Valuation in M&A
Why is valuation important?
The keys to successful M&A Right reasons Right information Right price Right implementation Strategy Due diligence Valuation Integration
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 Net synergies Costs Synergy leakage Minimum control premium Negotiating Range Standalone value of the target Value of the target to the acquirer
Common techniques used in M&A valuations 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.
Essential difference between multiple and DCF methods 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.
What is to be valued the equity or the whole firm? 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 To purchase a business the acquirer generally pays equity value (but also inherits the debts of the acquired business) Investment by share holders (equity) Enterprise Value Investment by debt holders (interest bearing debt)
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 BV of equity per share Enterprise Value Multiples: EV/Revenue EV/ EBITDA EV/EBIT Market capitalisation BV of ordinary shareholders equity
Transaction multiples 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 (preannouncement) 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).
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 = FCF 1 + FCF 2 + FCF 3 +. + FCF n (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
The concept of Time Value of Money Toda y Nominal value $397 m Nominal value $853m Nominal value $875 m Nominal value $898 m Nominal value Year 5 to $13,640 m $16,663m Value today (Present value) $13,338 m Present value = Present value $365 m Present value + $722 m + $681 m + Present value $643 m + Present value Year 5 to $10,927 m The cost of waiting (WACC = 8.7%) reduces the value of the free cash flow
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 FCF 1 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 Terminal year FCF 1 FCF 2 FCF 3 FCF t-1 FCF t 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 = FCF 1 + FCF 2 + + FCF t-1 + FCF t (1+r) -(t-1) (1 + r) (1 + r) 2 (1 + r) t-1 (r - g)
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
The concept of Free Cash Flow 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 Free Cash Flow to Debt Debt capital Equity capital Working Capital Net Assets Non-current Assets Cash from operations Free Cash Flow to the Enterprise Basis for valuing Enterprise Basis for valuing Equity Free Cash Flow to Equity 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
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 (FCF d+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 (FCF d+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 The most popular method of estimating the cost of capital is the Capital Asset Pricing Model (CAPM) Weighted average cost of capital under CAPM : WACC (r) = r e. E V + r d (1-t). D V where: r e = r f + b(r m - r f ) r d = interest rate t = corporate tax rate E = market value of equity D = market value of debt V = market value of the firm
Methods used in Australia Most popular method Source: 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
Terminal value how important? Percent of Enterprise Value Attributable to Residual value First 5 Years 100 90 After 5 Years 80 79 76 71 Percent 60 40 20 10 21 24 29 - Wendy's Brinker Int'l* McDonald's Tricon** * 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
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