Mergers & Inquisitions: Valuation

3 Major Valuation Methodologies

Comparable Companies, Precedent Transactions, and Discounted Cash Flow Analysis

Rank of 3 Major Methodologies from Highest to Lowest Expected Value

Nothing is ever definite, however, usually:

-Precedent Transactions (because of Control Premium built into acquisitions)

-DCF (most variable depending on assumptions)

-Comparable Companies

When would you NOT use a DCF?

-Company has unstable/unpredictable cash flows

-Debt and working capital serve fundamentally different role (i.e. don't use a DCF for banks)

Valuation Methodologies besides the 3 Major Ones

-Liquidation Valuation: valuing company's assets assuming they are sold off then subtracting liabilities

-Replacement Value: valuing a company based on the cost of replacing its assets

-LBO Analysis: Determining how much a PE firm could pay for a company to hit a target IRR (usually 20-25%)

-Sum of Parts: Valuing each division of a company separately and adding them together

-M&A Premiums Analysis: Figuring out premium paid on M&A deals and using it to establish company value

-Future Share Price Analysis: Projecting share price based on P/E multiples of comps, then discounting to present value

Common Valuation Multiples

-EV/Revenue

-EV/EBITDA

-EV/EBIT

-P/E

-P/Book Value

Would a LBO or a DCF give a higher valuation?

-Usually LBO is lower, since you are mostly valuing based on its terminal value. DCF values cash flows and terminal value.

How would you present valuation methodologies?

Football field chart

How would you value an apple tree?

Looks at value of comparable apple trees and value of apple tree's cash flows. Could even do DCF

Why can't you use Equity Value/EBITDA instead of EV/EBITDA?

Equity value only reflects value available to equity holders, but EBITDA is available to all investors. Have to use EV with EBITDA.

When would Liquidation Valuation produce the highest value?

If a company had substantial hard assets but market was severely undervaluing it for a certain reason (i.e. earnings miss, cyclicality)

How would you value Facebook in 2004 before it had revenue or profit?

Use Comps or Precedents and look at industry multiples (EV/Pageviews, etc.)

Do not try to use DCF, can't reasonably predict cash flows

What would you use with FCF multiples--Equity Value or EV?

-Use EV for unlevered free cash flow since it excludes interest and represents money available to all investors

-Use Equity Value for levered free cash flow since it includes interest so only represent money available to equity investors

Would you ever use Equity Value/Revenue?

Rare. Sometimes financial institutions with large cash balances use Equity Value since they have negative EVs, so you might use it if you have to compare a financial institution with a non-financial institution.

How do you select Comps/Precedents?

-Industry Classification

-Financial Criteria (Revenue, EBITDA, etc.)

-Geography

How do you apply the 3 valuation methodologies to actually get a value for the company you're looking at?

Take median multiple from a set of companies, then multiply by the relevant metric from the company you're evaluating.

What do you use a valuation for?

-Usually in pitch books or client presentations when telling clients what to expect for their valuation

-Could also be used in Fairness Opinion

-Could be used in defense analyses, merger models, LBO models, DCFs

Why would a company with similar growth and profitability to its Comps be valued at a premium?

-Stock price rose due to exceeding earnings expectations

-Has a competitive advantage not reflected in financials (patents, IP, etc.)

-Had a favorable ruling in a major lawsuit

-Has greater market share than its competitors

How do you account for competitive advantage in a valuation?

-Look at the 75 percentile or higher for multiples rather than medians

-Add a premium to some multiples

-Use aggressive projections

When would Comps produce a higher value than Precedents?

If there is a mismatch between the M&A market and the public market, say if no public companies have been acquired recently but small private companies have been acquired at low valuations.

Flaws with Precedent Transactions

-Rarely 100% comparable

-Data is tougher to find

Two companies have the same financial profile and are bought by the same acquirer, but the EBITDA multiple for one transaction is twice the multiple of the other one--why?

-One process was more competitive and had more companies bidding on the seller

-One company had recent bad news or a depressed stock price

-They were in industries with different median multiples

Why would someone prefer EBIT multiples to EBITDA?

"Does management think the tooth fair pays for capital expenditures?" --Warren Buffet

-EBITDA excludes sizable CapEx and hides how much cash is being used to finance operations

EV/EBIT, EV/EBITDA, and P/E all measure profitability. What's the difference and when do you use each?

P/E: Depends on capital structure, so used for banks, financial institutions, and other companies where interest payments/expenses are critical.

EV/EBIT: Includes depreciation and amortization, good to use in industries like manufacturing where D&A is large and CapEx and fixed assets are important.

EV/EBITDA: Excludes D&A, so used in industries like internet companies that don't have many fixed assets and have small D&A

How do you value a private company?

Generally same methodologies as public companies

-May discount public company comps 10-15% because private companies are less liquid

-Can't use premiums analysis or future share price analysis since private companies don't have a share price

-Valuation shows EV rather than implied per-share price

-DCF is tough because you have to estimate WACC based on public comps rather than calculating it (because private companies don't have a market cap or Beta)

When valuing a private company, why would you discount comps instead of precedent transactions?

With precedent transactions, once the company is acquired the shares become illiquid immediately.

Since shares of public companies will always be more liquid, you would discount them to account for it.

Can you use private companies as part of your valuation?

Only with precedents, doesn't make sense to use with comps or DCF

How do you value banks differently from other companies?

-Use P/E and P/BV rather than EV/EBITDA and other normal multiples.

-Use a dividend discount model rather than a DCF

-Pay more attention to NAV (Net Asset Value)

Walk through an IPO valuation for a company that's about to go public

1. Look at public company comps and decide on relevant multiples

2. Use chosen multiples to estimate EV

3. Work backwards from EV to get Equity Value, then subtract IPO proceeds since this is "new" cash

4. Divide the total number of shares to get per-share price

How do you calendarize a company's financial statements to show TTM (Trailing Twelve Months) instead of fiscal year?

TTM=Most Recent Fiscal Year + Partial New Period - Old Partial Period

Walk through a M&A premium analysis

1. Select precedents based on industry, date, and size

2. Get seller's share price 1 day, 20 days, and 60 days before the transaction was announced

3. Calculate 1 day premium, 20 day premium, etc. by dividing per-share purchase price by share price on each day

4. Get medians for each set, then apply them to current share price, share price 20 days ago, etc. to estimate how much of a premium a buyer might pay for it.

Only use this to value public companies

What's the difference in selections for M&A premiums analysis and Precedent Transactions?

-All sellers in M&A premiums analysis must be public

-Use a broader set of transactions for M&A premiums analysis

Still use similar financial, industry, geography, and date screening criteria.

How do you value Net Operating Losses and account for them in valuation?

Value them based on how much they'll save the company in taxes, so take the present value of the sum of future tax savings.

You rarely add them in, but if you did you'd treat them like cash (subtract to go from Equity Value to EV)

How do you select the report to use for public company comparables?

-Pick report with most detailed info

-Pick report with numbers in the middle range

How far back and forward do we usually go for comps and precedents?

-Usually look at TTM, then go forward 1 or 2 years