valuation approaches to mergers & acquisitions - wirc approaches to mergers... · contents •...

Valuation approaches to Mergers & Acquisitions

Sagar Gokani, Chief Manager – M&A & IR, Piramal Healthcare Limited

7th July 2012

Contents

• Approaches to Valuation

• Discounted Cash Flow

• Relative Valuation• Relative Valuation

• Valuing Synergy

Approaches to valuation

• Relates the value of an asset to the present value of expected future cashflows on that asset

Discounted Cash Flow

Relative Valuation

• Estimates the value of an asset by looking at the pricing of 'comparable' assets relative to a common variable like earnings, book value or sales

• Non traditional approaches such as replacement value, salvage value etc.

Other Approaches

Contents




• Valuing Synergy

Discounted Cash Flow – A primer

• The value of an asset is the present value of the expected cash

flows on the assetWhat is it ?

• Every asset has an intrinsic value that can be estimated, based

upon its characteristics in terms of cash flows, growth and risk

Philosophical basis

• To estimate the life of the asset

• To estimate the cash flows during the life of the asset

• To estimate the discount rate to apply to these cash flows to get

present value

Information required

DCF Choices: Firm Valuation versus Firm Valuation

� Firm Value:

• Sum of free cash flows to the firm over the life of

asset

Equity Value = Firm Value – Debt� Equity Value = Firm Value – Debt

• Sum of free cash flows to the equity shareholders,

i.e. after subtracting interest cost and debt

repayment

Preparing FCF forecasts

What is free cash flow to firm ?

EBIT

Less: EBIT * Tax Rate

Add: Depreciation

Less: Change in Working CapitalLess: Change in Working Capital

Less: Capital Expenditure

Free Cash Flow to Firm

Preparing FCF forecasts – Practical Issues

How do you forecast EBIT ?

Forecasting Sales

•Growth linked to:

•Market Growth

•Increasing market share in existing markets

•Introduction of new products

•Geographic expansion

• Price Increases

Operating Expenses

• Estimating Variable costs such as material cost, direct labor, conversion cost, sales commission etc.

• Estimating Fixed costs such as G&A expenses


How do you forecast working capital and capex ?

Forecasting working capital

• Start with the what the company did in the most recent years but do look at the company’s history and industry averages

• Working capital levels could be higher if a firm is expanding by launching new products or entering new geographies

Forecasting capex

• Capex should include both:

• maintenance capex that is commensurate with the existing and planned infrastructure and

• growth capex that ties with the growth forecasts of the business


How long should the forecast be ?

� Is linked to life of asset

� For assets with finite life, forecasts can be prepared for the full life

� For forecasts of business, forecasts should be for the period where one has

visibility of growth that is much higher than “perpetuity growth”

� “PERPETUITY GROWTH” is the normal growth that a business will continue

to grow at after the business reaches maturity stage to grow at after the business reaches maturity stage

� When the business hits maturity, one can take terminal value

� Terminal value:

________CF for last year_________

(cost of capital – perpetuity growth)


What should be the discount rate ?

� Discount Rate: Weighted Average Cost of Capital (WACC)

� WACC = cost of equity * (equity/equity+debt) + after tax cost of debt *

(debt/equity+debt)

� Market value should be used to calculate WACC

� Cost of equity is the return that equity shareholders would expect from a

company/business:company/business:

� Dividend Growth Model

kc = + g

� Capital Asset Pricing Model (CAPM)

kj = krf + j (km - krf )

� Cost of Debt is interest cost plus floatation cost, this should be tax adjusted

D1

Po

ββββ

Cashflow to Firm

EBIT (1-t)

- (Cap Ex - Depr)

- Change in WC

= FCFF

FCFF1 FCFF2 FCFF3 FCFF4 FCFF5

Forever

Firm is in stable growth:Grows at constant rateforever

Terminal Value= FCFF n+1/(r-gn)

FCFFn.........Value of Operating Assets

+ Cash & Non-op Assets= Value of Firm

DISCOUNTED CASHFLOW VALUATION

Cost of Equity Cost of Debt WeightsBased on Market Value

Discount at WACC= Cost of Equity (Equity/(Debt + Equity)) + Cost of Debt (Debt/(Debt+ Equity))= Value of Firm- Value of Debt= Value of Equity

Riskfree Rate :- No default risk- No reinvestment risk- In same currency andin same terms (real or nominal as cash flows

+Beta- Measures market risk X

Risk Premium- Premium for averagerisk investment

Type of Business

Operating Leverage

FinancialLeverage

Base EquityPremium

Country RiskPremium

Discounted Cash flow – Points to ponder

1. Sensitivity to discount rates and perpetuity growth rates is very high, example:

Year 1 2 3 4 5 Terminal year

FCF 100 110 121 133 146 146

DCF at a range of cost of capital and perpetuity growth rate

WACC/Perpetuity 0% 1% 2% 3%WACC/Perpetuity

growth rate

0% 1% 2% 3%

6% 2,332 2,697 3,244 4,155

8% 1,726 1,904 2,141 2,473

10% 1,364 1,465 1,591 1,753

12% 1,123 1,186 1,262 1,354

2. Long term targed debt-equity ratio should be taken for taking into account WACC

Contents




• Valuing Synergy

Relative Valuation – A primer

• The value of an asset is compared to the values assessed by the market for

similar comparablesWhat is it ?

• There is a comparable asset in the market which is already valued, which can

form the basis of valuation of this asset

Philosophical basis

• To identify comparable assets and obtain market values for these assets

• To convert these market values into standardized values, since the absolute

price cannot be compared

• To compare the standardized value or multiple for the asset being analyzed to

the standardized value for comparable asset, controlling for any difference

between the firms that might affect the multiple, controlling for any difference

between the firms that might affect the multiple, to judge whether the asset is

under or over valued

Information required

• Most valuations in public markets are relative valuations.

– Almost 85% of equity research reports are based upon a multiple and comparables.

– More than 50% of all acquisition valuations are based upon multiples

– Rules of thumb based on multiples are not only common but are often the basis for final

valuation judgments.

• While there are more discounted cashflow valuations in consulting and

Relative Valuation – relevance

• While there are more discounted cashflow valuations in consulting and

corporate finance, they are often relative valuations masquerading as

discounted cash flow valuations.

– The objective in many discounted cashflow valuations is to back into a number that has

been obtained by using a multiple.

– The terminal value in a significant number of discounted cashflow valuations is estimated

using a multiple.

• Define the multiple

o Same multiple can be defined in different ways by different users.

o Important that we understand how the multiples have been estimated

• Describe the multiple

Understanding relative valuation

oMutiples can have a skewed distribution

o One cannot just take averagee as indicator of typical multiple

o Critical that we understand the fundamentals that drive each multiple

o Nature of the relationship between the multiple and each variable

• Analyse the multiple

o Define the comparable universe and

o Adjust multiple for target company

• Apply the multiple

o One cannot just take averagee as indicator of typical multiple

• The following metric can be used as a basis for relative valuation:

• Sales – EV/Sales

• EBITDA – EV/EBITDA

• EBIT – EV/EBIT

• Earnings/Net Profit - Price-to-Earnings Ratio

Relative Valuation – various methods

• Book Value – Price to Book

• Cash Flow – EV/Cash flow

• Industry specific variable (Price per ton capacity of steel, per store value in the

days of retail boom, price per click in e-commerce)

Relative Valuation – Practical Issues

Which multiple should one use?

• While a range of values can be obtained from a number of multiples, the “best

estimate” value is obtained using one multiple

• Use the multiple that seems to make the most sense for that sector, given

how value is measured and created:how value is measured and created:

• In retailing: The focus is usually on same store sales (turnover) and profit margins.

Not surprisingly, the revenue multiple is most common in this sector.

• In financial services: The emphasis is usually on return on equity. Book Equity is

often viewed as a scarce resource, since capital ratios are based upon it. Price to

book ratios dominate

• In technology: Growth is usually the dominant theme. PEG ratios were invented in

this sector.

Relative Valuation – Practical Issues

What should be the control premium?

• If one is using multiples of publicly traded companies, one will have to

assigned control premium to the multiples

• The value of controlling a firm derives from the fact that you believe that you • The value of controlling a firm derives from the fact that you believe that you

or someone else would operate the firm differently (and better) from the way

it is operated currently

• The expected value of control is the change in value from changing the way a

firm is operated

Contents




• Valuing Synergy

Valuing Synergy• The key to the existence of synergy is that the

target firm controls a specialized resource that

becomes more valuable if combined with the

bidding firm's resources. The specialized

resource will vary depending upon the merger:

– In horizontal mergers: economies of scale, which– In horizontal mergers: economies of scale, which

reduce costs, or from increased market power, which

increases profit margins and sales.

– In vertical integration: Primary source of synergy

here comes from controlling the chain of production

much more completely.

– In functional integration: When a firm with

strengths in one functional area acquires another

Closing Comments

• Most M&A transaction are value destructive

for the acquiring company

• The reason for most of these is value overpaid • The reason for most of these is value overpaid

by acquirer try to buy a trophy asset

• As advisors we should help

companies/promoters to look at things more

objectively

Congratulations!

You are now all valuation

experts!

End of module!

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