 6.1% For training purposes only Note: All transactions reported in USD$ (a) Calculated as Offer Value of Equity plus total debt, minority interest and preferred stock, less cash & equivalents & unconsolidated affiliates. Footnotes are used for clarifying difficult formulas or unusual terminology Conclusion The objective of a precedent transaction analysis is to calculate and to understand the premiums and multiples paid in precedent transactions in which the acquirer sought control of the target company. This analysis lays the foundation for setting a realistic expectation of an acceptable premium and purchase price multiple in a contemplated transaction by the shareholders of the target company. An important difference in this analysis, when compared with the public comparables analysis, is that a control premium is built into the offer price and therefore the transaction multiples. Like other valuation techniques, precedent transaction analysis is as much an art as it is a science. Interpretation of the data requires familiarity with the industry and the assets involved. Often times, practitioners will specify a small subset from a broader group of precedent transactions. These "most comparable transactions" can be analyzed in more detail to get a better understanding of the circumstances leading to the specific valuation levels. A practitioner needs to know the story for each transaction in order to understand the transaction multiple when compared to similar transactions. Besides the three main considerations that typically influence multiples company size, financial & operating risk and growth prospects it is important to also understand the role of potential synergies on the price paid and the resultant multiple Training The Street, Inc. Page 15 of 28

16 A Primer on Discounted Cash Flow Analysis Training The Street, Inc. Page 16 of 28

17 A Primer on Discounted Cash Flow Analysis Discounted Cash Flow (DCF) Analysis yields the theoretical valuation of a firm. The concept behind a DCF analysis is that the value of a company is based on the present value of the cash flows that it can generate in the future. A DCF valuation has three major components: 1) A discount rate, called the weighted average cost of capital (WACC), which we will use to discount the future cash flows and the terminal value back to their present value; 2) Forecasting cash flows or, more precisely, unlevered free cash flows; 3) A terminal value of the company. Let s take each of these in turn: 1) Weighted average cost of capital In a DCF analysis, a company s value is determined by estimating its future free cash flows over a number of years, then discounting those cash flows back to the present, using a risk factor called the weighted average cost of capital (WACC). WACC captures the risk of those future cash flows and reflects the cost of the company s equity capital (cost of equity) and of its debt capital (cost of debt). You can also think of WACC as the blended rate of return that the company s equity and debt investors require to compensate them for the risk of investing in the company. The formula for weighted average cost of capital (WACC) is presented in graphic form: Cost of Debt X After tax cost of debt 1 Tax rate X Risk free rate + Beta X Market risk premium Percentage of debt Percentage of equity 2) Unlevered free cash flow X Cost of equity Weighted cost of debt + Weighted cost of equity Weighted Average Cost of Capital (WACC) Where: The tax rate is the marginal rate The risk free rate is typically the yield on the 10-year U.S. Government Bond Beta measures the volatility of a company s stock price compared to the overall market Market risk premium is the rate of return in the market minus the risk free rate. The U.S. market risk premium is often in the range of 4.0% to 7.0% Unlevered free cash flow is cash available to capital holders before debt holders are paid. Free implies that it is the cash flow in excess of what is needed to fund the company s operations. Loosely translated, it is the cash flow after taxes are paid, capital expenditure requirements are met, and working capital needs are deducted. Historical Projected FYE-2 FYE-1 FYE FYE+1 FYE+2 FYE+3 FYE+4 FYE+5 Sales $7,385.0 $7,998.0 $7,586.0 $7,705.5 $7,826.8 $7,950.0 $8,075.2 $8,202.4 Cost of goods sold 4, , , , , , , ,619.1 Gross Profit 3, , , , , , , ,583.3 Selling, General and Administrative 1, , , , , , , ,926.8 EBITDA 1, , , , , , , ,656.5 Less: Depreciation (263.0) (271.0) (264.0) (297.9) (315.0) (332.6) (350.7) (369.3) Less: Amortization EBIT 1, , , , , , , ,287.2 Less: 36.7% (437.9) (474.6) (465.4) (461.9) (464.6) (467.2) (469.9) (472.5) Tax-effected EBIT Plus: Depreciation and amortization Less: Capital expenditures (298.0) (345.0) (350.4) (356.0) (361.6) (367.2) (373.0) Less: Additions to intangibles (Increase)/decrease in w orking capital (119.0) (59.0) (3.9) (4.0) (4.1) (4.1) (4.2) Unlevered Free Cash Flow $672.4 $662.6 $739.9 $756.1 $772.7 $789.6 $806.8 In practice, finance professionals typically select a forecast period of 5 to 20 years. The length of the projection period depends on the characteristics of the company and its industry. A main consideration for determining the length of this period is when the company will reach a steady state Training The Street, Inc. Page 17 of 28

18 One steady-state indicator is when a company is sustaining its capital investment that is, all the company s new spending goes simply to replacing the fixed assets that they are losing in a given year from depreciation. This implies that the business is only replacing existing fixed assets in order to sustain its current levels of production, rather than investing in new or additional property, plants or equipment. Another sign of steady state operations is when the company s working capital or short-term operating cash flows have stabilized. 3) Terminal value of the company The terminal value of a company represents the present value of the sum of the additional cash flows beyond the forecasted period. Two methods are widely used to project the terminal value: a) The Terminal Multiple Method: This assumes that at the end of the forecast period, the company is worth a lump sum that is calculated as a multiple of an operating metric, e.g., a multiple of EBITDA: Terminal Value = multiple x EBITDA n Where n equals the final year of the forecast period There are many important factors to take into account when determining the terminal multiple. Most practitioners begin with the current trading multiple, then examine whether that multiple is sustainable and reasonable. If it is not, they make adjustments to reflect the estimated multiple in a mature-state and in a normal economic environment. b) The Perpetuity Growth Rate Method: This assumes that the company s free cash flows will grow at a moderate, constant rate indefinitely: Where FCF n x (1 + g) FCF is the normalized free cash flow in period n Terminal Value = (r - g) g is the nominal perpetual growth rate, and r is the discount rate or WACC The nominal perpetual growth rate (g) is the company s sustainable long-run growth rate. This rate can be higher than inflation but should not exceed the growth rate of the overall economy. Rates vary by situation and company, but the typical range is 2% to 5%. Getting to a per share value: PV of Free Cash Flows Enterprise Value Net Debt* PV of Terminal Value The present value of unlevered free cash flows plus the present value of the terminal value gives you the enterprise value of a firm. To derive equity value from enterprise value, subtract net debt. * For a public company, most professionals will calculate down to equity value per share, so that they can compare the calculated intrinsic value to the current share price. Equity Value Equity Value Diluted Shares To calculate equity value per share, take the total equity value calculated above and divide it by the number of diluted shares outstanding. TTS Takeaways There is no single right answer when doing a DCF analysis, but there are simple steps one can take to improve the quality of the analysis. First, use reasonable and defensible assumptions for your forecasted period. Second, consider materiality when you are trying to develop your assumptions; what is the impact on the final output? Third, there is no perfect WACC or terminal multiple to use, but look at industry averages as a sanity check. Fourth, compare your final equity value per share to the current stock price. If your assumptions reflect general market consensus, then your implied share price should be within a reasonable range of it. Finally, because a DCF analysis has so many variables, your final equity value per share should be shown as a range rather than as one single number in order to account for some variability in those assumptions. * In this example, net debt refers to all interest-bearing liabilities, plus the value of preferred stock, plus the value on any non-controlling interest (often called minority interest), less all cash and cash equivalents Training The Street, Inc. Page 18 of 28

19 A Primer on Merger Consequences Analysis Training The Street, Inc. Page 19 of 28

20 A Primer on Merger Consequences Analysis Merger Consequences Analysis, also known as affordability analysis, is used to determine what an acquirer could afford to pay for a potential target. The affordability analysis is performed in the pre-transaction phase to: (i) evaluate the effect of the transaction on shareholder value, (ii) validate whether the EPS for the acquirer will increase or decrease post-transaction and (iii) evaluate the impact of the transaction on the credit profile of the acquirer. Both the acquirer and target will perform this analysis. The acquirer s objective is to determine how much it can pay while the target is focused on how much it could potentially receive. This analysis does not reflect the fair or appropriate price for an acquisition, but addresses the maximum price that the acquirer can afford to pay taking into account certain financial constraints and parameters. Merger Consequences Analysis for publicly traded companies is often referred to as accretion/dilution analysis. This analysis helps quantify the impact a combination of the two companies will have on the combined consolidated earnings. In other words, will the newly combined company report stronger EPS than the acquirer on a standalone basis in the years subsequent to the transaction. Another affordability question that this analysis seeks to validate, this time, focusing on credit implications, is how much new debt the acquirer can borrow without adversely affecting its credit profile and/or credit rating. The analysis requires evaluating how all the costs and benefits (pro forma impact) of a transaction impact the acquirer. Therefore, one way to approach the analysis is to divide it into three steps: Step 1: Structure the Terms of the Transaction Step 2: Calculate the Transaction Adjustments Step 3: Analyze the Pro Forma Impact Step 1: Structure the Terms of the Transaction Determine the offer price per share The first assumption is to determine a price per share that the acquirer will offer the target in exchange for ownership. Although we can t determine what price the acquirer can afford to pay just yet, we can make preliminary assumptions on the target s valuation expectations based on public comparables, acquisition comparables, and DCF analyses. The offer price is typically higher than the target s share price, and is expressed as a percentage premium. Another way of thinking about it is the extra amount which the acquirer is willing to pay in order to gain control of the target. Historically, control premiums have averaged around 20-40%, but are influenced by both macroeconomic conditions as well as transaction specifics (i.e. the nature of the transaction (hostile or friendly), expected synergies, and the type of consideration paid). Decide on consideration mix The next step is assessing if the acquirer can raise the funds necessary to complete the transaction. The three typical forms of consideration are stock, borrowed funds (or debt) and excess cash from the acquirer s balance sheet. When issuing stock, the acquirer is issuing new shares of its own stock which they then exchange for shares of the target. In other words, the acquirer is matching the value of the offer price with its own shares. The consideration mix will be influenced by the financial constraints and parameters. Step 2: Calculate the Transaction Adjustments Balance sheet adjustments and goodwill When combining the acquirer and the target, there is more to do than summing the assets and liabilities. One of the key adjustments to the balance sheet is accounting for the impact of the financing consideration and transaction costs. The incremental debt and/or equity used to fund the purchase price is debited or credited to the balance sheet of the acquirer. Also certain transaction fees (i.e. advisory fees) are either immediately expensed while others (i.e. financing costs) are deferred. Since the acquirer is assuming all of the target s balance sheet items (not just purchasing shares), the target s assets and liabilities must be restated to their fair market value. If the value offered to the target is greater than the market value of the assets (net of existing goodwill and liabilities), the residual amount is allocated to goodwill. The accounting for these adjustments is called purchase accounting or acquisition method Training The Street, Inc. Page 20 of 28

21 Step 2: Calculate the Transaction Adjustments continued Basics of purchase accounting Offer Value Excess Purchase Price Write up to fair market value Goodwill Write up to fair market value Offer Value Net Identifiable Assets of Target Net Identifiable Assets of Target Net Identifiable Assets of Target Phase 1 Phase 2 Phase 3 Phase 1: Calculate the excess purchase price. Simply take the offer value and subtract the book value of the target s net identifiable assets. Net Identifiable Assets = Assets Existing Goodwill Liabilities Noncontrolling Interest Phase 2: Determine the fair market value. Typically a professional appraiser will use cash flow analysis, comparables analysis, and other valuation techniques to estimate the fair market value of the target s assets. Any adjustment needed to restate book value to a fair value is called a write-up and will be reflected on the combined balance sheet. A common modeling technique is to estimate the write-up as a percentage of the excess purchase price for allocation. The write up percentages will vary from industry to industry. You can review the merger documents of precedent transactions to try and analyze historical write-up amounts as a percentage of the purchase price and use that as a preliminary assumption. Purchase Price Allocation Offer Value 10,450.0 Less: Net identifiable assets of target (235.0) Excess purchase price for allocation 10,215.0 Less: Fixed asset write-up (a) (2,043.0) Less: Indefinite life intangibles write-up (b) (1,532.2) Less: Definite life intangibles write-up (c) (1,021.5) Plus: Deferred tax liability (d) 1,746.8 Goodwill Created 7,365.0 (a) Fixed asset write-up: 10,215.0 x 20.0% = 2,043.0 (b) Indefinite life intangibles write-up: 10,215.0 x 15.0% = 1,532.2 (c) Definite life intangibles write-up: 10,215.0 x 10.0% = 1,021.5 (d) Deferred tax liability = SUM(write-ups) x acquirer tax rate (38.0%) Phase 3: Calculate Goodwill. Now that you have allocated the excess purchase price to specific assets, the "residual" goes to goodwill. Goodwill is the excess purchase price over fair market value of net identifiable assets acquired. Note: A deferred tax liability is generated as a result of the incremental depreciation and amortization from the write-ups. A temporary timing difference arises from this disconnect between when taxes are reported as opposed to when they re actually paid. This is an advanced tax concept and should be discussed in detail with an experienced tax advisor. Income statement (pre and post-tax) adjustments There are a few core transaction adjustments that most merger models account for. They are: (a) Incremental interest expense from new debt issued to finance the transaction (b) Synergies - Additional cash flows or cost savings resulting from the combination of two similar businesses, divided into two categories: incremental revenue or cost savings (c) Additional depreciation and amortization expense resulting from the asset write-ups (d) Adjusting for forgone interest income on the cash off the existing balance sheet used to finance acquisition (e) New shares issued as part of the transaction consideration Calculate pro forma EPS by combining the two companies net incomes and then accounting for all incremental adjustments. Pro Forma EPS = Acquirer s Net Income + Acquirer s Shares Outstanding Target s Net Income + +/- After-tax Incremental Adjustments New Shares Issued Training The Street, Inc. Page 21 of 28