OCTOBER 2004

INTRODUCTION TO VALUATION METHODS USED IN INVESTMENT BANKING
C O N F I D E N T I A L S T R I C TL Y P R I V A T E AN D

U S E D

I N

I N V E S T M E N T

B A N KI N G

CONFIDENTIAL, FOR TRAINING PURPOSES ONLY

M E TH OD S

This presentation was prepared exclusively for the benefit and internal use of the JPMorgan client to whom it is directly addressed and delivered (including such client’s subsidiaries, the “Company”) in order to assist the Company in evaluating, on a preliminary basis, the feasibility of a possible transaction or transactions and does not carry any right of publication or disclosure, in whole or in part, to any other party. This presentation is for discussion purposes only and is incomplete without reference to, and should be viewed solely in conjunction with, the oral briefing provided by JPMorgan. Neither this presentation nor any of its contents may be used for any other purpose without the prior written consent of JPMorgan. The information in this presentation may be based upon any management forecasts provided to us and reflects prevailing conditions and our views as of this date, all of which are accordingly subject to change. In preparing this presentation, we have relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources or which was provided to us by or on behalf of the Company or which was otherwise reviewed by us. In addition, our analyses are not and do not purport to be appraisals of the assets, stock, or business of the Company or any other entity. JPMorgan makes no representations as to the actual value which may be received in connection with a transaction nor the legal, tax or accounting effects of consummating a transaction. Notwithstanding the foregoing (but subject to any applicable federal or state securities laws), JPMorgan and the Company may disclose to any and all persons, without limitation, the tax treatment and tax structure of any transaction contemplated hereby and all materials (including opinions or other tax analyses) relating thereto, so long as such disclosure is not made prior to the earlier of (x) public announcement of discussions relating to the transaction or of the transaction itself and (y) the execution of an agreement to enter into the transaction. JPMorgan’s policies prohibit employees from offering, directly or indirectly, a favorable research rating or specific price target, or offering to change a rating or price target, to a subject company as consideration or inducement for the receipt of business or for compensation. JPMorgan also prohibits its research analysts from being compensated for involvement in investment banking transactions except to the extent that such participation is intended to benefit investors. JPMorgan is a marketing name for investment banking businesses of J.P. Morgan Chase & Co. and its subsidiaries worldwide. Securities, syndicated loan arranging, financial advisory and other investment banking activities are performed by J.P. Morgan Securities Inc. and its banking affiliates. JPMorgan deal team members may be employees of any of the foregoing entities.

I N T R O D U C TI O N

T O

VAL U ATI O N

MICHIGAN BUSINESS SCHOOL

I N V E S T M E N T

B A N KI N G

Agenda

Valuation overview Discounted cash flow Publicly traded comparable company analysis Comparable transactions analysis LBO analysis Additional valuation materials

1 8 17 23 28 36

I N T R O D U C TI O N

T O

VAL U ATI O N

M E TH OD S

U S E D

I N

MICHIGAN BUSINESS SCHOOL

1

Applications

Acquisitions Acquisitions How much should we How much should we pay to buy the pay to buy the company? company?

Divestitures Divestitures How much should we How much should we sell our sell our company/division for? company/division for?

Research Research Should our clients buy, Should our clients buy, sell or hold positions inin a sell or hold positions a given security? given security?

Fairness opinions Fairness opinions IsIs the price offered for the price offered for company/division fair company/division fair (from a a financial point of (from financial point of view)? view)?

Valuation
Hostile defense Hostile defense IsIs our company our company undervalued/ undervalued/ vulnerable to raider? vulnerable to a a raider? Public equity offerings Public equity offerings For how much should we For how much should we sell our company/division sell our company/division inin the public market? the public market?

VALUATI O N

O V E R VI EW

New business New business presentations presentations Various applications Various applications

Debt offerings Debt offerings What is the underlying What is the underlying value of the business/ value of the business/ assets against which assets against which debt is being issued? debt is being issued?

MICHIGAN BUSINESS SCHOOL

2

Valuation methodologies Valuation methodologies Discounted cash flow analysis “Intrinsic” value of business Present value of projected free cash flows to all providers of capital Publicly traded comparable companies analysis “Public market valuation” Value based on market trading multiples of comparable companies How does a firm’s financial performance match to market value? Comparable acquisitions analysis “Public market valuation” Value based on multiples for comparable companies in sale transactions Includes control premium Leveraged buyout/recap analysis Value based on debt repayment and return on investment Value to a financial/LBO buyer Other Liquidation analysis Break-up analysis Historical trading performance Private company valuation Expected IPO valuation Premiums paid analysis VALUATI O N O V E R VI EW MICHIGAN BUSINESS SCHOOL 3 .

JPMorgan utilizes several methodologies that are consistent with industry practices consistent with industry practices (1) Discounted cash flow Analyzes the present value of a company’s free cash flow (2) Publicly traded comparable companies Utilizes market trading multiples from publicly traded companies to derive value (3) Comparable acquisition transactions Utilizes data from M&A transactions involving similar companies (4) Leveraged buy out Used to determine range of potential value for a company based on maximum leverage capacity VALUATI O N O V E R VI EW MICHIGAN BUSINESS SCHOOL 4 .Approach to valuation In arriving at a preliminary valuation for its clients. JPMorgan utilizes several methodologies that are In arriving at a preliminary valuation for its clients.

net debt2 Equity value = Assets Liabilities and shareholders’ equity O V E R VI EW Enterprise value Enterprise value Net debt Equity value 1 2 VALUATI O N Assume book value of debt approximates market value of debt Net debt equals total debt + minority interest + capitalized leases + short-term debt .Equity value versus enterprise value Enterprise value = Market value of all capital invested in a business1 (often referred to as “transaction value”) The value of the total enterprise: market value of equity + net debt Equity value = Market value of the shareholders’ equity (often referred to as “offer value”) The market value of a company’s equity (shares outstanding x current stock price) Enterprise value .cash and cash equivalents MICHIGAN BUSINESS SCHOOL 5 .

Equity value versus enterprise value (cont’d) Equity value or offer value Equity value or offer value Enterprise value or transaction value Enterprise value or transaction value Value for owners of business Multiples of Net income After tax cash flow Book value Value available to all providers of capital Multiples of Sales EBITDA EBIT VALUATI O N O V E R VI EW MICHIGAN BUSINESS SCHOOL 6 .

40 $47.0% discount rate DCF analysis 7.00 $37.Application example: Valuation summary Implied share price Implied share price $64.00 $37.0x—9.0%—11.0x With synergies 2008E EBITDA of $1.25 O V E R VI EW 10.0x—9.0% of sales.60 $60.10 40.70 $55.00 52-week trading range 7.50 $60.00 $34.20 20.60 $54.50 50.6x LTM sales 9.00 $50.30 $38.00 Current stock price = $34.00 $45.0x—9.75 30.0x 25% IRR LTM EBITDA LBO 1 2 3 VALUATI O N Share prices are based on 157.0x MICHIGAN BUSINESS SCHOOL 7 . capitalized at 8.500mm 3 8.0x 2004E EBITDA Public market comparables 2 Analyst price target 1.00 $19.3x LTM EBIT Precedent comparable transactions 7.6 million diluted shares outstanding Forecasts are based on JPMorgan research Synergies assumed to be 6.00 $50.8x LTM EBITDA 13.00 $55.

I N V E S T M E N T B A N KI N G Agenda Valuation overview Discounted cash flow Publicly traded comparable company analysis Comparable transactions analysis LBO analysis Additional valuation materials 1 8 17 23 28 36 I N T R O D U C TI O N T O VAL U ATI O N M E TH OD S U S E D I N MICHIGAN BUSINESS SCHOOL 8 .

Discount rate Step 2 Step 2 Terminal value Step 3 Step 3 Estimate the value of the business at the end of the forecast period. However. The typical forecast period is 10 years. C A S H Adjustments D I S C O UN T E D Step 5 Step 5 MICHIGAN BUSINESS SCHOOL 9 .DCF analysis: the process Projections Step 1 Step 1 Project the operating results and free cash flows of a business over the forecast period. Present value F L OW Step 4 Step 4 Determine a range of values for the enterprise by discounting the projected free cash flows and terminal value to the present. Use the weighted average cost of capital (WACC) to determine the appropriate discount rate range. the range can vary from five to 20 years depending on the profitability horizon. Adjust your valuation for all assets and liabilities not accounted for in cash flow projections.

balance sheet and statement of cash flows) typically provide all the necessary elements Quality of DCF analysis is a function of the quality of projections Often required to “fill in the gaps” Confirm and validate key assumptions underlying projections Sensitize variables that drive projections Sources of projections include Target company’s management Acquiring company’s management Research analysts Bankers F L OW D I S C O UN T E D C A S H MICHIGAN BUSINESS SCHOOL 10 .The first step in DCF analysis is projection of unlevered free cash flows Calculation of unlevered free cash flow begins with financial projections Comprehensive projections (i. fully-integrated income statement..e.

you may want to adjust for the non-cash (or deferred) portion of a firm’s tax provision. you should only include actual cash taxes paid in the DCF. Depending on the firm and industry. The tax footnote in the financial statements will give you a good idea of whether this is a meaningful issue for your analysis MICHIGAN BUSINESS SCHOOL 11 . even if those projections include the effects of debt Start your calculation with EBIT (earnings before interest and taxes) EBIT (from the income statement) Plus: Non-tax-deductible goodwill amortization Less: Taxes (at the marginal tax rate) Equals: Tax-effected EBITA Plus: Deferred taxes1 Plus: Depreciation and any tax-deductible amortization Less: Capital expenditures F L OW Plus/(less): Decrease/(increase) in net working investment Equals: Unlevered free cash flow D I S C O UN T E D C A S H 1 Although beyond the scope of our current discussions.Free cash flow is cash available to creditors and owners after taxes and reinvestment Unlevered free cash flows can be forecast from a firm’s financial projections.

1 17.6 — $69.9 $49.6 2005E $585.3 — 26.3 21.5 53.6 3.8 1. 2001 Net sales EBITDA Less: Depreciation EBITA Less: Taxes at marginal rate Tax-effected EBITA Plus: Depreciation Plus: Deferred taxes Less: Capital expenditures Less: Incr.0 68.0 13.8 0.7 2007E $708.6 5.0 27.3 109.3) $0.8 Discounted value of unlevered FCF Discounted value of FCF 2004P—2008P Key assumptions: Deal/valuation date = 12/31/04 Marginal tax rate = 40% Discount rate = 10% C A S H D I S C O UN T E D JPMorgan convention is to use the “mid-year” convention—which assumes cash flows happen midway during the year MICHIGAN BUSINESS SCHOOL 12 .7 21.9 23.5 48.8 — $46./(decr.5 82.0 53.0 90.8 $59.4 2008E $779.2 74.8 29.5 43.4 — 29.3 120.4 2004E $532.0 — 20.6 141.3 16.0 96.0 40.8 14.3 — 24.6 117.8 19.4 106.Projections Stand-alone projections for Company X ($ millions) Stand-alone projections for Company X ($ millions) Fiscal year ending December 31.0 8.5 155.6 39.2 $40.5 36.5 $48.2 $54.5 $49.7 19.8 — $53.0 $0.0 69.0 $189.0 88.2 128.2 $72.6 — 22.7 17.4 132.5 61.5 $46.0 80.0 12.0 0.6 2006E $644.3 32.2 7.5 46.5 $44.3 4.3 (40.6 99.9 $44.8 $65.9 $400.5 23.5 16.4 2.4 — $61.) in working capital Unlevered free cash flow Adjustment for deal date Unlevered FCF to acquirer Memo: Discounting factor F L OW 2002 $440.0 $79.9 2003 $484.0 10.

the true cost of debt is the after tax rate due to the ability of interest expense to shield taxes. The overall cost of capital is the weighted average of the cost of debt and the cost of equity WACC = rd * (Total debt) + re * (Total equity) (Total cap) (Total cap) More accurately stated the formula is: WACC = rd * [D *(1-T)] + re * E D+E D+E E = market value of equity D = market value of debt T = marginal tax rate re = return on equity (from CAPM) rd = return on debt (assumed to be weighted average cost of debt¹) Because interest is tax deductible. the analyst should try to estimate the current market cost of debt by looking at the market cost of debt of comparable companies (with similar credit ratings) MICHIGAN BUSINESS SCHOOL 13 . The tax rate used should be the marginal tax rate for each specific company F L OW D I S C O UN T E D C A S H ¹ In order to be more accurate.Weighted average cost of capital (WACC) formula Most firms use a combination of debt and equity to fund their operations.

7 883.6 792.Terminal values: The exit multiple method In the EBITDA exit multiple method.4 1.0 100.0 F L OW 11% 12% C A S H D I S C O UN T E D A review of the terminal value and implied perpetuity is useful to help understand the drivers of the DCF value Note: DCF value as of 12/31/04 based on mid-year convention 1 Based on 40.0X $24.0 866.8 1.9 3.4 702.0x 8.3 677.0 100.4 755.8 5.8 821.9 904.3 777.0x $687.1% 3.9 876.9 804.0x $884.5 $802.97 8.97 21.18 21.113.80 17.6 = C Firm value at 2008P EBITDA multiple of 6.076.39 Implied perpetuity growth rate at 2008P EBITDA multiple of 6.8 193.1 182.2% 1.2 834.0x 7.0x $784.0x 0.6 186.55 7.0X $19.9 693.1 4.3 E Equity value per share1 at 2008P EBITDA multiple of 6.9 2.1 745.6 975.6 1.1 189.3% 2.0x 7.13 calculated using the treasury method MICHIGAN BUSINESS SCHOOL 14 .3 $1.77 23.0 million basic shares outstanding and 2.0x 8.4 907.9 616.0 100.01 22.17 18.4 802.0x 78% 77 77 77 76 80% 80 80 79 79 8.8 Discount rate 8% 9% 10% Net debt 12/31/04 $100.0 2.0x 8.3 8.8 828.2 3.0x 7.1 2.17 20.013.2 594.0 3. a multiple is applied to the final year’s EBITDA to determine a terminal value in the final year.007.16 16.1 773.5 851.2 $999.2 7.2 934.0 million options with a weighted exercise price of $8.7 1.87 23.9 4.0 4. This terminal value is discounted to the present and added to the PV of the cash flows A + B Discounted terminal value at 2008P EBITDA multiple of 6.5 662.7 - D = Equity value at 2008P EBITDA multiple of 6.41 19.6 875.4 855.7 941.0 100.4 718.3 Terminal value as percent of total firm value 6.6 976.9 776.0x $899.0x 82% 82 82 82 81 Discounted Discount rate 8% 9% 10% 11% 12% FCF 2004–2008 $196.47 17.0X $21.67 18.041.0 966.5 $916.6 638.0x 7.8 728.0x $1.

9 681.6 852.0 823.5% 83% 81 78 76 73 Terminal value as percent of total firm value 3.0 883.0 million basic shares outstanding and 2.88 20.292.5% $1.95 3.4 6.0% $1.0 at perpetuity growth rate of 2.0 923.6x 7.0% 9.14 23.0% 85% 82 79 77 75 3.5 5.0% $29.0% $1.9 3.96 21.26 25.40 15.5 582.062.4 5.8 Implied EBITDA exit multiple at perpetuity growth rate of 2.162.2 1.5 6.4 3.0 100.0 968.2 977.1 668.1 2.5 3.12 17.7 5.8 1.8 733.12 18.5% $1.0 100.8 1.8 Discount rate 8% 9% 10% 11% Net debt 12/31/04 $100.0 771.8 905.8 752.13 calculated using the treasury method C A S H MICHIGAN BUSINESS SCHOOL 15 .8 1.0 100.1 618.0 871.0 811.6 752.7x 8.5% 10.7 687.5% 86% 83 81 78 76 - D = Equity value E Equity value per share1 at perpetuity growth rate of 2.0% $1.12 3.7 622.5% $1.005.4 883.223.187.5% 8.7 + B Discounted terminal value at perpetuity growth rate of 2.3 708.319.1 189.3 808.5% $1.8 2.1 768.9 794.419.1 182.1 5.5 F L OW 12% D I S C O UN T E D The PV of a growing perpetuity in year 5 is: FCF * (1+g) (r .1 718.8 7.095.0 535.0 6.5% $1.84 16.0 million options with a weighted exercise price of $8.Terminal values: The perpetuity method In the perpetuity method the final year cash flow is used to determine the terminal value of the cash flows A Discounted Discount rate 8% 9% 10% 11% 12% FCF 2004–2008 $196.192.6 186.0 666.087.9 = C Firm value at perpetuity growth rate of 3.34 14.31 15.7 587.8 193.8 3.6 505.59 22.59 18.5% $991.0 983.0 100.g) Thus.7 570.6x 8. this PV 5 years forward must then be discounted back to the valuation date Note: DCF value as of 12/31/04 based on mid-year convention 1 Based on 40.1 3.37 3.5% $32.077.1 3.5% $26.8 652.9 6.

synergies. etc. terminal values. discount rates. etc. D I S C O UN T E D C A S H Check it with a calculator! MICHIGAN BUSINESS SCHOOL 16 . warrants.) Footnote assumptions in detail Think about other value enhancers and detractors — NOLs — Options.Concluding DCF remarks DCF analysis is a key valuation methodology Three key variables Projections/relevant and incremental cash flows (unlevered free cash flow) Weighted average cost of capital (discount rate) Residual value at end of the projection period (terminal value) Remember Validate and test projection assumptions Determine appropriate cash flow stream Utilize appropriate cost of capital approach Carefully consider all variables in the calculation of the discount rate Thoughtfully consider terminal value methodology F L OW Sensitize appropriately (base projection variables.

I N V E S T M E N T B A N KI N G Agenda Valuation overview Discounted cash flow Publicly traded comparable company analysis Comparable transactions analysis LBO analysis Additional valuation materials 1 8 17 23 28 36 I N T R O D U C TI O N T O VAL U ATI O N M E TH OD S U S E D I N MICHIGAN BUSINESS SCHOOL 17 .

the comparable companies' multiples may or may not be higher than comparable acquisitions’ multiples The trick to comparable company analysis is to find good comparables The bad news: no two companies are really comparable The good news: it doesn't matter. net income. etc. arbs. book value and other key operating statistics by the respective comparable company multiples ANALY SI S P U BLIC LY T RAD E D C O M P ARA B L E C OM P ANY MICHIGAN BUSINESS SCHOOL 18 .) has to deal with the same problem Once you have chosen the comparable companies. because everybody else (equity research analysts. calculate the implied value of your company by multiplying the company’s historical and projected sales. traders. EBIT.Overview Comparable company analysis values a company by reference to other publiclytraded companies with similar operating and financial characteristics. Depending on market conditions. EBITDA. It compares the public company value with operating statistics to calculate the valuation multiple Comparable companies values do not incorporate the “control” premiums reflected in comparable acquisitions.

look for companies with similar characteristics to those of the business being valued Operational Financial C OM P ANY Industry Product Markets Distribution channels Customers Seasonality Cyclicality Size Leverage Margins Growth prospects Shareholder base P U BLIC LY T RAD E D C O M P ARA B L E MICHIGAN BUSINESS SCHOOL 19 .Identifying the right peer group The key to compiling a trading comparables analysis is to identify companies that are considered comparable and that closely resemble the composition and function of the Company you are evaluating SIC code search Research reports ANALY SI S 10K To find comparable companies.

) For other industries. Industrials. Distribution.) Reading analyst reports will help you understand the metrics analysts use to value the sector and the industry Certain sectors have unique metrics Telecommunications Natural resources Retail/Real estate C OM P ANY ANALY SI S P U BLIC LY T RAD E D Enterprise value to — Run rate revenue (LQA) — 2000 to 2002 revenue — Net PPE (Latest 10-Q) — Route miles (Latest 10-Q) — Fiber miles (Latest 10-Q) — Access lines (Latest 10-Q and 1-year forward) C O M P ARA B L E Enterprise value to — Pretax Sec10 — EBITDAX — Reserves — Production Equity value — Discretionary cash flow Enterprise value — Square footage — EBITDAR MICHIGAN BUSINESS SCHOOL 20 . etc. Restaurants. certain multiples are more relevant for some industries than others For many industries. Transportation.Choosing the right metric Even with standard metrics. Biotech. etc. P/E multiples are more widely followed (Pharmaceuticals.g. FV/EBITDA multiples are the most common trading metric (e.

0% 14.8x 11.0x 17.5% 15.079 $4.616 3.0% 1.4x 7.5x 13.5x 12.128 $17.75 88.0x 15.149 3.2x 11.5x 7.Managed care trading comparables $ millions.8% 94.84x 0. except for per share data Company Large capitalization WellPoint Aetna $111.0% 91.05 36. high Equity value2 FV/EBITDA4 Firm value3 2004E 2005E P/E5 2004E 2005E LTGR5 2004E PEG ANALY SI S Anthem Cigna Mean Median Mid c apitalization Oxford PacifiCare Coventry Humana Health Net WellChoice Mean Median Small c apitalization Sierra American Medical Security Median Blended mean Blended median UnitedHealth Group 1 2 3 T RAD E D C O M P ARA B L E C OM P ANY P U BLIC LY 4 5 As of 4/16/04 Based on diluted shares outstanding using the treasury stock method Calculated using equity value plus debt Based on equity analyst research reports.63 18.9x 8.10 26.7x 11.5x 7.0x 12.2% 15.0% 17.4% 72.0x 12.3% 92.3x 7.028 3.9x 12.88x 1.1% 88.90x 0.7x 13.8x 7.5% 85.5x 10.2% 75.25 42.5% $43.0% 13.6x 12.0% 15.8x 6.6% 92.0x 11.1x 9.0% 15.98 25.86x 0.0% 13.9% 92.1x 8.74 92.4x 10.598 12.62 38.979 2.8x 7.82x 0.0% 92.1x 4.9x 7.6x 11.273 $19.2x 7.05 87.6x 11.4x 15.87x 0.4x 7.0x 7.0% 15.561 3.379 $1.89x 0.1x 9.8% 15.3x 12.87x 0.5x 7.372 4.7x 6.4x 11.264 9.6x 12.3x 12.5x 6. includes investment income Based on I/B/E/S MICHIGAN BUSINESS SCHOOL 21 .7x 10.1x 11.87x 0.1% 89.13x 0.3x 13.752 3.5% 13.973 3.427 3.9x 15.5% 15.4x 13.2x 10.8% $35.99x 0.322 397 $1.926 14.6x 7.8x 6.35 65.5% 92.9x 14.3x 13.41 95.0% 15.4% $65.22 94.1x 11.5x 7.0% 13.99x 1.94x 1. except for per share data $ millions.211 13.979 $46.4x 6.6x 7.96x 0.2x 11.7x 8.80x 0.3x 6.02x Share price1 % of 52-wk.0x 11.00x 0.3% 92.69x 0.0% 13.1x 6.0% 12.88x 0.0% 15.3x 8.04x 0.164 16.5x 7.5x 11.4x 7.3x 7.40 87.1x 7.7% 13.8x 7.0% 10.9x 10.324 427 $4.5% 90.5% 90.8x 5.2x 8.4x 10.3x 13.927 10.4x 8.7x 7.1x 11.2x 7.2% $53.7x 6.7% 92.773 8.8x 11.9x 6.965 4.5x 13.

out of the money converts. amortization of intangibles) Determining a value range Thoughtfully consider the multiple range—using the mean/median is not thoughtful Calculate the value correctly (Firm value versus Equity value issue) P U BLIC LY T RAD E D C O M P ARA B L E C OM P ANY MICHIGAN BUSINESS SCHOOL 22 .. Ensure your income statement projections are uniform across your comps — Adjust for extraordinary items and one time charges — Calendarize so that projections reflect the same time periods — Check analyst projections to make sure they are treating all expense components the same across the comps (e. capital leases.Concluding remarks on comparable companies Trading comps are an important valuation metric for a number of reasons Benchmark of how the equity market is valuing the company stand alone and relative to its peers Every CEO knows his own multiples and those of his peers Key steps for comps ANALY SI S Choose the right comparable companies and valuation metrics to focus on Spread the comps correctly Use the comps to determine a valuation range Getting the comps correct Ensure you have correctly captured the equity and net debt components — Diluted shares (includes options using the treasury method and convertibles if in the money) — Net debt includes preferreds. etc.g.

I N V E S T M E N T B A N KI N G Agenda Valuation overview Discounted cash flow Publicly traded comparable company analysis Comparable transactions analysis LBO analysis Additional valuation materials 1 8 17 23 28 36 I N T R O D U C TI O N T O VAL U ATI O N M E TH OD S U S E D I N MICHIGAN BUSINESS SCHOOL 23 .

look for acquisitions of companies in similar industry spaces. etc. termination fees. As in comparable companies analysis.)? How much are buyers paying? Deal technicals (e.. technology. The trick is to find the right comparable transactions and to ferret out the information required to do the math.) C O MP AR ABL E T RA N SAC T I O N S MICHIGAN BUSINESS SCHOOL 24 . lock-up options. etc. with comparable operational and financial characteristics Recent transactions are a more accurate reflection of the values buyers are currently willing to pay than acquisitions completed in the further in the past because market fundamentals are subject to dramatic change over the periods of time Establish relative values of various component businesses i. break-up analysis) ANALY S I S Multiples should be based on the latest public financial information available to the acquiror at the time of the acquisition Develop understanding of M&A activity in industry Relative activity Who is buying? What are they buying (market share.g..e.Overview of comparable transactions analysis Comparable transactions analysis values a company by reference to other private market sales of similar businesses.

strategic benefits and synergies C O MP AR ABL E T RA N SAC T I O N S MICHIGAN BUSINESS SCHOOL 25 . e.. reverse acquisitions Purpose is similar to that of public comparables analysis except that by looking at prior acquisitions.g. including control value. “private market” values sometimes differ from public market values Measure private market value.Overview of comparable transactions analysis (cont’d) Comparable transaction analysis contains information about selected acquisition transactions in the same industry as the company being evaluated or in similar situations. valuation multiples. control premium) of the target company. social issues. hostile. and technical transaction elements ANALY S I S In addition.e. LBO. insight can be gained as to the premium paid to gain control (i.

1x/13.1x 19.0% 4/29/02 4.695 16.7x 20.8x $2.1 11.1x 23.4 10.Selected precedent managed care transactions Transaction value ($mm) 10-day premium paid (offer/ average) LTM 1-year forward¹ Transaction value/ LTM EBITDA Equity value/ net income Transaction value/ adjusted members2 LTM EBIT / adjusted members2 Long term growth rate3 Date announced Acquiror/ target 4/26/04 UnitedHealth /Oxford Anthem/ WellPoint UnitedHealth /MAMSI WellPoint/ Cobalt Anthem/ Trigon WellPoint/ CareFirst WellPoint/ RightCHOICE $4.7 19.529 20.0% T RA N SAC T I O N S 11/21/01 1.813 $125 20.999 7.7x 9.3x 22.506 $1.9% 5 Based on highlighted transactions 6 LTM EBITDA based on Company financials as of 6/30/04 MICHIGAN BUSINESS SCHOOL 26 .8x 15.6x $2.2x 16.300 NA 11.8% 10.0% 10/27/03 2.358 45.8x 26.8%4 8.2x LTM/1-year forward $698 $1.8 12.3x 13.0 10.2x 16.8x $2.7x 13.1x $1.6x $152 15.7x 33.714 $417 11.9% 43.5x 13.9x 17.792 $3.6x $106 NA Mean5 Offer6 1 2 11.5% 10/27/03 17.724 $310 $154 13.8% 9.0% ANALY S I S 6/3/03 930 13.828 $125 15.6x 20.0x 15.2x 15.3x/14.0% C O MP AR ABL E Forward estimates based on equity research at the time of the transaction Adjusted members calculated using 100% of risk members and 20% of non-risk members.3x $51 NA 10/18/01 1.984 $1.254 $202 16. as of most recent filing prior to announcement 3 I/B/E/S long term growth rate prior to announcement 4 Premium paid to the 10-day average stock price prior to the news of the rumored Wellchoice/Oxford transaction was 18.326 24.

2 + Six months 10-Q (6/04) $1.4 – Six months 10-Q (6/03) $1. revenues for nine months should be used when calculating LTM results.6 C O MP AR ABL E Note: If the third quarter Form 10-Q is being used.292.325.0 = LTM (6/04) $2.447.480.Calculating the LTM (latest twelve months) Fiscal year + Most recent period – Period ending one year prior to most recent QT QT-1 ANALY S I S Q1 Q2 Q3 Q4 Q1 Q2 Annual T RA N SAC T I O N S Example: Terra Industries LTM = 6/30/04 Example: Terra Industries LTM = 6/30/04 Annual (12/03) Total revenue $2. not three months MICHIGAN BUSINESS SCHOOL 27 .

I N V E S T M E N T B A N KI N G Agenda Valuation overview Discounted cash flow Publicly traded comparable company analysis Comparable transactions analysis LBO analysis Additional valuation materials 1 8 17 23 28 36 I N T R O D U C TI O N T O VAL U ATI O N M E TH OD S U S E D I N MICHIGAN BUSINESS SCHOOL 28 .

LBO analysis provides another perspective on M&A transactions A leveraged buyout is an acquisition transaction in which much of the purchase price is funded with debt. as strategic players vie with financial sponsors for the same assets L B O AN A L Y S I S MICHIGAN BUSINESS SCHOOL 29 . as cash flows generated during the investment period are used to pay down debt Financial sponsors profit by exiting three to five years after the transaction Sell the target to another buyer Take the target public Recapitalize the target Assumptions regarding the investment transaction. acquiring with the expectation of selling in several years) Financial sponsors generally analyze a transaction using LBO methodologies in the first instance (and DCF. usually done by financial sponsors This type of capital structure provides the ability to “leverage” returns on a relatively small equity investment.e.g... a shorter investment horizon) Strategic buyers sometimes behave like financial investors (i. comparable companies/transactions analyses thereafter) LBO valuation may be useful from a competitive point of view. the exit and the period between the acquisition and the exit are critical to determining an appropriate capital structure and potential returns to equity M&A clients include both financial sponsors and strategic players Financial sponsors typically pursue M&A transactions with different perspectives and objectives (e.

leverage and valuation MICHIGAN BUSINESS SCHOOL 30 .The process of LBO analysis Develop an integrated model of the business that projects EBITDA and cash available for debt repayment over the investment horizon (typically three to five years) Estimate the multiple at which the sponsor can be expected to exit the investment at the end of the investment period Projections Projections Terminal value Terminal value Pro forma Pro forma capitalization capitalization Determine a transaction structure and a pro forma capital structure that result in realistic financial coverage IRR IRR Calculate returns (IRR) to the equity sponsor L B O AN A L Y S I S Adjustments Adjustments Tweak the transaction/capital structure as needed to achieve harmony (if possible) between IRR.

The initial steps in an LBO analysis are identical to those in a DCF analysis The same financial projections developed for a DCF analysis can be used to build a basic LBO model Free cash flows are expected to be used to service debt. and is calculated on the basis of multiples Multiple of exit-year EBITDA is generally used to bound the valuation of the enterprise in any possible exit scenario L B O AN A L Y S I S MICHIGAN BUSINESS SCHOOL 31 . with positive flows to equity typically coming at exit Amount and predictability of free cash flows dictate whether a company is an attractive or viable LBO target Cash flows are not discounted Terminal value drives valuation.

as well as transaction-related leakage Refinancing existing debt Transaction expenses Equity purchase price Debt and equity to be rolled-over Sources must equal uses Any debt or equity that is rolled-over shows up under both sources and uses Always depict every part of the capitalization. including New debt New equity Rolled-over debt and equity Uses of funds should address all parts of the target’s existing capital structure. whether it changes pro forma or not L B O AN A L Y S I S MICHIGAN BUSINESS SCHOOL 32 .Pro forma capitalization and transaction structure are set forth in “sources and uses” Sources should show the entire pro forma capitalization of the company.

exchangeable debt.to 8-year tenor First in line at liquidation Lowest coupon years Subordinated debt Subordinated debt Sample inputs Senior/sub notes Discount notes 25%–35% of total capital T + 350–650 7–10 years Typically supplied by an investment or commercial bank or a mezzanine fund Riskier debt/typically unsecured Primarily bullet structures Typical tenor is 10-year High coupon Typically supplied by an investment or commercial bank or a mezzanine fund (often sponsor-affiliated) Multiple forms: Convertible debt. debt (conv. convertible preferred stock.LBO models are driven by the characteristics of the sources of capital for the transaction Components of capital Components of capital Senior debt Senior debt Revolving Term Sample inputs 30%–50% of total capital LIBOR + 200-400 5–8 Typically supplied by an investment or commercial bank Usually secured/most restrictive covenants Amortizing 5.) Preferred stock PIK Warrants Sample inputs 0%–35% total capital High teens/low 20s 7–10+ years AN A L Y S I S Common equity Common equity Sample inputs 20%–40% of total capital 20%-30% IRR 5–7 year horizon Typically supplied by a financial sponsor Highest risk/cost of capital Sometimes “stapled” to high-yield paper to attract broader investor group Minimum annual returns >20% L B O MICHIGAN BUSINESS SCHOOL 33 . PIK securities and warrants Expected IRR in the 15—20% range Mezzanine securities Mezzanine securities Sub.

394 2.550 $2.899 35% $683 $1.371 25% $869 $1.5x $2.550 $2.612 8.347 2.336 2.00x Assumes management promote of 5% Valuation as at 12/31/01 3 Leverage based on bank/bond case 1 2 Exit multiple 7.232 2. equity contribution 35% $751 $1.550 $2.612 6.550 $2.154) $3.5x $2.550 $2.4x 25% $1.062 2.0x $2.440 8.1x 35% returns Plus: 2008 cash Less: 2008 total debt Implied 2008 total equity value Implied 2008 sponsor equity value1 Required return Implied max.496 $2.475 2.635 35% $614 $1.5x $556 3.550 $2.199 2.515 8.530 2.613 36 (1.774 $2.550 $2.Sample LBO valuation analysis $ millions $ millions Exit multiple 2008 projected EBITDA Implied 2008 firm value 6.5x $2.75x 5.278 7.5x $2.378 2.164 7.5x Maximum leverage3 4.169 $36 (1.154) $2.182 2.419 L B O AN A L Y S I S MICHIGAN BUSINESS SCHOOL 34 .062 $1.7x 30% $890 $1.114 2.550 $2.0x $2.515 $2.250 2.154) $2.278 7.266 2.233 7.433 2.052 $2.571 2.8x 30% returns 7.131 2.0x 30% $728 $1.440 6.50x 4.301 7.301 7.5x $2.313 2.0x $2.5x $556 $4.233 7.550 $2.419 8.0x LTM EBITDA) Implied firm value2 Implied LTM EBITDA multiple Value sensitivity analysis Exit multiple 6.6x Plus: Maximum transaction debt (@ 5.164 Exit multiple 7.359 7.185 2.5x 25% returns 7.0x $556 $3.359 7.1x 25% $965 $1.3x 30% $809 $1.891 $36 (1.

IRR drivers $ millions $ millions No operating improvement/ No arbitrage Operating improvement/ No arbitrage Operating improvement and arbitrage At purchase EBITDA purchase multiple EBITDA on purchase date Firm value at purchase date Debt at purchase (5x EBITDA) Equity value invested EBITDA exit multiple EBITDA at exit Firm value at exit Debt (after paydown of $75 per yr.024 125 899 35.0x $100 700 125 575 23.0% 8.) Equity value at exit IRR (5-year exit) 7.0x $100 $700 500 200 7.0x $128 896 125 771 31.0x $128 1.5% 7. and 3) Multiple expansion (arbitrage) AN A L Y S I S L B O MICHIGAN BUSINESS SCHOOL 35 .1% Three important factors drive IRRs: 1) De-levering 2) Operating improvement.

I N V E S T M E N T B A N KI N G Agenda Valuation overview Discounted cash flow Publicly traded comparable company analysis Comparable transactions analysis LBO analysis Additional valuation materials 1 8 17 23 28 36 I N T R O D U C TI O N T O VAL U ATI O N M E TH OD S U S E D I N MICHIGAN BUSINESS SCHOOL 36 .

Several other types of analysis are common in M&A transactions Pro forma analysis—what is the impact on the company of this merger/acquisition? Earnings impact (accretion/dilution) Growth impact Multiple impact Premiums paid analysis—how does the premium to be paid compare with prior transactions? Analysis at various prices (AVP)—At different prices what are the implied premiums and multiples? MAT E RIA LS Contribution analysis (stock for stock deals) Shareholders of each company receive shares in the merged entity—contribution analysis looks at what each company gives versus what it gets Shares traded analysis Attempts to establish cost basis in shares Interloper analysis On the buyside. tactically it is important to determine which other companies may be interested in the target Once other potential bidders have been identified it is important to analyze their capacity to pay and the pro forma impact on their earnings ADDITI O N AL VALUA TI O N MICHIGAN BUSINESS SCHOOL 37 .

stock.Purpose of pro forma analysis Evaluate the impact of a merger or acquisition on the income statement and balance sheet of a potential buyer Pro forma analysis is used to determine Pricing capacity of Acquirer to pay for Target based on certain key measures Optimal form of consideration (cash. combination) Key measures Dilution in earnings per share Pretax synergies required to break even Leverage/capitalization MAT E RIA LS Interest coverage Post-transaction ownership ADDITI O N AL VALUA TI O N MICHIGAN BUSINESS SCHOOL 38 . other securities.

Accretion/(dilution) Proforma calculation Proforma calculation Acquiror standalone EPS Acquiror NI Target NI Combined NI Transaction adjustments: Amortization of identifiable intangibles Incremental interest expense from transaction debt Foregone interest income on cash Amortization of transaction fees Tax rate differential Total transaction adjustments Pro forma net income Total shares outstanding Pro forma EPS xxx xx xx XX A (xx) (xx) (xx) (xx) (xx) (XX) B MAT E RIA LS A—B xxx xxx ADDITI O N AL VALUA TI O N MICHIGAN BUSINESS SCHOOL 39 .

5x 31.20% and financing fees of 0.4x 27.9%) $9.39x $373 89.5 ($0.5x 12.4 $735.9x P/E 2005E 9.EPS accretion/dilution summary $ millions.67 0.3% 97.11) (1.5 2.8 1.5% ($0.3x 8. Acquiror estimates based on JPMorgan equity research.0%) $9.4x 27.27) (4.7 2.696.3x 20% $27. except per share data $ millions.6x 31.9 $843.2%) $27.1%) $15.35) (5.5x 31.6 ($0.0% of excess purchase price allocated to non-goodwill intangibles and amortized over 10 years. expect EPS.47x $446 87.47 0.18 $5.49x $465 87.0 1.4 1.6 2. transaction expenses of 0. which is based on I/B/E/S. existing Target debt is refinanced at this rate 1 Based on I/B/E/S 2 Exchange ratio calculated as offer price per share over Acquiror price of $57. except per share data EPS1 Current price Target Acquiror 9/27/04 $22.4 ($0.21) (3.5%) $12.5%) $11.8 $735.7% 10.660.67 $57.31) (5.5 2.5% ($0.1%) $13. 10.7% ($0.1 1.5 1.9% 12.1x ($0.7x $ millions.9 $735.3%) $24.1% 13.0x 11.3 ($0.660.13) (1.9%) $8. Assumes interest expense of 6.3% MAT E RIA LS 2005E $—EPS 2005E %—EPS Add’l pre-tax synergies to break even Pro Pro Pro Pro forma forma forma forma debt capitalization debt/pro forma 2003E EBITDA debt/pro forma total cap VALUA TI O N 75% stock/ 25% cash 2004E $—EPS 2004E %—EPS Add’l pre-tax synergies to break even 2005E $—EPS 2005E %—EPS Add’l pre-tax synergies to break even Pro Pro Pro Pro forma forma forma forma debt capitalization debt/pro forma 2003E EBITDA debt/pro forma total cap $0.3 million in Target debt MICHIGAN BUSINESS SCHOOL 40 .4% ($0.678.4% NM $820.6 1. Assumes transaction date of 12/31/03.5% 13.3%) $5.2x 25% $28.7x 30% $29.17) (2.2 2.4x 9.586.5x 31.87 2005E $2.0 ($0.30) (4.43 $6.70 2004E 10.99 % 52-wk high 99.8 ($0.10% for illustrative purposes.7% ($0.51x $483 87.0%) $18.8%) $30.20 0.34 0.4x 9.0%.7 $735.03 0.08) (1.5x 11.9 1.696.6 2.13) (2.9 $839.6% NM $0.24) (4.5 1. except per share data Premium to Target Implied offer price per share Implied exchange ratio2 Implied transaction value3 Implied Acquiror ownership Target 2004E transaction P/E Target 2005E transaction P/E 100% stock 2004E $—EPS 2004E %—EPS Add’l pre-tax synergies to break even 0% $22.7%) $21.99 3 Includes assumption of $33.5%) $23.15) (2.03 0.0 2. tax rate of 37.7 ($0. except per share data $ millions.678.5%.4x 27.3x 28.7 2.9 $848.5% ADDITI O N AL Note: Target estimates based on equity research.586.39) (5.9% 2004E $2.5% ($0.18) (3.

It takes 1/2 of FC stock to acquire CC MAT E RIA LS Earnings Shares outstanding EPS Stock Price 2.5 $1.66 Accretive.00 1 Consulting club (CC) 10x $10.00 1. assuming multiple stays the same ADDITI O N AL VALUA TI O N MICHIGAN BUSINESS SCHOOL 41 .00 1.00 1.33 $26.Bootstrapping Potentially increasing your P/E by acquiring a company with a lower P/E and “bootstrapping” Acquiror’s P/E Finance club (FC) P/E multiple Stock price EPS Shares outstanding 20x $20.00 1 FC acquires CC for stock.

Premiums paid analysis for US targets 1 day prior to announcement (median %. 2004YTD) 1 month prior to announcement (median %.5bn+ 1 month prior to announcement: $0.5bn+ 1 day prior to announcement: $0. 2004YTD) 1 month prior to announcement (median %. 2004YTD) Median: 20% Median: 23% 24% 15% 10% 25% 22% 22% 24% 30% $0.5bn+ Stock 40% 44% 36% 52% 38% 31% 34% 13% 28% 30% 22% 25% Cash 1 VALUA TI O N 27% 26% 27% 32% 20% 29% 18% 27% 19% 25% 15% 20% ADDITI O N AL 1999 2000 2001 2002 2003 2004YTD 1999 2000 2001 2002 2003 2004YTD Source: Thomson Financial Note: Includes all transactions with US targets (friendly and hostile) from 1/1/99 to 7/31/04 1 Cash transaction if cash is greater than 40% MICHIGAN BUSINESS SCHOOL 42 . 2004YTD) 1 day prior to announcement (median %.5-$1bn # of transactions 27 $1-$5bn 32 $5-$10bn 4 $10bn+ 5 1 day prior to announcement: $0.5bn+ Stock Cash 1 1 month prior to announcement: $0.5-$1bn # of transactions 27 MAT E RIA LS $1-$5bn 32 $5-$10bn 4 $10bn+ 5 $0.

00 45.7 9.2%) (1.8 0.7x 10.1% 34.37 0.5% 50.9% 42.64 9.80x 0.4% $527 30 $558 $33.9% 29.0 12.7x 15.00 41.9% $483 30 $513 $32.61 $25. except per share data $ millions.0%) (7.0% 25.3% 46.78 0.7 0.5% (5.9 0.7%) 3.4x 10.82x 0.3 0.6% 26.75 0.9x 9.76 $22.69 0.4% 22.9%) $377 30 $407 Operating Implied firm value Implied firm value multiples LTM revenue2 2004E revenue 2005E revenue LTM EBITDA2 2004E EBITDA 2005E EBITDA Implied P/E multiples LTM EPS2 2004E EPS 2005E EPS 1 Metrics3 $740 $744 $799 $57 $58 $62 $2.7% 59.75 0.8 15. except per share data Current Price per share Implied premium/(discount) to: Current price (9/10/04) 52-week high One month prior average price Three month prior average price Six month prior average price One year prior average price Implied equity value1 Add: Total debt2 MAT E RIA LS Offer $30.00 28.5% $531 30 $562 $34.60 $24.1mm fully diluted shares outstanding as of 9/5/04 provided by management 2 As of 6/30/04 3 Based on management estimates MICHIGAN BUSINESS SCHOOL 43 .2x 10.4 13.3 16.76 10.75x 0.2 ADDITI O N AL VALUA TI O N Based on 16.1x 6.69x 0.8% 21.7x 14.74 10.75 40.82 0.9% 42.39 $27.9% 19.6 9.9 17.0% 44.83 (15.15 $2.2 13.55x 0.00 49.5x 10.9x 0.0x 8.8% $564 30 $594 $36.1% 54.04 $2.20 $23.6 17.9x 9.0 9.00 53.9% 33.0% 37.78x 0.9% 46.51x 7.76x 0.2x 7.5% 38.Analysis at various prices $ millions.80 0.9 8.1% 18.1x 15.1% 32.0% 38.3 9.7% $547 30 $578 $35.70 9.7 9.6x 16.1 16.8 14.2x 16.70 9.6x 11.3 14.39 $23.2% 38.0% $580 30 $610 $23.0% 18.2x 15.72 10.8 0.0% 34.1% 31.9% 46.55x 0.0 16.8x 9.3 14.3% 8.1% 30.3% 42.9% 51.

1% 91.360 ADDITI O N AL Note: Estimates for London and Umbrella based on projections prepared by Umbrella management.1% 13.940 $46.2005E EBITDA .Contribution analysis Contribution London Revenue .0% 86.2004E EBITDA .2004E Net income .2005E 14.2% Total ($mm) $40.7% 14.1% 89. analysis excludes transaction adjustments MICHIGAN BUSINESS SCHOOL 44 .850 $3.542 $2.126 $4.9% 10.9% $48.8% Umbrella 85.3% 85.0% 13.3% 86.7% 14.2004E Revenue .695 $49.195 VALUA TI O N MAT E RIA LS Current equity value Transaction equity value 8.9% 86.2005E Net income .9% 86.1% 13.868 $5.

00—26.50 75% $26.25—22.00—22.50 Cum: 21% Note: As of 9/10/04 Source: Tradeline $23.00 45% $25.76 $19.57 $27.50—28.320 180 $24.50 Cum: 44% $23.420 266 $23.50—25.00 51% $25. daily trading vol (’000s) Total shares traded (’000s) Peak daily volume (’000s) VWAP High price Low price 56 7. daily trading vol (’000s) Total shares traded (’000s) Peak daily volume (’000s) VWAP High price Low price 53 1.38 $22.17 $27.25 $22.50 100% 25% 7% $22.25—23.00—23.00 100% $22.07 45% 29% 6% $22.Shares traded analysis One-month One-month Avg.50—28. daily trading vol (’000s) Total shares traded (’000s) Peak daily volume (’000s) VWAP High price Low price 61 15.51 $23.167 180 $22.50 72% $26. daily trading vol (’000s) Total shares traded (’000s) Peak daily volume (’000s) VWAP High price Low price 53 3.00—26.50—25.50—22.76 $22.00 35% 80% 94% MAT E RIA LS Six-month Six-month Avg.00—23.50 $22.75—23.25 Cum: 29% 44% 14% 24% 6% $23.75 $22.75 VALUA TI O N 21% 24% 27% 28% 8% 42% 25% 18% 7% $22.60 $27.132 266 $25.07 Three-month Three-month Avg.07 1 year 1 year Avg.00 100% Cum: $19—21 8% $21—23 50% $23—25 75% $25—27 93% $27—29 100% ADDITI O N AL MICHIGAN BUSINESS SCHOOL 45 .

3% NA NA Thermo-Electron $1.06 4.Interloper analysis Potential acquirors Apogent 2003 cash EPS Accretion/dilution .66 0.94 $8.08) (4.06 $9.07) (5.26 0.2% NA NA Waters $1.$ Accretion/dilution .01) (0.0 19% $1.$ Accretion/dilution .08 16% 84% $5.19 on 7/12/03 Assumes synergies of $30 million with 50% realized in 2003 MICHIGAN BUSINESS SCHOOL 46 .13 4.48 $11.5 12% $3.8)% 20.96 24% 76% $7.04 2.2 8% $1.4% NA NA Ownership PBSC Acquiror 2003 Break even price 2004 Break even price 1 2 21% 79% $6. implying a price per share of $8.35 0.G&A 2004 cash EPS Accretion/dilution .60 (0.1)% 9.24 ADDITI O N AL VALUA TI O N Based on Pedro offer of 0.53 (0.0% NA NA Mettler-Toledo $2.0 2% $1.46 based on Pedro closing price of $27.3% NA NA $1.89 13% 87% $7.0)% 15.G&A MAT E RIA LS Applied BioSystems $1.41 0.6)% 6.00 (0.44 11% 89% $9.01 1.% Incremental pretax synergies to break even % of target S.02) (1.08 6.36 (0.4)% 2.311 shares per Pablo share.41 $12.19 (0.45 $9.11) (4.% Incremental pretax synergies to break even % of target S.07 0.4 26% $2.

Palepu. Stewart ADDITI O N AL VALUA TI O N MAT E RIA LS MICHIGAN BUSINESS SCHOOL 47 .Valuation references Valuation—Measuring and Managing the Value of Companies. Bernard. Koller and Murrin Introduction to Business Analysis and Valuation. Copeland. & Healey Mergers & Acquisitions. Marren The Quest for Value.

Master your semester with Scribd & The New York Times

Special offer for students: Only $4.99/month.

Master your semester with Scribd & The New York Times

Cancel anytime.