M &A Va t i A n a lua on lysis

1

M &AVa l a t onA a l i u i n ys s
Lea r i g Object ve: nn i Defn M &Ava l a tonm et ie u i hods a n u s e t d hem t es tm a t t va l e of o i e he u a na cqu i ii t r et s ton a g .

Va l a t onM et u i hodol i og es
Valuation is the heart of any merger and acquisition analysis. It is a means of determining the transaction's parameters: the minimum and maximum bid range, potential synergies and the target's operating dynamics. In addition, certain quantitative analyses can indicate the potential level of dilution, the benefits to buyer and seller and the level of any future returns on the investment. However, the value of a business is not just a quantitative exercise; qualitative considerations also affect the value assigned to the business. There are several standard methods for determining the value of an M&A transaction: n publicly traded comparable peer company analysis and acquired comparable peer company analysis (frequently referred to as comparables) n pro forma analysis n leveraged buyout analysis In addition, in stock-for-stock mergers, there are valuation techniques to determine the impact on the respective shareholder groups. However, no one method will determine a single price for the target; the outcome of the analysis will be a range of values.
Public Peer Company Analysis Pro Forma and DCF Analysis

Valuation Range

Acquired Peer Company Analysis

Leveraged Buyout Analysis

From a qualitative perspective, any nonfinancial details uncovered during the due diligence discovery process will affect value. Significant intangibles that can raise the value of a business above the price range indicated by the quantitative valuation methods include:

© G lobecon G r oup,Lt d .

M &A Va t i A n a lua on lysis

2

n brand names n patents n degree of market share held by the target n ability to expand geographically n innovative products n manufacturing skill n turnaround situations involving prior mismanagement n undervalued assets The existence of the following may have a negative impact on the valuation range for the target: n environmental hazards n obsolete facilities n current or anticipated litigation Moreover, if there are only a few available companies in a given industry, many potential buyers or intense buyer interest in a particular target, the price may increase. Under these circumstances, particularly determined buyers may choose to make a preemptive bid — at a price much higher than the range indicated by the valuation methods — just to guarantee success.

Com pa r bl Peer Com pa n A a l i a e y n ys s
There are two types of comparable company analysis: n publicly traded peer company analysis n acquired peer company analysis These peer analyses compare companies in an industry on the basis of growth rates, margins, capital structure, size and returns, as well as multiples based on financial line items such as sales, EBIT, net income and book value. Publicly traded comparables highlight the current market assessment of the target vis-à-vis its peers. Acquired company analysis reviews the premiums paid by acquirers for recent comparable peer acquisitions (generally over the last two years). Understanding both types of comparable company analysis gives insight into a company's value by comparing capital structures,

© G lobecon G r oup,Lt d .

M &A Va t i A n a lua on lysis

3

analyzing business performance and highlighting market values relative to other companies in the target's peer group. Similar to other types of financial analyses, comparable company analysis is a mix of art (selecting the relevant peer group and interpreting the results) and science (calculating the financial ratios). The methodology for calculating the quantitative aspects of both sets of analyses is essentially the same. First, the peer group for the target is selected. Then financial ratios are calculated to show the value of the company relative to its peers. Finally, the peers are ranked by various measures in order to discover why the company might be valued as it is.

Peer Com pa n A a l i Pr y n ys s oces s
Choos e Peer G r p à ou - si m - si m - si m - si m ia rln ofbu s i es s l ie n ia r s i l ze ia rlf cycl s t g e l ie e a ia r ca pia ls t u ct r l t r u e Va l a t onà u i Ca l l t fn n a lr tos cu a e i a ci a i - fn prce r a tve t peer i d i el i o s - i t r et over l ed or u n va l ed? s a g va u der u I t pr a t onà ner et i Do r n i g s a k n - r n by pr ia biiy a k oft lt - r n by g r t a k ow h - r n by l a k ever g e a

Sel i g t Peer G r p ectn he ou
No set of peer companies is truly identical to the target, but certain elements should be similar. Peer companies should: n be in the same industry n share the same life-cycle stage (all growth companies or all mature companies) n have similar revenues n have comparable sales bases (distributors versus direct sales, retail versus wholesale, franchise versus owned) n share the same product lines n have similar manufacturing processes (manufactured versus assembled) n have comparable capital structures At times, it is difficult to find an adequate set of comparable companies (usually defined as at least five peers). This is particularly true when seeking acquired peer companies since, except for in particularly acquisitive industries, it is rare for several companies in the same industry to be acquired within the last two to three years. In these cases, it is acceptable to use companies in industries with similar operating dynamics as those of the target (e.g., a vacuum cleaner manufacturing company could be compared to other companies that produce small household appliances).

© G lobecon G r oup,Lt d .

M &A Va t i A n a lua on lysis

4

Va l a ton u i
The quantitative aspect of the comparables analysis is illustrated in the following example. Since the calculations are similar for publicly traded and acquired peer company analyses, the example will focus on a publicly traded analysis.

Ex m pl a e
All five companies below are publicly traded US telephone companies. Phone companies represent an ideal peer group, since all share a similar industry, product line, life-cycle stage, customer base, capital structure and, to a lesser extent, revenues. It is possible to estimate the target's share price by calculating comparable financial ratios for companies A, B, C and D. Step 1: Calculate the equity and total value for the peer companies. (All US dollar figures are in millions, except per share data.)
Com pa n y A B C D Ta r et g
Not : es

Sha r e Pri ce 27.88 20 .25 27.50 28.38 28.13

Sha r es Ou t t n n s a di g 80 .7 60 .3 27.9 61.8 66.6

Equ iy Va l e1 t u 2,249.92 1,221.0 8 767.25 1,753.88 1,873.46

Cor a t Va l e2 por e u 3,113.62 1,738.38 1,158.35 2,971.68 3,236.46

1. equity value = share price x shares outstandin g 2. corporate value = equity value + book value of preferred equity at liquidatio n + short - term debt + long - term debt + minority interest - cash and marketable securities

Step 2: Calculate various multiples for the peer group.
Equ iy Va l e a s M u l i e of t u tpl : Com pa n y Net Ca s h 1 2 I com e n Fl ow A B C D
Not : es 1. equ iy va l e / n i com e over t l s t 12 m onhs t u et n he a t 2. equ iy va l e / ca s h fow , w here ca s h fow = ca s h fow f om oper ton – pr er ed s t t u l l l r a i s ef r ock di den vi ds 3. cor pora te va l e / com m onequ iy, w here com m onequ iy = book va l e u t t u 4. corpor te va l e / EBI a u TDA w her EBI , e TDA= n i com e + i t es t ex s e + ta x + depreci ton& a m or i ton et n ner pen es a i tza i 5. corpor te va l e / EBI w here EBI = n i com e + i teres t expen e + ta x a u T, T et n n s es 6. corpor te va l e/s a l a u es

Cor a t Va l e a s M u li e of por e u t pl : 4 5 Com m on EBI TDA EBI T Sa l 6 es 3 Equ iy t 2.3 2.3 1.9 1.6 6.4 6.8 6.6 5.1 9.9 11.3 11.4 8.6 2.3 1.9 2.0 1.8

13.9 14.6 15.5 11.0

6.7 6.5 5.9 4.1

© G lobecon G r oup,Lt d .

M &A Va t i A n a lua on lysis

5

Step 3:Categorize the data in step 2 in terms of the maximum, minimum, mean and median multiples for the peer group.
Equ iy Va l e As M u l i e Of t u tpl : M u li e t pl Net I com e Ca s h Fl n ow M a xm u m i 15.5 6.7 M ea n 13.8 5.8 M edi n a 1 14.3 6.2 M ii u m nm 11.0 4.1
Not e:

Cor a t Va l e As M u li e Of por e u t pl : Com m onEqu iy EBI t TDA EBI T Sa l es 2.3 6.8 11.4 2.3 2.0 6.2 10 .3 2.0 2.1 6.5 10 .6 1.9 1.6 5.1 8.6 1.8

1.median =

second highest number in column + third highest number in column 2

This table shows the multiples paid by equity investors for shares of similar companies. Publicly traded peer company valuation analysis derives multiples of net income, EBIT, EBITDA, cash flow, book value and sales for a set of peer companies. Step 4:Using the target's actual financial data and the peer group multiples, find a range of equity values for the target. (Note: numbers may not agree exactly due to rounding.)
U s i g Equ iy Va l e: n t u Net I com e Ca s h Fl n ow 143.4 396.4 U s i g Cor a t Va l e: n por e u Com m onEqu iy EBI t TDA 780 .7 568.9 I pu t Equ iy Va l e2 m ed t u 1,795.6 2,50 5.5 1,561.4 2,164.2 1,639.5 2,334.9 2,186.0 1,538.4

Ta r et g com pa n y I pu t Equ iy Va l e1 m ed t u M a xm u m i 2,222.7 M ea n 1,978.9 M edi n a 2,0 50 .6 M ii u m nm 1,577.4
Not : es

EBI T 30 2.3

Sa l es 1,80 5.9

2,655.9 2,299.1 2,457.7 1,625.2

2,0 83.2 1,750 .7 1,841.4 1,236.8

2,790 .6 2,248.8 2,0 68.2 1,887.6

1. i pu t equ iy va l e = equ iy va l e m u li e f om s t 3 x t r et com pa n va l e m ed t u t u tpl r ep a g y u

2. i pu t equ iy va l e m ed t u

= (corpora te va l e m u li e f om s t 3) x (ta r et com pa n va l e) + (ca s h & m a r eta bl u tpl r ep g y u k e s ecu rtes ) – (l g -term debt + s hor -term debt + pref r equ iy a tlqu i tonva l e + ii on t er ed t i da i u m i oriy i t es t ) n t ner s = (corpora te va l e m u li e f om s t 3) x (ta r et com pa n va l e) – 1,363 u tpl r ep g y u

Note that the imputed equity values for EBIT, EBITDA and sales are equal to the corporate value less the net book value of any debt, preferred equity, minority interests and cash or marketable securities. If this additional calculation were not done, the imputed equity values for net income and book value would not be equivalent to the imputed values generated with the EBIT, EBITDA and sales multiples because they are based on the corporate value, not the equity value, of the company. The rationale for this difference is that earnings are received only by equity holders (and are therefore a multiple of equity value), whereas EBIT is received by holders of both debt and equity (and is therefore a multiple of corporate value).

© G lobecon G r oup,Lt d .

M &A Va t i A n a lua on lysis

6

Step 5:Divide the values in step 4 by the target's shares outstanding (66.6) to find a range of per share equity values for the target.
Net I com e n M a xm u m i M ea n M edi n a M ii u m nm 33.37 29.71 30 .79 23.68 Ca s h Fl ow 39.88 34.52 36.90 24.40 Com m onEqu iy t 26.96 23.44 24.62 32.82 EBI TDA 37.62 32.50 35.0 6 23.10 EBI T 31.28 26.29 27.65 18.57 Sa l es 41.90 33.77 31.0 5 28.34

I t pr a ton ner et i
The EBIT and EBITDA ratios generated by the analysis are most relevant for M&A purposes. In general, sales multiples produce the upper end of the imputed equity valuation range for an industry since they fail to incorporate the cost structure. EBIT and EBITDA multiples provide the closest approximation of the ongoing value of a company because they reflect the operating cash flow without consideration for the capital structure. Book value provides a floor to the imputed valuation range because it reflects historical costs but ignores cash flow or profitability. Price/earnings multiples are less reliable gauges of value because of differences in capitalization, tax treatment and economic cyclicality. At times, unique multiples are used in certain industries in which profitability and value are not necessarily reflected in operating performance. For example, the cellular telephone industry looks at corporate value to total POP (percent of population); retailers use same-store sales growth; hospital companies look at the number of beds; cement or linerboard companies use price per ton of capacity; and real estate and timberland companies use price per acre. The goal of this analysis is to find a tighter range of equity values than is implied by the range between the minimum and maximum values. At times, however, the business attributes of either the highest- or lowest-valued company may be the most similar to those of the target, in which case the maximum or minimum values for that particular company should be stressed in the analysis. (Such variations can be especially important when valuing private companies with different operating characteristics than their public peers.) The median is useful when the peer group contains extreme minimum or maximum values that distort the value of the mean. In the above example, a typical (i.e., mean or median) imputed share value for the target company ranges from a low of USD 23.44 per share (using book value) to a high of USD 36.90 per share (using cash flow), while the actual public trading price for the target was USD 28.13. The range clearly captures the target's current public market value. In fact, the target company's stock price had fluctuated between USD 28 and USD 31 per share over the prior 12 months. Although the imputed range now appears quite wide, further analysis is likely to narrow it.

© G lobecon G r oup,Lt d .

M &A Va t i A n a lua on lysis

7

U s i g Ra n i g s t I t pr t Res u ls n k n o ner et he t
Why would a valuation imply that the company is overvalued, fairly valued or undervalued compared to its peers? Rankings help explain why a company is valued the way it is by showing trends in operating and financial performance within the peer group and how the target has fared relative to those trends.

Ra n i g s by M a r i s , Lever g e a n G r t k n g n a d ow h
EBI TDA 1 2 3 4 5 Debt t M a r i o g n A C Ta r et g D B 36% 35% 32% 30 % 28% Thr ee-Yea r Ca pia lza t on t i i A D C B Ta r et g 46% 49% 52% 55% 61% Sa l G r t es ow h B A D C Ta r et g 19% 9% 8% 5% 5%

In this example, the target company, although a dominant market player, has the slowest growth in sales. It also has the highest debt-to-equity ratio (and return on equity), so it is optimizing its capital structure relative to its peers. However, its EBITDA margin is only average, so perhaps it can improve operating performance. Interpreting the peer company analysis also involves checking the numbers for accuracy and common sense, reevaluating the peer group for its suitability and eliminating extreme values, and finding the story in the numbers, that is, an explanation, at least in part, for the company's valuation relative to its peers. The steps are broken down in the following checklist: n Are the calculations accurate? Are the accounting methods similar and have all extraordinary gains, losses and accounting changes been eliminated? n Are the numbers consistent with common sense? Are the multiples reasonable and in line with one another? If not, why not? Were there any stock splits, mergers or other events that would skew the numbers? n Is each company comparable from a financial viewpoint? an operational viewpoint? Are there extreme values that should be excluded? n Finally, and most important, what conclusions can be drawn? Rankings are the natural extension of the peer company valuation analysis. To estimate the exact offer price, however, it is up to the buyer to refine the valuation estimate based on any other available information on the company and using other techniques, such as acquired peer company analysis, pro forma analysis (with a discounted cash flow analysis incorporated) and LBO analysis.

© G lobecon G r oup,Lt d .

M &A Va t i A n a lua on lysis

8

A ied Peer Com pa n A a l i cqu r y n ys s
Acquisitions of peer companies are also analyzed in order to refine the estimate of the value that could be obtained in an actual sale and the premium that would be paid relative to the public market valuation. In short, this analysis provides a benchmark on acquisition values. Compiling information on comparable acquisition transactions also helps develop an understanding of the M&A activity in the industry: the rationale for transactions, the speed at which they are taking place, who the active acquirers are and their appetite for possible additional acquisitions. This knowledge can help generate a transaction strategy useful to both buyers and sellers, for instance, whether the buyer should make a preemptive bid or the seller should have an auction instead of a negotiated sale. Although the previous example focused on publicly traded peer companies, a set of acquired peer companies is calculated in almost the same way. There are only two differences: equity value and corporate value are replaced by the offer value and transaction value in the calculations and the interpretation of the results. The offer value and transaction value are used because they reflect the price level at which the various acquisitions took place. The offer value indicates how much it costs to buy common equity and equity equivalents, while transaction value reflects the value of equity plus refinancing of debt and transaction expenses. The logic is equivalent to using the current trading ranges for the publicly traded peer companies. The following example illustrates how a typical offer value and transaction value, incorporating several capital structure items, are calculated.

© G lobecon G r oup,Lt d .

M &A Va t i A n a lua on lysis

9

Ex m pl a e
Of er Va l e f u A s u m pt on s i s Ofer prce per s ha r f i e 12.0 0 Com m ons ha r es ou t t n n s a di g Ex ci a bl opton er s e i s ou t t n n s a di g Com m ona n opton d i s ou t t n n s a di g 15,0 0 0 50 0 15,50 0 Tot lbook va l e ofl g a u on t m debt er Les s :Q u a niy con t tt ver ed Va l e ofl g -t m debt u on er a s s u m ed Prce ofcom m ona n i d opton i s 186,0 0 0 Shor -t m debt a n t er d cu r en l g -t m debt r t on er A . ex ci e prce of vg er s i opton i s Les s :Pr oceeds f om r opton i s Book va l e of u con tbl debt ver i e Con s i prce ver on i Nu m ber ofs ha r es i s u ed s Pu r s e prce of cha i con tbl debt ver i e Pa r va l e ofcon tbl u ver i e pr er ed ef r Con s i prce ver on i Nu m ber ofs ha r es i s u ed s Pu r s e prce of cha i pr er ed ef r Tot lof er va l e a f u 7.0 0 (3,50 0 ) Oper tn ca s h r ied a ig equ r Ca s h a va ia bl l e Les s :Ex s ca s h ces 70 0 15,0 0 0 (14,30 0 ) 10 .0 0 2,0 0 0 24,0 0 0 Tot l t a n a ct onva l e a r s i u 1,0 0 0 7.0 0 143 1,716 20 8,216 30 7,916 Tr n a ctoncos t a s i s 4,0 0 0 40 ,0 0 0 90 ,0 0 0 Tr n a ct onVa l e a s i u Va l es u A s u m pt on s i s Ofer va l e f u Va l es u 20 8,216

(20 ,0 0 0 ) 70 ,0 0 0

20 ,0 0 0

Comparing acquisition premiums for peer company transactions indicates the percentage premium above the equity market price that is required to purchase a company in that particular industry, and the rankings, once again, should explain why.

Pro For a A a l i m n ys s
A pro forma analysis quantifies the impact of combining two companies' balance sheets and income and cash flow statements based on a proposed transaction. The term pro forma refers to the combined financial statements after the proposed transaction date. After the initial statements are created as of a given date in the past, the financial projections for the combined company can be altered as forecasts change. For example, economic benefits resulting from the consolidation of manufacturing facilities or administrative functions can be modeled, as can the impact of early debt repayment or

© G lobecon G r oup,Lt d .

M &A Va t i A n a lua on lysis

10

increased dividends. The target's pro forma and projected statements can then be subjected to a discounted cash flow analysis to estimate the value of the business. In order to calculate a pro forma accurately, a number of assumptions must be made: n the timing of the transaction n accounting for the transaction (purchase or pooling of interests) n the transaction's structure (stock or asset purchase) n the form of consideration (all stock, stock and cash, debt, etc.) n the extent and value of potential synergies Once these assumptions have been made, the pro forma financial statements and projections can be calculated. A pro forma analysis usually includes at least the following: n transaction summary (pooling vs. purchase and forms of consideration) n pro forma opening balance sheet n pro forma projected combined income statements, balance sheets and cash flow statements n pro forma financial ratios n pro forma indebtedness summary n projected target income statements, balance sheets and cash flow statements n projected acquirer income statements, balance sheets and cash flow statements n discounted cash flow analysis of the target n an earnings cross-over analysis that shows whether the transaction is dilutive to existing shareholders The assumption on timing determines the date of the initial financial statements (historical pro formas), while the assumption about the form of consideration determines the number of shares outstanding (for pooling) or the level of initial debt, equity and cash on the balance sheet (for purchase). All of this is then presented on the transaction summary page. The pro forma opening balance sheet for both a pooling and purchase pro forma is illustrated in the tables titled "Tax-Free Pooling Accounting Combined Balance Sheet" and "Tax-Free Pooling Accounting Combined Statements of Income", and "TaxFree Purchase Accounting Combined Balance Sheet" and "Purchase Accounting Combined Statements of Income" assuming a December 31 transaction date.

© G lobecon G r oup,Lt d .

M &A Va t i A n a lua on lysis

11

The historic statements are also carried forward for a period of time (generally five to ten years), with assumptions about growth and margins for each company (the "projected statements"). The separate acquirer and target statements are then combined to create the pro forma projected combined statements.

Ta x ee Pooln A -Fr i g ccou ni g Com bi ed Ba l n Sheet tn n a ce
Decem ber 31 (i n USD t s a n ) hou ds Ca s h Recei bl va es I venor n t y Pr i a s s et epa d s Fi ed a s s et x s Pa t t ens G oodw il l Pa ya bl es A ual ccr s I com e t x pa ya bl n a e Lon -t m debt g er Ca pia la n s u r u s t d pl Com pa n X y Hi t i l s or ca 30 0 1,0 50 90 0 120 2,370 1,425 – – 3,795 90 0 375 30 0 1,575 570 1,650 3,795 Com pa n Y y Hi t i l s or ca 75 30 0 450 75 90 0 60 0 – – 1,50 0 150 113 120 383 75 1,0 42 1,50 0 Pro For a Com bi ed m n Com pa n Xa n Y y d 375 1,350 1,350 195 3,270 2,0 25 – – 5,295 1,0 50 488 420 1,958 645 2,692 5,295

Ta x ee Pooln A -Fr i g ccou ni g Com bi ed St t ens ofI com e tn n a em t n
Decem ber 31 (i USD t s a n ) n hou ds Sa l es Cos t ofs a l es G r s pr i os oft Seli g , g en a la n ln er d a dm i i t a tve ex s es ns r i pen I com e f om oper ton n r a i s Feder li com e t x a n a * Net i com e n Ret r ons a l u n es Com pa n X y Hi t i l s or ca 3,750 (2,250 ) 1,50 0 (750 ) 750 (375) 375 10 % Com pa n Y y Hi t i l s or ca 1,0 50 (630 ) 420 (210 ) 210 (10 5) 10 5 10 % Pro For a Com bi ed m n Com pa n Xa n Y y d 4,80 0 (2,880 ) 1,920 (960 ) 960 (480 ) 480 10 %

* a s s u m es a 50 % s t tu tor t x r te a y a a

© G lobecon G r oup,Lt d .

M &A Va t i A n a lua on lysis

12

Pu r s e A cha ccou ni g Com bi ed Ba l n Sheet tn n a ce
Decem ber 31 (i USD t s a n ) n hou ds Pro For a m Com pa n Y y Com bi ed n M a r et Va l e k u X Ba s ed on /Y of W r t i e-Up Pooln ig (A s u m pt on ) s i s 375 – 1,350 – 1,350 75* 195 – 3,270 75 2,0 25 975* – 450 * – 458 (1) 5,295 1,958 1,0 50 – 487 – 420 – 1,957 – – – 645 – 2,693 1,958 5,295 1,958 Com pa n Y y Ef ect of Ta x f Di f en f er ces (2) – – – – – – – 69 69 – – – – 69 – – 69 Pro For a m Com bi ed n X Ba s ed on /Y Pu r s e cha 375 1,350 1,425 195 3,345 3,0 0 0 450 526 7,322 1,0 50 487 420 1,957 69 645 4,650 7,322

Ca s h Recei bl va es I venor n t y Pr i a s s et epa d s Fi ed a s s et x s Pa t t ens G oodw il l Tot la s s et a s Pa ya bl es A ual ccr s I com e t x pa ya bl n a e Def r i com e t x er ed n a es Lon -t m debt g er Ca pia la n s u r u s t d pl Tot lla biii a n a i ltes d s ha r ehol s ' equ iy der t
Not : es

(1) Res i a lva l e ca l l t a s f l s : du u cu a ed olow Pu r s e prce cha i Com pa n Y Ca pi la n Su rpl s y ta d u Ex s t be a loca ted ces o l Les s :Reva l a ti ofi tfa bl a s s et t f i m a r et va l e u on denii e s o a r k u Al ted t g oodw il loca o l *Al ton m a de by a ccou na ns . loca i t t (2) U n St tem en ofFi a n a lA der a t n ci ccou n n St n r No. 96, the la biiy m ethod ofa ccou ni g r ies recog ntonof ti g a da ds i lt tn equ r ii t t x efect ofdif en he a f s fer ces bet eena s s i n va l es a n t ta x ba s es of t n a s s et a cqu ied a s d ef r i com e w g ed u d he he et s r er ed n t x a s s et orla biii . The a ct a la m ou n of t e a loca ti s w ou l n a s i ltes u t hes l on d eed t be ca l l t by a na ccou ni g or t x o cu a ed tn a pr es s i a l of on . 3,0 0 0 (1,0 42) 1,958 (1,50 0 )* 458

Pu r s e A cha ccou ni g Com bi ed St t ens ofI com e tn n a em t n
Decem ber 31 (i USD t s a n ) n hou ds Pro For a Com bi ed m n X onTa x ee /Y -Fr Pooln Ba s i ig s 4,80 0 (2,880 ) – – 1,920 (960 ) – 960 (480 ) 480 10 .0 % Pro For a m Com bi ed X on n /Y Pu r s e Ba s i cha s 4,80 0 (2,880 ) (136) (75) 1,70 9 (960 ) (13) 736 (374)* 362 7.5%

Sa l es Cos t ofs a l es Pl s (m i u s ) a ddii a ldepr a ton n u n ton eci i , et I venor a dju s t en, n ofdif en i t x n t y m t et fer ce n a ba s i s G r s pr i os oft Seli g , g en a la n a dm i i t a tve ex s es ln er d ns r i pen 1 G oodw ila m or i tonover 40 yea r l tza i s I com e f om oper ton n r a i s Ta x pr s i ovi on Net i com e n Ret r ons a l u n es
1

G oodw ila m ori ton= tota lg oodw il÷ 40 or[ l tza i l 526 ÷ 40 ]

© G lobecon G r oup,Lt d .

M &A Va t i A n a lua on lysis

13

* Thi ex m pl does n t ea t g oodw ila s dedu ctbl f t x pu rpos es . Ta x dedu cti lt i ra r y s eena n u s u a ly lm i s a e ot r l i e or a biiy s el d l i ted t a s s et pu r s es ofdi s i s . How ever t t ea t en ofg oodw ili M &As i a ti s i a com plca t a r of t x l w , o cha vi on , he r m t l n tu on s i ed ea a a a n the r u l ti s g over i g i a r evol n . The rea deri recom m en d eg a on nn t e vi g s ded t con u l w i a nex ti t s a rea . Ta x o s t th per n hi pr s i = (g ros s pr i – g en a lexpen es ) × (t x r te) or[ ovi on oft er s a a (170 9 - 960 ) × 50 %].

Di cou ned Ca s h Fl (DCF) A a l i s t ow n ys s
A DCF valuation model is based on the idea that the company's value is equal to the present value of the future cash flows. Coupled with the projected target financial statements, the DCF can be used to value a range of cash flow scenarios based on different operating assumptions for the target. It can also model the impact of different financing techniques through the impact on the acquirer's cost of capital, that is, the discount rate used for merger and acquisition transactions. The acquirer's cost of capital is equivalent to the return required to induce the acquirer to make an investment, in this case, an investment in another company. In order to calculate the target's value, the DCF method requires three variables: n the target's free cash flow n the acquirer's weighted average cost of capital (WACC) n an analysis of what the company would be worth at some point in the future based on certain financial ratios from the comparable peer company analysis The target's free cash flow is calculated in the separate projected income and cash flow statements of the target in the pro forma analysis. Free cash flow is defined as:
f ee ca s h fow r l = + + – oper tn pr i (EBI × (1 - t x r t a i g oft T) a a e) depr a tona n ot n -ca s h cha r es eci i d her on g cha n e i ca s h f om w or i g ca pia l g n r k n t ca pia lex diu r t pen t es (s u ch a s def r t x ) er ed a es

A typical DCF analysis will include at least three scenarios: n Base case: cash flow reflects the expected cash flow stream generated by the target for the benefit of the acquirer. n Worst case: cash flow reflects minimal contributions from the target. n Best case: cash flow reflects any synergies that can be obtained from the transaction. The acquirer's weighted average cost of capital is the cost of each debt and equity capital component and the amount of that component in relation to the total capital structure. The components of the calculation are as follows:

© G lobecon G r oup,Lt d .

M &A Va t i A n a lua on lysis
WACC = interest cost of debt ×(1 - tax rate) ×

14

book value of debt + preferred dividend book value of capital book value of preferred stock book value of common stock × + [risk - free rate + (beta ×market premium)] × book value of capital book value of capital

W her e: rs k -f ee r t = r u r ona rs k -f ee i ves t en s u ch a s a US Tr s u r bon i r a e et n i r n m t ea y d bet = a m ea s u r oft s t 's vol tlt w ih r pect t t m a r et a e he ock a iiy t es o he k m a r et pr i m = hi t i ls t k em u s orca ock m a r et r u r m i u s t rs k -f ee r t k et n n he i r a e

The last term in the WACC equation is known as the capital asset pricing model (CAPM) and provides a measure of the firm's cost of common equity. Note that for M&A transactions, the acquirer's weighted average cost of capital is calculated using the book value of the debt and equity, not the market value. Mergers and acquisitions are two of the circumstances in which the average cost, not the marginal cost (or the cost of the next incremental addition of debt or equity) is appropriate. Using the acquiring company's own cost of capital to discount the target's projected cash flows is appropriate only when it can be safely assumed that the acquisition will not affect the risk level of the acquirer. If the acquisition of the target will strain the bond ratings of the acquirer, and therefore change the acquirer's cost of capital after the transaction, the cost of capital should be adjusted to reflect the additional risk. As a practical matter, most DCF analyses use a range of discount rates above and below the acquirer's actual rate to account for various transaction capital structures. Finally, when calculating the terminal values for the DCF valuation, either the perpetuity or the growing perpetuity methods may be used. The choice of method usually depends on the acquirer's intentions. Most corporate buyers use the growing perpetuity method because they intend to add value to the target, whereas most financial (LBO) buyers use the perpetuity method because they intend to sell the investment after a certain period of time (typically five to seven years). Terminal values are generally based on EBIT or EBITDA rather than after-tax cash flow (net income + depreciation + deferred taxes). Since after-tax cash flow is usually subject to various leverage decisions and tax rates, such valuations are rarely comparable across companies. Therefore, M&A prices are usually based on multiples of operating cash flow (EBIT or EBITDA), depending on the variability in the level of fixed asset depreciation for a given industry. This is because an acquirer is interested in the operating cash generated by a target before leverage is added.

© G lobecon G r oup,Lt d .

M &A Va t i A n a lua on lysis

15

The EBIT or EBITDA income statement figure is multiplied by the relevant multiple (usually a range as with the discount rate) from the acquired peer company comparables. For example, if the range of acquisition multiples of EBIT for a given industry are 6.8-8.4 (and an average of 7.6), the perpetuity calculations would look like this:
present value of perpetuity = EBITn ×7.6 discount rate

present value of growing perpetuity =

(EBITn ×7.6) ×(1 + growth rate) discount rate - growth rate

The numerator establishes the value of the business in the future, discounted back to year n. This terminal value, or value of the business in year n, is then discounted back to the present along with the cash flows. The steps in a DCF analysis can be summarized as follows: 1. Calculate the weighted average cost of capital of the acquirer. 2. Apply the target's free cash flows from the projected financial statements. 3. Calculate the terminal value using one of the perpetuity methods. 4. Calculate the present value of the free cash flows and the terminal value. 5. Subtract the net book value of any debt to determine the value of equity. 6. Divide by the number of shares outstanding, adjusting for possible dilution resulting from convertible securities, warrants or stock options, if appropriate. 7. Compare the share price to the DCF value. The values from each scenario of the DCF analysis can then be compared to those generated from the publicly traded and acquired peer company analyses as well as an LBO analysis to determine the appropriate value for the business.

A ton lPr For a I f m a ton ddii a o m nor i
A pro forma analysis can also answer the following questions: n What is the per share dilution, if any, from the transaction? n What is the breakeven point (the point at which the company makes the same earnings per share after the transaction as it would have without the transaction)? n Is the ongoing combined business insolvent or liquid? n Will the combined operations meet existing debt covenants?

© G lobecon G r oup,Lt d .

M &A Va t i A n a lua on lysis

16

Ea r i g s C r s -OverA a l i nn os n ys s
Corporate buyers are driven primarily by the impact of the acquisition on earnings per share and the returns received as forecasted by the DCF analysis. Valuation of a target company based on an earnings cross-over analysis (a component of the pro forma analysis) is usually more indicative of the price a corporation is willing to pay than peer company analysis. Therefore, this type of analysis is particularly useful for companies that will be acquired by a corporate buyer. An earnings cross-over analysis quantifies the positive or negative incremental earnings impact of a transaction. The first two questions in the previous list pertain to the earnings cross-over analysis, or the impact of the transaction on earnings per share; the last two pertain to creditworthiness. Since a pro forma analysis contains individual projected financial statements for both the acquirer's business and the target's business, it is possible to calculate the expected earnings for the acquirer alone. This result can then be compared to the pro forma combined results to determine the impact of the acquisition. If the acquirer pays too much for the target, the combined earnings per share may be lower (dilutive) than for the acquirer alone. The point at which the earnings are no longer dilutive is called the breakeven point. The principles behind an earnings cross-over analysis include the following: n If the income derived from the acquisition exceeds the acquisition expenses (interest expense and the fees of lawyers, accountants and bankers) in the near or medium term, the acquisition is usually acceptable. n Some buyers will not accept any dilution in the first year due to the impact on the stock price (although foreign purchasers will usually take a longer-term view). n Without synergies, most cross-over analyses show initial or long-term dilution. (In a bidding contest, synergies frequently enable one bidder to prevail over another.) n Stock-for-stock transactions in which the buyer's stock is trading at a lower P/E ratio than the P/E ratio paid for the target tend to be more dilutive than cash deals. Ex m pl a e The following is an earnings cross-over analysis done for an M&A project code-named "Crimson." Code names are standard for merger and acquisition valuations in order to minimize the number of individuals who know the true identity of the target and the acquirer. The use of code names helps prevent early leaks to the media or illegal insider trading in the equity of either company before the public announcement of the transaction.

© G lobecon G r oup,Lt d .

M &A Va t i A n a lua on lysis

17

Crm s onEa r i g s C r s -OverA a l i i nn os n ys s
(i USD m ilon , ex n li s cept per s ha r a m ou ns ) e t A s u m pt on s i s Cor a t Bu yer Sou r ofFu n : por e 's ce ds Crm s on ca s h ba l n i 's a ces 20 0 Bu yer r i a n efn ces a l debt l Net i t es t ex s e i : ner pen s 7.5% Of er Va l e a n Fi a n n f u d n ci g Ofer va l e per s ha r f u e Nu m ber ofs ha r ou t t n n es s a di g Ofer va l e f u Debt r i a n efn ced Optonpr i oceeds Ca s h Net debt r ied equ r Ea r i g s I pa ct nn m Oper tn i com e a ig n Net debt i t es t ex s e1 ner pen Ta x pa ya bl (@ 40 %) es e At -t x i com e conrbu ton fer a n ti i (bef e s yn g i ) or er es
Not e: 1. a s s u m es n a m or i tonofdebt a n a on i e i cr s e of30 0 m iloni Yea r 2 f ca pia lex di r o tza i d e-tm n ea li n or t pen tu es

50 .0 0 28.941 1,447 3,10 0 (54) (20 0 ) 4,293 Yea r 1 314 (322) (8) 3 (5) Yea r 2 369 (344) 25 (10 ) 15 Yea r 3 428 (344) 84 (33) 51 Yea r 4 487 (344) 143 (57) 86 Yea r 5 485 (344) 141 (56) 85

As the calculations show, the acquisition of Crimson will be dilutive to the net income of the acquirer for only one year. After the first year, the transaction will provide a positive earnings increase for the acquirer. An additional component of a pro forma analysis is a projection of operating and balance sheet ratios. These financial ratio projections attempt to quantify the combined company's growth rates in sales, operating margins, interest coverage and debt-to-equity ratios. If the combined cash flows of the businesses are not sufficient to pay down any debt assumed in the transaction, or if interest coverage is not sufficient to satisfy debt covenants, this analysis will highlight those problems prior to initiating the transaction. Changes to the forms of consideration, or the choice of acquisition structure, can then be made.

Lever g ed Bu you tA a l i a n ys s
The purpose of an LBO analysis is to determine the absolute minimum amount of equity that is needed to finance a transaction without taking the company into bankruptcy or violating debt covenants. It is often used for M&A valuation purposes even if there is no intent on the part of the buyer or the seller to use a leveraged acquisition structure. The reason it is used is to determine the price a leveraged buyer can afford to pay for the

© G lobecon G r oup,Lt d .

M &A Va t i A n a lua on lysis

18

business if it were acquired mainly with debt. LBO buyers were so prevalent during the mid- to late 1980s that any buyer had to prepare for LBO competition on a transaction. Although LBO and MBO (management buyout) buyers are less active today, they still exist. Therefore, it is important to know how much such a buyer could afford to pay in order to plan an appropriate acquisition pricing strategy. An LBO analysis begins with an initial balance sheet that allows the buyer (management or an LBO firm in most cases) to alter the forms of consideration used to finance the transaction. In general, an LBO buyer will attempt to pay for the target's equity using any excess cash or marketable securities on the target's balance sheet, followed by senior debt, senior subordinated debt, junior subordinated debt, pay-in-kind preferred stock and, finally, the least amount of common equity possible. The reason for this sequence of financing options is that the buyer wants to minimize its future interest expense by using the least expensive form of consideration first (cash) followed by the least expensive type of debt, before moving down the balance sheet to more expensive forms of debt or equity financing. The projected financial statements are linked to the initial pro forma statements so that any change made in the forms of consideration can be reflected throughout the projected period. For example, any change in the expected interest rate on debt or the dividends on a preferred issue will be carried through the projected income statement and change earnings per share. In addition, any increases in interest or principal payments on debt or preferred stock financing will be reflected in the projected balance sheets and cash flow statements. The degree of leverage allowed depends on the answers to two questions: 1. Is the senior debt paid down in five to seven years? 2. Are the interest coverage ratios sufficient to satisfy the debt covenants? As long as the cash flow projections from the business satisfy these two requirements, the leveraged structure can be used. Once the maximum price that could be paid and the levels of debt have been determined, the target's financial performance is again subjected to a discounted cash flow analysis. However, the WACC used for the DCF analysis may be different than in the standard pro forma example because if the leverage reduces the company's debt rating below investment grade, the cost of capital for the acquirer might be much higher. Or the WACC could be that of the target (which is financing itself in the case of an MBO), reflecting a greater degree of leverage than the acquirer has. The results would then be compared to those obtained from the standard pro forma analysis when designing a pricing strategy.

Prci g M a t i i n rx
Finally, most transaction analyses include a pricing matrix. The purpose of a pricing matrix is to show the range of multiples that will be paid for a given target as the offer price rises or falls. The buyer can use the matrix to negotiate the price within a predetermined range of acceptable multiples based on the trading ranges of the target's peers.

© G lobecon G r oup,Lt d .

M &A Va t i A n a lua on lysis

19

For example, if comparable acquisitions for the company shown in the "Pricing Matrix" table had been made for a range of EBIT multiples between 7.5 and 7.7, the buyer would know from looking at the matrix what the range of offer prices should be. For example, an offer of USD 40 per share for a particular target would reflect an EBIT multiple of 7.6 and a book value multiple of 2.32.

Prci g M a t i i n rx
(a m ou ns i USD) t n Of er f Prem i m u Pri ce/ Of er Pri f ce/ Of er f t M a r et o k Pri per Pri ce ce: Of er Tr n a ct on LTM EPS: LTM EPS: TV/EBI f a s i T: TV/Sa l : es Sha r e 2.48 2.48 33.25 Va l e* Va l e (TV)** u u 314 4,153 33.25 0% 90 8 2,20 3 13.4x 1.92 7.0 x 0 .53x 38.0 0 14% 1,0 38 2,333 15.3x 2.20 7.4x 0 .56x 38.50 16% 1,0 52 2,347 15.5x 2.23 7.5x 0 .57x 39.0 0 17% 1,0 65 2,360 15.7x 2.26 7.5x 0 .57x 39.50 19% 1,0 79 2,374 15.9x 2.29 7.6x 0 .57x 40 .0 0 20 % 1,0 93 2,388 16.1x 2.32 7.6x 0 .57x 40 .50 22% 1,10 6 2,40 1 16.3x 2.34 7.6x 0 .58x 41.0 0 23% 1,120 2,415 16.5x 2.37 7.7x 0 .58x 41.50 25% 1,134 2,429 16.7x 2.40 7.7x 0 .58x
* n m ber ofs ha res ou t ta n n :27.32 u s di g ** ofer va l e ofequ iy + debt a n pr er ed s t f u t d ef r ock a s s u m ed - ca s h = USD 1,295

I t pr i g t Res u l s ner et n he t
There is no one value for a business. The ultimate price paid for a company is a combination of valuation methodologies, qualitative factors and the desire of the acquirer's management for the purchase. Each component of a valuation analysis adds another perspective on pricing the target.

© G lobecon G r oup,Lt d .

M &A Va t i A n a lua on lysis

20

Public Peer Company Analysis

Current Market Assessment

Acquired Peer Company Analysis

Premium for Control

Pro Forma & DCF Analysis

Value of the Business

Leveraged Buyout Analysis

Worth with Maximum Debt

In general, the price offered for a company is within a range indicated by a composite (though not necessarily an average) of the results obtained from the quantitative analyses. The initial offer price within that range depends on the level of competition expected, the opportunities to increase the initial offer and other negotiating considerations (such as the ability to warrant, i.e., assign responsibility for, old litigation or environmental liabilities to the previous owner). In any case, the initial offer is rarely accepted unless a preemptive bid is proposed. At times, buyers bid higher than the price indicated by the valuation methods. The buyer may believe that additional value can be found once access to internal information is allowed. However, this is a risky strategy. It is better to bid within the indicated range and then increase the bid after inside information is provided and the additional value confirmed. Otherwise, the buyer risks paying too much and diluting earnings per share. This strategy also provides negotiating room to increase the bid due to the qualitative factors.

Cor a t Vs M &AVa l a t onTechnqu es por e u i i
The main distinction between corporate and M&A valuation techniques is that M&A analysis assumes that a company's existing capital structure ceases to exist (and may be replaced by the acquirer). Valuation techniques used when no change of control is considered assume that the business continues to operate with the same capital structure. This distinction enables a potential buyer to use the book value of debt (rather than the market value) when calculating equity value in the peer company analyses, performing the DCF analysis and calculating the acquirer's WACC.

© G lobecon G r oup,Lt d .

M &A Va t i A n a lua on lysis

21

The rationale for using book value is that unless there is a change of control provision in each indenture of the seller's debt instruments, the debt need not be repaid upon completion of the transaction. If it must be repaid, it can be repaid at its book (or face) value, rather than at the prevailing market price. Any required refinancing will be at the blended WACC of the two companies, not the WACC of either the target or the acquirer. In addition, if the target has a lower cost of debt on its books, this benefit accrues to the buyer. Under these circumstances, the buyer has no incentive to refinance, and therefore maintains the debt on the books at the prevailing interest rate. For corporate valuation purposes, when WACC is calculated, debt is always assumed to cost whatever the next incremental piece of debt costs, i.e., the current market rate. In addition, DCF analysis assumes the market value of debt because one of the purposes of the analysis is to determine the ongoing value of the equity of the business, assuming current market rates.

© G lobecon G r oup,Lt d .

M &A Va t i A n a lua on lysis

22

Su m m a r y
n Quantitative valuation methods provide a range of possible prices for a target. n Qualitative factors, such as brand names, patents and environmental concerns, will influence the value assigned to a company. n There are two forms of peer company analysis: publicly traded comparables and acquisition comparables. n There are three steps in a peer company exercise: identifying the target's peers, calculating the multiples and interpreting the results using rankings. n A publicly traded peer company analysis uses equity values and corporate values, whereas an acquired peer company analysis uses offer values and transaction values. n The acquired peer company analysis calculates the premiums paid for companies in the target's peer group. n A pro forma analysis calculates the performance of the target and acquirer after the transaction, assuming either pooling or purchase accounting. n A DCF analysis estimates the value of the business in light of the acquirer's weighted average cost of capital. n An earnings cross-over analysis shows the degree of dilution inherent in a transaction and when the deal will realize an increase in earnings. n An LBO valuation determines the maximum price that can be paid for a business using the least amount of equity and the maximum amount of debt. n Successful M&A transactions are largely the result of the buyer's strategy when initiating an offer for a company.

K ey Ter s m
A ied Peer Com pa n A a l i cqu r y n ys s Ca pia lA s et Pri n M odel(CA ) t s ci g PM Com pa r bl a es Cor a t Va l e por e u Ea r i g s C r s -OverA a l i nn os n ys s Equ iy Va l e t u I ves t en G r de n m t a Lever g ed Bu you tA a l i a n ys s M a n g em en Bu you t a t Peer Com pa n A a l i y n ys s Pr For a A a l i o m n ys s Pu blcl Tr ded Peer Com pa n A a l i iy a y n ys s Ter i a lVa l e m n u W a ra n r t W ei ht g ed-A a g e Cos t ofCa pia l(W A ver t CC)

© G lobecon G r oup,Lt d .

M &A Va t i A n a lua on lysis

23

Ex ci e er s
1. Which of the following would have a positive impact on the value of a business? a. b. c. d. outstanding litigation strong existing management potential environmental liabilities obsolete facilities

2. True or False: Publicly-traded peer company analysis establishes the implied current market valuation for a business, while acquired peer company analysis establishes the value assuming the control premium required to purchase a company in a given industry. ____ 3. True or False: When performing a pro-forma, analysis is it necessary to project the individual financial statements of the target only? ____ 4. True or False: Even if a corporate acquirer is purchasing a company an LBO analysis should be performed as well. ____ 5. Company A wants to make a tender offer to acquire Company B. Company A has determined that the present value of Company B's expected cash flows is GBP 32 million. Company B has 10,500,000 shares outstanding and the current market price is 175 pence. What is the most likely per share tender offer bid that Company A will make and why? a. b. c. d. 175 pence 250 pence 305 pence 325 pence

© G lobecon G r oup,Lt d .

M &A Va t i A n a lua on lysis

24

A s w er t Ex ci e n s o er s
1. Which of the following would have a positive impact on the value of a business? a. b. c. d. outstanding litigation strong existing management potential environmental liabilities obsolete facilities

2. True or False: Publicly-traded peer company analysis establishes the implied current market valuation for a business, while acquired peer company analysis establishes the value assuming the control premium required to purchase a company in a given industry. True
Pu blcl r ded peer com pa n a n l i es t bls hes t i pled cu r en m a r et va l a ton i y-t a y a ys s a i he m i r t k u i f a bu s i es s , w hie a cqu ied peer com pa n a n l i es t bls hes t va l e a s s u m i g t or n l r y a ys s a i he u n he conr pr i m r ied t pu r s e a com pa n i a g i t ol em u equ r o cha y n veni du s t y. n r

3. True or False: When performing a pro-forma, analysis is it necessary to project the individual financial statements of the target only? False
The fn n a l s t t ens of bot t bu yer a n t t r et s hou l be pr i a ci a em t h he d he a g d oject ed, en bln a ig t a n l t t pr he a ys o oject t per or a n of bot com pa nes i di du a ly, bef e com bi i g he f m ce h i n vi l or nn t r r u ls , a n g i n t bu yer t fexbiiy t cha n e s a l or m a r i a s s u m pton f hei es t d vi g he he l i lt o g es g n i s or eiher com pa n t det m i e t i pa ct on t com bi ed va l e of t bu s i es s es . I t y o er n he m he n u he n t m a k es i ea s y t ca l l t t DCF va l a ton of t t r et r u ls a n r n s en ii t t o cu a e he u i he a g 's es t d u s tviy a n l es . a ys

4. True or False: Even if a corporate acquirer is purchasing a company an LBO analysis should be performed as well. True
The LBO a n l i g i a ys s ves t cor a t bu yer a ni he por e dea of how com pettve a fn n a lbu yer ii i a ci cou l be i a bi n cones t G en a ly, a cor a t bu yer ca npa y m or i s yn g i ca n d n ddi g t . er l por e e f er es be es t bls hed. Ot w i e, t a dded l a i her s he ever g e w il r u l i a l er cos t of ca pia l a n a l es t n ow t d g i a nLBO bu yer t a dva na g e. ve he t

5. Company A wants to make a tender offer to acquire Company B. Company A has determined that the present value of Company B's expected cash flows is GBP 32 million. Company B has 10,500,000 shares outstanding and the current market price is 175 pence. What is the most likely per share tender offer bid that Company A will make and why? a. b. c. d. 175 pence 250 pence 305 pence 325 pence
To i du ce s ha r n ehol s t s el, t a cqu ier w ou l ha ve t ofer m or t n t cu r en der o l he r d o f e ha he r t prce of175 pen bu t w ou l pr er t pa y l s t nw ha t t com pa n beleves t t i i i ce, d ef o es ha he y i ha t s w or h, w hi i 30 5 pen (G BP32 m ilon÷ 10 .5 m ilons ha r ). t ch s ce li li es

© G lobecon G r oup,Lt d .

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.