Professional Documents
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Analysis Handbook
CONFIDENTIAL | 2006
Table of Contents
Introduction 11
3
1.3.1. Sources of Deal Specific Information 57
1.3.2. US Filing Codes 57
1.4. Sample Output Sheet 58
1.4.1. Example: Logistics Sector 58
2. How to Complete a Compacq Analysis 59
2.1. Filling in the Qualitative Columns 59
2.2. Target Financial Performance 59
2.2.1. Selecting which Target Financial Statements to Use 59
2.2.2. Calculating LTM Income Statement 59
2.2.3. Extraordinary / Non-recurring Items 59
2.2.4. Acquisitions / Divestitures 60
2.2.5. Announced Synergies 60
2.2.6. Cyclicality 60
2.3. Consideration Paid and Assumed Liabilities 61
2.3.1. Transaction Structure 61
2.3.2. Consideration Levered or Unlevered? 61
2.3.3. Shares Outstanding 61
2.3.4. Preferred Stock and Convertible Debt 61
2.3.5. Options and Warrants 62
2.3.6. Assumption of Debt 63
2.3.7. Minority Interests 63
2.3.8. Investments in Associated Companies 63
2.3.9. Marketable Securities 64
2.3.10. Capital / Financial Leases 64
2.3.11. Operating Leases 64
2.3.12. Pension Liabilities 65
2.3.13. Financial Fixed Assets 65
2.3.14. Contingent Liabilities 66
2.4. Special Situations 66
2.4.1. Dividend Distributions to Selling Shareholders 66
2.4.2. Earn-Outs 66
2.4.3. Tax Basis Step-up 67
3. Compacq Analysis Output 67
3.1. Cross Checking the Results 67
3.2. Standard Output 67
3.3. Sector Specific Multiples 67
4. Common Pitfalls 68
5. Example 68
5.1. Step 1: Information Gathering 68
5.2. Step 2: Filling in the Qualitative Columns 68
5.3. Step 3: Prepare LTM Income Statement 69
5.4. Step 4: Calculate Consideration Paid and Assumed Liabilities 69
5.4.1. Calculation of Equity Consideration 70
5.4.2. Calculation of Enterprise Value 71
5.5. Step 5: Calculate Industry Specific Multiples 71
5.5.1. Calculate Adjusted Enterprise Value 71
5.5.2. Calculate EBITDAR 71
5.5.3. Resulting Multiples 72
Valuation Matrix 75
1. Overview 75
1.1. Objectives 75
1.2. What Is a Valuation Matrix? 75
1.3. What Is a Valuation Matrix Used For? 75
1.4. What Is Needed to Complete a Valuation Matrix? 75
1.5. What Does a Valuation Matrix Look Like? 75
2. How to Complete a Valuation Matrix 78
2.1. Getting Started 78
2.1.1. Select Appropriate Sources of Information 78
2.1.2. Setting Up a Valuation Matrix 78
2.2. Common Inputs and Outputs 78
2.2.1. Range of Offering Prices / Company Values 78
2.2.2. Time Periods 78
4
2.2.3. Multiples 78
2.3. General Valuation Matrix Steps 78
3. Common Pitfalls 80
4. Case Studies 82
4.1. Merger Application 82
4.2. IPO Application 85
5
2. How to Complete a Contribution Analysis 122
2.1. Key Aspects of the Analysis 122
2.2. What are the Inputs? 123
2.3. Mechanics of the Analysis 123
3. Common Pitfalls 124
4. Case Study 124
4.1. Case Study Inputs 125
4.2. Answer These Questions 125
6
3.3. Choice and Use Of Projections 178
3.4. Interpretation of IRRs 178
4. Common Pitfalls 179
5. Example 180
5.1. The Amadeus Global Travel Transaction Example 180
5.1.1. Company Presentation 180
5.1.2. Key Transaction Considerations 180
5.1.3. Financial Projections 183
5.1.4. Equity Returns 183
6. Case Study 184
7
Introduction
9
Introduction
The Investment Banking Department Analysis Handbook is a practical guide on valuation techniques for
analysts and associates at Credit Suisse. It introduces approaches and Credit Suisse preferred
methodology for financial analysis. The handbook assumes little or no experience conducting the
analyses covered and can be used as a step-by-step guide when preparing analyses for the first time.
This is the first edition of the Investment Banking Department Analysis Handbook and feedback from the
Firm’s analysts and associates is essential to make it a success and become an integral part of both the
fulltime and summer analyst and associate programmes. Please provide feedback to the Analyst and
Associate Programme Manager.
The Investment Banking Department Analysis Handbook could not have been completed without the hard
work and commitment of the following Credit Suisse employees: Ronan Agnew, Giuseppe Baldelli,
Gemma Barclay, Alastair Blackman, Jane Brean, Stephen Carter, Bruno Delmas El-Mabsout, Didier
Denat, Gabor Illes, James Janoskey, Ishan Kaul, Daniel Lawrence, Pierrick Morier, Jeff Murphy, Edouard
Muuls, Guy Noujaim, Antonio Occhionero, Gianluca Ricci, Anastasia Sakellariou, Martin Schmidt, Piotr
Skoczylas, Nishan Srinivasan, Flavio Stellini, Cathy Topping, Marc-Oliver Thurner, Alexander Voronyuk,
Matthew Wallace, Jens Welter and Klaus Wuelfing. Their dedication to the book and the training and
development of analysts and associates has been invaluable.
Christopher Horne
Chief Operating Officer, IBD Europe
11
Comparable Companies Analysis
13
Comparable Companies Analysis
1. Overview
This chapter addresses the following:
„ What is the purpose of a Comparable Companies (“Compco”) analysis? What it is used for?
„ What are the common ratios used in Compco analysis? How are they calculated?
„ When should pro forma Compco analysis be prepared? How should the pro forma adjustments for
various events be made?
„ What are the common pitfalls of Compco analysis? How can they be avoided?
„ To determine how a public company is valued compared with its public peers (i.e. if it is over- or under-
valued by the market in comparison with similar, listed companies)
„ To value a private / limited liquidity company (where market valuations are often distorted) or an
unlisted subsidiary of a company
„ As a potential sub-set of the above, to perform a sum-of-the-parts valuation of a company (i.e. where
the business divisions that make up the company are diverse in business profile, and revenue model,
and, therefore, require different types of comparison)
Compco analysis can also be used to assess how relatively cheap or expensive a particular sector is in
comparison with others.
1.2. Where Does Compco Analysis Fit into Overall Valuation Analysis?
It is not only vital to understand the Compco analysis itself but also how it fits into the overall valuation
exercise. To avoid inappropriate conclusions, which could arise from simply using market data, it is
important to apply other valuation techniques in conjunction with Compco analysis. When considering
Compco analysis it is important to bear in mind the following:
Compco analysis provides a market-based valuation. Therefore, to the extent that the market is over- or
under-valuing an asset, the Compco analysis will reflect this and will mirror these market biases (e.g.
take-over speculation).
For example, during the “tech boom” of 2000, the market often valued technology stocks at extremely
high multiples (see the following chart) and often higher than their fundamental Discounted Cash Flow
(“DCF”) valuation. Today, given the benefit of hindsight, “tech boom” multiples, though market
determined, were irrationally high.
15
Comparison of Forward Multiples Over Time
65.4x
54.1x
41.9x 42.0x
13.7x
9.5x
5.6x 3.4x 3.6x
1.3x
Terra Lycos
Terra Lycos
Lycos Europe
Lycos Europe
Lastminute.com
Lastminute.com
eBay
eBay
Yahoo!
Yahoo!
Tiscali
Tiscali
US Europe
Source: Factset
As highlighted above, Compco analysis is often used to benchmark sectors against each other in order to
analyse their relative valuations. However, comparability can be significantly impaired by structural
differences between sectors in a range of areas including inter alia, risk and growth profile, cyclicality,
seasonality, different accounting treatments, fiscal rules, technology life cycle and cash conversion. Later
in this chapter, key adjustments, and their respective rationales, will be discussed and highlighted in
detail.
A Compco valuation is only as good as its set of comparable companies. To obtain an accurate valuation
of a target company (the company for which the multiples are being calculated) it is critical to identify a set
of listed peers that are truly comparable. Not only should the comparable companies typically be in the
same sector, ideally they should also be comparable in terms of market position, size, growth rates and
margins. Whilst perfect comparables never exist, benchmarking can identify the closest comparables that,
with appropriate judgement, can be used in valuation analysis.
Availability of Information:
In many situations, insufficient information is available to generate the long-term forecasts required for a
DCF valuation. The Compco analysis requires less forecast data.
Minority Valuation:
The Compco-based valuation provides a minority valuation of a company, since it is based on traded
shares where control is not being transferred. This makes it particularly suitable for valuations in IPOs,
secondary offerings, minority buy-outs and other transactions which do not involve transfer of control of
the company. Both DCF and comparable acquisitions of majority stakes analysis include a control
premium embedded in their valuation.
16
Key Pros and Cons of the Compco Valuation Methodology
Pros Cons
p Based on market benchmarks and, therefore, less q Affected by short-term market forces (e.g. bid
dependent on subjective assumptions speculation)
p Commonly used and easily understood by most q Difficulty in selecting best comparables
investors and boards
p Ideal for minority stake trading valuation (including q Availability of good quality short-term financial
IPO analysis) forecasts
p Can be used as a quick, “back of the envelope” q Inaccurate, unless adjustments are made
valuation tool to support a detailed company (illustrated in this chapter)
specific approach (e.g. DCF) q Unless placed in the context, does not always
accurately account for the long-term business
performance (i.e. growth beyond initial years)
1.3.1. Consistency
It is important to consider that some valuation measures apply only to equity holders (for example, Market
Cap), while others apply to all stakeholders (debt holders, minorities and equity holders).
At different stages of the life cycle of a business (e.g. start-up, growth, maturity and decline) different
metrics gain in relative importance when assessing value. For start-up businesses, with negative or very
low EBITDA / earnings, the standard multiples are less relevant. On the other hand, for mature
businesses with less growth, but greater EBITDA / earnings, and lower capital expenditure, cash flow
multiples are more relevant.
„ Enterprise Value based multiples: metrics such as Revenue, EBITDA and EBITA apply to all investors
and, therefore, should be used with Enterprise Value
„ Market Value based multiples: metrics such as Profit before Tax, Profit after Tax and Net Income (post
minorities) are calculated once the cost of debt has been taken into account. Therefore, when used for
the purpose of calculating multiples, they should be used with a valuation which only applies to equity
holders, namely Market Cap
„ Yields: when appropriate financial metrics are divided by Market Cap, the ratios are known as yields
(i.e. a summary measure of cash flows that equity holders expect in any given year relative to current
market equity value of the company). Unlike multiples, these are commonly presented as percentages.
Examples of yields are Dividend Yield and Free Cash Flow (“FCF”) Yield. (See the Discounted Cash
Flow Analysis chapter for a discussion on levered and unlevered FCF)
P/E multiples account for differences in capital structure, tax base and asset base. Other multiples focus
more narrowly on operating items. The EBITDA multiple, for example, excludes all non-operating
differences (e.g. depreciation).
Similarly, cash flow metrics such as EV / (EBITDA – Capital Expenditure (“Capex”)) or Market Cap / FCF,
reveal how comparatively cheap or expensive a company is, in terms of its ability to generate cash-flow
(important for companies that have heavy capital expenditure requirements, which are not adequately
captured by Profit and Loss (“P&L”) metrics). In the following example, Mobinil appears cheap or in-line
with peers on an EBITDA basis, but expensive on an (EBITDA – Capex) basis.
17
VOD TEM MOBINIL COS Average Mobinil trades on lower
EV / EBITDA EBITDA multiples than
the average
2006 5.9x 7.6x 4.9x 8.9x 6.8x
2007 5.6x 6.8x 5.0x 8.3x 6.4x
On a EV / (EBITDA –
EV / (EBITDA – Capex) Capex) basis, it trades at
higher multiples
2006 9.0x 11.3x 28.7x 20.5x 17.4x
2007 8.3x 9.4x 25.7x 14.4x 14.5x
18
Exercise:
Consider the following multiples and determine if they are consistent and why. If they are not consistent,
suggest correct alternatives. Solutions can be found in the separate Investment Banking Department
Analysis Handbook – Solution Set.
1.3.4. Uniformity
It is important to apply a consistent multiple definition across the set of peers to ensure proper
comparability. For example, if pension liabilities were included in the Enterprise Value for only some of the
comparables, it would be impossible to accurately compare and derive valuation benchmarks from them.
In this case, comparables excluding pension liabilities should be adjusted accordingly.
Similarly, it is important to use the same definition of the P&L item (e.g. EBITDA). For example, TV
broadcasting companies have different accounting approaches to the treatment of the costs / expenses of
Programming Rights. The same is true of the way some consumer companies treat brand and marketing
expenditure (e.g. beer mats and umbrellas for beer companies). Some companies treat these
expenditures as an operating cost, whilst others capitalise the rights as part of their assets (intangibles)
and amortise them over time. In the latter case, EBITDA would be artificially high when compared to the
former. On a multiple comparison basis, all other things being equal, the latter case would make the
company look cheaper than the former. To make the approach truly uniform, for example, programming
rights amortisation / brand expenditure should be added back to operating costs (as a proxy for the
operating costs) for all peers (and reduce EBITDA).
1.3.5. Correlation
Relative valuation is theoretically correlated to the growth prospects of a company. Therefore, all other
things being equal, if the target company has growth comparable to the high end of the comparables set,
it should logically enjoy a valuation towards the high end of the comparables set.
A regression analysis of the 2 year forecast EBITDA Compound Annual Growth Rate (“CAGR”) versus
2
valuation multiple would typically show a strong correlation (high R ). This is because, investors are
usually willing to pay more for companies with higher growth prospects. However, it is important to bear in
mind that growth will not always be the most important driver.
The other critical factor to consider for an investor is the risk attached to actually achieving the expected /
forecast growth. Therefore, conceptually, multiples can be considered as 1/(i – g), where i = risk of the
stock and g = expected future growth. Other things remaining constant (including relative growth forecasts
between the companies), the multiple for a higher risk stock will be lower and for a lower risk stock the
multiple will be higher. Inherent risk is, therefore, one of the critical reasons why stocks with similar growth
profiles trade differently.
„ Low liquidity of stock (without a free and regular trade of a stock, valuations can become distorted)
„ Operating factors, such as number, and strength, of competitors and barriers to entry
„ Rights attached to shares (all other things being equal, a class of share with greater voting rights
attached to it should trade at a premium to a class of share with less voting rights)
19
Regression Analysis: EV / Sales ‘06E vs. Sales CAGR (‘06E - ’08E)
4.0x
3.5x
R2 = 98.3%
3.0x
EV / Sales ('06E)
2.5x
2.0x
1.5x
1.0x
0.5x
0.0x
0% 2% 4% 6% 8% 10% 12%
Sales Growth ('06E-'08E)
„ Equity research reports usually contain a Compco analysis showing the comparables used by the
analyst. Equity research can be obtained from:
§ Research & Analytics (http://research-and-analytics.csfb.com)
§ Thomson Financial
§ Multex
„ Bloomberg lists the key competitors in each sector which could form a basis for a set of comparables
„ Colleagues – those that have been involved in precedent work in the sector and especially those that
have sector experience
For example, in businesses where capital expenditure is lumpy (such as for lottery companies which
typically sign long-term contracts with governments to provide services – capital expenditure occurs when
these long-term contracts begin) it may be preferable to use EBITA, as depreciation smoothes out the
Capex spend over the period of the contract, whereas with a cash-conversion multiple such as EBITDA –
Capex, may be affected by the lumpy nature of Capex spend (absent any normalisation adjustment). The
following table illustrates selected industry specific multiples. Consult industry bankers for the appropriate
metrics when preparing Compco analysis.
20
Selected Industry-Specific Multiples
EV / EBITDAR Retail, Airlines „ Used when there are significant rental and lease
expenses incurred by business operations
EV / Reserves Oil & Gas „ Used when looking at Oil & Gas fields and companies
heavily involved in upstream
„ Gives an indication of how much the field is worth on a
per barrel basis
EV / Production Oil & Gas „ For producing fields, gives value on a barrel per day
production basis
Ports „ For container ports, gives value per tonne of cargo
handled
Airports „ For airports, gives value per passenger through airports
EV / Capacity Oil & Gas „ For refiners, gives a value metric in terms of barrel per
day of refining capacity
Market Cap / Book Technology / Banks / „ Used for Semiconductor industry
Value (“P/BV”) Insurance „ Book value of equity is used since there can be
significant earnings fluctuation in this sector
„ Bank’s shareholders equity is important because it is
looked at as a buffer / protection for depositors
EV / FFO(1) Real Estate „ Principally used in the US
21
1.6. Frequency of Updates
The table below provides a guide as to when the various components of the data in a Compco should be
updated.
22
1.7. Formatting
In terms of tables, one year of historical multiples (representing LTM period) and at least two years of
forward multiples should be shown. Also included on the output sheet should be the following:
„ Margins
„ Share price
„ Market Cap
1
„ Net Debt and other adjustments
„ Enterprise Value
1.7.3. Names
The Compco analysis should always be neatly labelled, including the following:
Whenever any adjustment is made, it is essential that this be noted on the output page. Again, include the
source used for making the adjustment and the reason for the adjustment.
1
For example: Minorities
23
Illustrative Compco Output
Comparable Company Multiples – Mature Incumbents Industry
(€ in millions, except per share amounts – calendarised for 31 Dec YE)
Deutsche France Portugal Telecom Telekom
Belgacom BT Group Telekom Eircom Telecom KPN OTE Telecom Swisscom Italia Telefonica Austria Telenor TeliaSonera Median
Country Belgium UK Germany Ireland France Netherlands Greece Portugal Switzerland Italy Spain Austria Norway Sweden
Stock Price (Local currency) 26.00 2.15 13.82 2.14 18.63 9.33 19.16 9.91 410.00 2.28 12.85 19.75 80.25 46.20
Local currency EUR GBP EUR EUR EUR EUR EUR EUR CHF EUR EUR EUR NOK SEK
Stock price to 52 week high (15.8%) (9.2%) (16.2%) (12.7%) (27.9%) (5.8%) (0.8%) (5.1%) (5.5%) (18.2%) (9.3%) (4.7%) (2.1%) (9.0%) (9.2%)
Stock price to 52 week low 4.0% 9.5% 8.0% 43.4% 5.9% 47.6% 39.4% 35.2% 5.7% 2.7% 5.7% 34.7% 64.1% 30.1% 9.5%
(1)
Market Value - Actual 8,957 26,470 57,991 2,300 49,118 19,592 9,415 11,187 14,906 42,374 61,713 9,505 17,475 21,369
(1)
+ Financial Debt - 16,001 44,647 2,588 53,225 9,981 3,440 7,584 1,476 39,351 55,332 3,344 3,995 2,375
(1)
- Cash and Cash equivalents (534) (4,161) (6,008) (495) (5,211) (1,041) (1,512) (3,912) (656) - - (139) - (2,002)
(1)
Enterprise Value - Actual 8,423 38,310 96,630 4,393 97,132 28,532 11,343 14,859 15,726 81,725 117,045 12,709 21,469 21,742
(1)
Enterprise Value - Actual 8,423 38,310 96,630 4,393 97,132 28,532 11,343 14,859 15,726 81,725 117,045 12,709 21,469 21,742
+ Unfunded Pension Liability 508 844 3,774 578 2,519 1,034 694 1,912 840 - - 95 225 171
+ MV of Minorities 1,664 - 4,795 - 11,543 257 3,556 2,141 1,888 381 8,015 21 2,873 3,561
- MV of Uncons.Associates - (393) (1,300) - (876) - (368) (1,022) - (3,266) (2,264) (5) (3,338) (6,006)
Adjusted Enterprise Value 10,595 38,761 103,899 4,972 110,318 29,823 15,224 17,889 18,454 78,840 122,796 12,820 21,229 19,468
Price / Earnings
2006 10.8x 10.9x 13.2x 17.0x 10.4x 15.5x 24.3x 21.0x 13.2x 14.1x 11.7x 18.4x 16.0x 11.9x 13.2x
2007 11.5x 11.9x 13.7x 11.7x 9.7x 14.9x 15.1x 16.7x 13.6x 12.7x 11.4x 15.5x 14.8x 11.6x 12.7x
2008 11.7x 12.9x 14.0x 10.5x 9.0x 14.9x 12.6x 15.1x 13.9x 11.6x 10.3x 13.6x 15.0x 11.9x 12.6x
Methodology
(1) Actual Market Value, Financial Debt, Cash and Cash equivalents and Enterprise Value are based on information from latest available financial statements adjusted for any further transactions taken into account in the
forecasts. Market Value reflects fully diluted shares outstanding on a treasury method basis. Financial Net Debt reflects consolidated group net debt and is calculated as short- and long-term interest bearing liabilities less
cash and equivalents. Convertible securities are included in Debt until actually converted (i.e. excluded for calculation of fully diluted shares outstanding).
2. How to Complete a Compco Analysis
„ Other sources for share price information, which could be used as crosschecks, are Bloomberg or
Datastream, with the Financial Times also a potential source
„ Certain companies have multiple classes of shares. To determine the Market Cap of these companies,
the share price for shares in each class must be determined. Company Annual Reports disclose
(usually in a note to the financial statement called Share Capital) the various share classes
„ Certain companies have unlisted shares. While these shares might not be priced on a public market,
they do form part of the total equity of the firm and should be included in the Market Cap. The share
price of listed shares can serve as a proxy for the share price of unlisted shares. However, it is
important to keep in mind that, in reality, there are usually differences in the voting rights assigned and
dividend payout policies to various classes of shareholder, which might lead shares of different classes
to trade differently
„ Fully Diluted: assumes all exercisable in-the-money options, warrants and convertibles are exercised
§ Outstanding versus Exercisable Options: It should be noted that not all outstanding options are
exercisable. It is common for companies to issue options with a vesting period (a minimum period of
time during which they remain un-exercisable). Therefore, even if these options are technically in-
the-money they can not be exercised if the vesting period has not expired. Since these options can
not be exercised (even when technically in-the-money) they should not form part of the share capital
of the company. Therefore, when calculating shares outstanding, only the exercisable options
should be used in the fully diluted calculation.
For valuation purposes, the fully diluted number of shares outstanding is almost always used. Shares
resulting from exercisable options or convertibles that are in-the-money should be added to shares
outstanding. Options are in-the-money if the strike price of these instruments is less than the current
market price. This means that a holder of these securities would rationally exercise the option to realise a
gain by selling in the market, as underlying shares are available at less than market price. Usually the
notes to the financial statements in the Annual Report will illustrate the various tranches of options and
25
warrants, describing average strike price per tranche. Equivalent information will also be disclosed for
convertible instruments.
Weighted average shares outstanding is a measure of the average shares that were outstanding during a
particular year. As with shares outstanding this can be basic weighted average shares or fully diluted
weighted average shares (the latter assumes that all in-the-money options were exercised).
During the course of the financial year, the company will typically have exercised options and/or
convertible instruments, undertaken share buy-backs, rights issues, etc. It will rarely be the case that the
number of shares outstanding will be the same for a company over the course of the year.
Valuation occurs at a point in time rather than over a period of time (e.g. Market Cap refers to a point in
time not a period). Therefore, shares outstanding and not weighted average shares should always be
used for valuation purposes.
Please note that it is convention to use price at close of the trading day to avoid any intra-day price
fluctuations.
P&L items (recorded over the financial year) should be translated at the average exchange rate for the
financial year. Balance Sheet items should be translated at the exchange rate at the point that the
Balance Sheet was recorded.
Forecasts are obtained from broker reports. It is advisable to use CS research, if CS covers that particular
company. If CS research does not cover the company, another major broker can be used unless a
smaller broker has particular insight into the company (e.g. if the smaller broker is also the company’s
corporate broker for UK companies). Ideally, if not CS research, it is preferable to use a common broker
for as many of the comparables as possible.
In any event it is essential to benchmark the selected broker forecast (including CS) against consensus
forecasts, such as I/B/E/S. For the purpose of the Compco analysis it is crucial that the forecasts used are
representative of the market view. Therefore, even when a particular broker has detailed financial
forecasts, these should not be used for the analysis if they are outliers compared with consensus
forecasts.
The front page of each CS research report carries the name of the analyst covering that particular stock.
„ The current process is set out below but please always check for changes in policy which may be put
in place from time to time
§ Permission (via e-mail) must be requested from Richard Kersley, David Mathers or Debra Batey,
before contacting the research analyst to obtain models
§ Once permission has been granted, the same e-mail (i.e. with the permission) should be forwarded
to the research analyst requesting the model
For US Companies
„ US Equity research models may be downloaded via the Model Repository in Spider
(http://spider.app.csfb.net/nirvana.asp?Direct=Y)
26
„ At times, European research analysts cover US listed companies (companies that operate in Europe
but are listed in the US) and these may not be available on Spider
„ For US listed models, analysts must be contacted via a LCD chaperone and not directly
„ Paul Barry, Anna Marie Mottram or Katrina Glover from LCD should be requested to act as chaperones
in the same email sent to Richard Kersley, David Mathers or Debra Batey requesting permission to
obtain US models
Build up consensus forecasts by using all available research notes and creating averages for each
financial item (e.g. Revenues and EBITDA). Judgement should be exercised when creating a consensus
from scratch to avoid distortions, which can arise from including outliers (e.g. bullish or bearish estimates).
Judgement also needs to be exercised when compiling consensus numbers for outer years as, typically,
there will be fewer brokers forecasting outer years – thus changing the basis of the consensus.
Some companies may not disclose sufficient information to calculate Net Debt, neither in their interims nor
disclosed separately. In this case, the numbers used by brokers should be applied and noted accordingly.
Some companies / brokers might show both local GAAP and IFRS restatement. In this case, it is
preferable to use IFRS to facilitate comparability.
27
Key Differences Between IFRS and US GAAP
28
2.2.5. Calendarisation of Statements
Different companies have different financial year-ends. For example, many UK companies have a March
year-end.
For Compco analysis, the financials of all companies should be calendarised to a common year-end
(typically December). In most situations, calendarisation is usually aligned with the year-end of the target
company. It is important to note that forecast estimates may also require calendarisation. Remember to
check the basis on which they are presented when completing the Compco analysis.
In the example below, the company has a March year-end. To obtain December year end financials for
2006, 3 months from the financial year 2006 financials (or ¼) and 9 months from the financial year 2007
financials / forecasts (or ¾) are taken. As a formula, this would be:
Mar 2005 Dec 2005 Mar 2006 Dec 2006 Mar 2007
Similarly, to obtain LTM financials for a company that has released its 6-month results, the computation
would be as follows:
3
EBITDALTM = EBITDA6m’05 + (EBITDA2004 – EBITDA6m’04)
2
to 30 September 2005
3
to 30 June 2005
29
2.2.7. Adjustments to Financial Projections
Normalisation
Since the objective of the Compco analysis is to arrive at the underlying value of a company, any effects
that are temporary or one-off in nature should be stripped out, in order to prevent the generation of an
inaccurate multiple. This is known as normalising financials.
30
Example: Non-recurring Income / Charges (Exceptionals)
The example below demonstrates a step-by-step approach to eliminating exceptional items from the
Compco analysis to derive a normalised Compco:
31
Example: Mergers and Acquisitions Adjustments
An acquisition or disposal by a company distorts the reported growth profile of a company’s financial
results – it may also impact Net Debt. For this reason, it is important to make a pro forma adjustment to
the company’s financials so that they can be analysed on a like-for-like basis. The best sources for
information to enable accurate pro forma adjustment are the company’s website (investor relations) and
equity research.
Annualisation is an important concept, especially in the context of an M&A pro forma. Companies
consolidate acquired business financials in their financial statements from the time of completion of the
transaction. Therefore, if a transaction completes in, say June 2005, the target will only be consolidated
from June onwards (assuming acquirer’s year ends in December).
If no pro forma adjustment is made, on a Compco basis the EV would consolidate the entire equity value
of the target (for a 100% acquisition), but the EBITDA would only include the target’s performance for 6
months, making the multiple artificially high.
The multiple should be adjusted by annualising 2005 EBITDA. For example, if the 6 month EBITDA is
€500m, the annualised 12 month EBITDA in the following manner, €500m/(6/12) = €1,000m.
Obviously, if available, it is better to use the target’s actual 2005 EBITDA rather than to annualise on a
straight-line basis.
In the example below, Company A acquires Company B – because of the high multiple paid for the
acquisition (15.0x one year forward EBITDA) the pro forma multiple rises by nearly half a turn.
Multiple Valuation
15.0x 15,000
Price 85
Shares outstanding 705
Market Cap 59,925
Existing Net Debt 125
Adjustments 21,608
Adj EV 81,658
Acquisition finance 15,000
Pro forma adj EV 96,658
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Step 4: Calculate Multiples
„ Synergies from combination: any assumptions on synergies from an acquisition should be duly noted
and sourced in the file. Synergies could materially alter the multiples
„ Acquisition of minority stake: minority stakes should not be pro forma adjusted as they are excluded
from the Compco analysis (consolidated analysis) in any case (see below)
Typically a company will have subsidiaries and associates as part of its group structure. General
accounting rules for subsidiaries and associates are as follows:
„ Subsidiaries
A subsidiary is a company over which the holding company exercises significant control – typically 51%
or more ownership. In such a case, the subsidiary company will be fully consolidated. A parent
recognises 100% of the assets and liabilities of its subsidiaries on a line-by-line basis. Minority interest
is recognised at the bottom of the balance sheet as a separate part of equity. Similarly, in the income
statement, 100% of the subsidiaries’ income is recognised on a line-by-line basis, but minority interests
are separately identified (and deducted) at the bottom of the statement. The target company may
exercise control though owning less than 50% of the equity (e.g. through contractual agreements). In
such a case it will be consolidated as a subsidiary.
„ Associates
An associate is a company where control is not held (i.e. typically owns less than 50% and typically
more than 20%) by the holding company. An entity is treated as an associate when the parent has
significant influence over it (i.e. it can influence but not control the financial and operating policies of the
entity). This may arise through share ownership, or other means (e.g. appointment of directors or
contractual arrangements). From an accounting perspective, these assets are included using the
Equity Method. Under the Equity Method the parent recognises, in one line, its share of the assets and
liabilities of the associate – including any goodwill that arises on the acquisition. The parent will
recognise its share of the associate’s net income on one line of the income statement.
Proportionate consolidation is not permitted under IFRS for associates.
„ Joint Ventures
A joint venture arises where there is joint control between the parties. The economic shareholding does
not have to be split on a 50:50 basis; rather it is the ability of each party to prevent the other venturer/s
from exercising control alone that results in a joint venture.
A joint venture can be accounted for under the equity method or on a proportionate consolidation basis.
Whichever method is chosen should be applied to all joint venture interests of the relevant group.
The Efficient Market Theory is centred on the concept that prices of securities are the result of perfect and
efficient information. In other words, markets see through the accounting rules that give companies
greater credit (in their financials via full consolidation) for subsidiaries than their ownership would strictly
warrant (when the subsidiary is not 100% owned). In theory, the market price of equity only credits
companies up to their level of ownership in the subsidiaries.
This means that multiples may look distorted by inconsistencies between the numerator and denominator,
in the absence of any further adjustments. Consider the EV / EBITDA multiple – the numerator “EV”
consists of Net Debt (determined by the accounting rules described above) and Market Cap (based on the
efficient market theory). The denominator consists of EBITDA (determined by the accounting rules as
described above). Thus, while accounting rules give the company full credit in the financials even when
33
subsidiaries are not fully owned, or no credit when there is a less than controlling interest in an associate,
the market sees through this and rewards exactly to the extent of ownership.
Where a company has a subsidiary of which it owns 51% it will often account for 100% of the EBITDA and
Net Debt of this subsidiary, while the market only values the owned stake (i.e. 51%).
There are two principal ways to calculate Compco multiples in this context:
„ Proportionate Multiples
Some companies report proportionate financials as well as consolidated financials and brokers will
provide forecasts on the same basis. If this is not available, the latest results, website or equity
research (last resort) will contain the corporate structure of the group and the ownership level in each
asset. EBITDA (or any other metric forecasts) per asset should be obtained and the proportionate
EBITDA can be calculated by the summing of EBITDA of each asset weighted by the relevant
ownership level. Proportionate Net Debt can be obtained in exactly the same manner.
Market Cap by its very definition (assuming Efficient Market Theory) is proportionate. Thus an internally
consistent multiple can now be obtained.
„ Consolidated Multiples
The EV should be adjusted such that it corresponds to financial accounting rules. Therefore,
(estimated) market values of the un-owned stakes in consolidated subsidiaries should be added to
Enterprise Value, whilst (estimated) market values of unconsolidated minority stakes should be
deducted, as they do not relate to consolidated metrics.
Most Compcos are calculated on a consolidated basis, this is the standard Credit Suisse method.
However, the choice between calculating a consolidated and a proportionate multiple is ultimately
determined by the specific structure of the company, as discussed below.
„ If the subsidiary in question is listed, then the market value of the company should be used
„ If the asset (subsidiary or associate) has been recently acquired, the acquisition price should be used
to calculate the asset value
„ If the subsidiary or associate is not listed nor been recently acquired, the estimated market value of the
particular asset should be applied from equity research
§ This is typically found in brokers’ analysis
„ When none of the above are available, the book value of the asset (from the balance sheet of the
parent company) should be used as a proxy. However, it should be noted that this is often quite
different than the current market value of the asset
Compco analysis is normally conducted on a consolidated basis mainly because it is generally easier to
obtain the information required for this calculation. However, if a company has a large stake in a large
unlisted company, it may be advisable to undertake a proportionate Compco, as the consolidated
Compco may be too dependent on one equity research valuation of the subsidiary / minority stake.
The Vodafone multiple is highly sensitive to brokers’ valuations of VZW, if the consolidated approach is
used.
The following illustration highlights the differences in methodology, as well as the differences in output
between the consolidated and proportionate approaches.
34
Example: Multiples on Consolidated and Proportionate Basis
The following example illustrates the method for calculating multiples on both a consolidated and
proportionate basis.
The first step would be to determine the consolidation basis from the annual accounts of the parent
company. It is necessary to identify the firm’s economic stake in each of its subsidiaries and associates
and how it consolidates them.
„ For subsidiaries: add the un-owned equity value to the parent company’s EV
§ In this example, the parent company owns 65% of the UK subsidiary, which has an EV of €90,000m
§ Obtain the equity value of the UK subsidiary by subtracting from the EV its Net Debt of €100m. The
equity value is, therefore, equal to €89,900m
§ Add 35% of this (€31,465m) to the EV of the parent
„ For associates: subtract the owned equity value from the parent company’s EV
§ In this example subtract 30% of the Italian assets equity value (calculated as above) from the
parent’s EV
Step 4 – Calculate EV
Consolidated Proportionate
Price 85 Price 85
NOSH 705 NOSH 705
Market Cap 59,925 Market Cap 59,925
Net Debt 125 Net Debt 358
EV 60,050 EV 60,283
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Step 5 – Minority Adjustments
Defined benefit liabilities are often seen as debt as they reflect financing provided by employees to fund
the operations of the company. They result in a financial obligation that a company needs to fulfil in the
future.
According to International Accounting Standards 19 (“IAS 19”) the balance sheet treatment of pension
related liabilities is as follows:
The amount recognised as a defined benefit liability shall be the net total of the following amounts:
„ The present value of the defined benefit obligation at the balance sheet date
„ Plus any actuarial gains (less any actuarial losses) not recognised because of the treatment set out in
the detailed rules
„ Minus the fair value at the balance sheet date of plan assets (if any) out of which the obligations are to
be settled directly
An entity shall recognise the net total of the following amounts in the P&L, except to the extent that
another standard requires or permits their inclusion in the cost of an asset:
„ Interest cost
„ The expected return on any plan assets and on any reimbursement rights
„ Actuarial gains and losses, as required in accordance with the entity's accounting policy
The actuarial gains and losses on pension assets and liabilities (e.g. deviation of expected returns and
liabilities from actual experience) can either be deferred using the corridor approach (for actuarial gains
and losses less than 10% of plan assets or liabilities) or taken direct to equity through the Statement of
Recognised Income and Expense (“SoRIE”) as they occur.
Defined benefit liabilities are increasingly being recognised as part of the company’s financial debt and
added to Market Cap to arrive at Enterprise Value by the market. The notes to the financial statements
disclose the Net Present Value (“NPV”) of the defined benefit obligations as well as the market value of
36
assets set against these. The difference between the two is the defined benefit net liabilities. This
unfunded portion arguably represents a source of financing for the company (liability to be redeemed in
the future – used to finance production in the present) and, therefore, should be added to the debt of the
company.
If the unfunded portion of the pension liability is added to debt, then the corresponding interest cost from
this liability should flow through the net financing costs in the P&L rather than in operating costs (where it
is commonly reported by companies).
In spite of the above theory, equity analysts do not always adjust for pension liabilities and the market has
yet to develop a consistent approach. The implication of this is that the market may have a different view
of a particular company’s valuation than the analysis (adjusted for pension liabilities) may suggest.
As a general rule, adjust for pensions if the target company meets two criteria:
„ Companies in the industry / sector typically have significant under-funded pension obligations
The example below illustrates how multiples change when adjusted for unfunded pension liabilities.
Price 85
NOSH 705 Pension Adjustment
Market Cap 59,925 NPV of PBO 5,000
Net Debt 125 Market value of funded portion (500)
(1)
Adjustments 21,608 Unfunded portion of pension liabilities 4,500
ADRs provide additional liquidity and are listed on a US exchange. ADRs / ADSs are usually based on the
listed ordinary shares. For example 1 ADR is often equal to 5 ordinary shares. If 80% of the ordinary
shares are part of the ADR programme, then 80% ownership of the company is in the hands of ADR
holders and 20% in the hands of holders of ordinary shares. To calculate market capitalisation, it is
common practice to use the price of the more liquid of the two.
37
ADRs and ordinary shares usually trade differently (i.e simply converting the ADR into local currency
using the spot FX rate will not normally equal the ordinary share price). These differences arise due to a
number of factors, such as:
„ Possible FX arbitrage
Outstanding Shares for Market Cap and Fully Diluted Equity Value
Treasury Shares
Treasury shares are not considered part of the company’s share capital and should be deducted from
shares issued and outstanding to arrive at the number of shares outstanding used for Compco analysis.
Preferred Shares, Convertible Debt, Convertible Preferred Shares and Share Options & Warrants
„ Preferred shares are a class of share which have very limited or no voting rights and a pre-determined,
fixed dividend amount. In the event of liquidation, holders of preferred shares are considered senior to
holders of common equity. These can be treated as debt or as equity, depending on particular features
and this needs to be established on a case by case basis. If preference shares pay a fixed dividend,
are redeemable at the issuer’s discretion, non-convertible to equity and carry no votes, they are treated
as debt (for example, some UK preference shares). On the other hand, if they are convertible, non-
redeemable and carry a non-guaranteed dividend, they are treated as equity (for example, Italian
savings shares).
„ In order to decide on the appropriate treatment for convertibles, options or warrants, assess whether
they are in-the-money or out-of-the-money. To do this use the rules below:
§ Strike price > Market price = Out-of-the-money
§ Strike price < Market price = In-the-money
„ Convertible Debt is a hybrid instrument that is debt for a certain period of time (vesting period). Once
the vesting period is over, the debt is convertible into equity shares of the company at a pre-determined
price. Out-of-the-money convertibles are treated as debt. Generally, in-the-money convertible debt is
treated as part of equity. This is applied in the following manner:
§ If the convertible bonds are in-the-money, assume they are exercised
§ Deduct the face / book value from Net Debt
§ Add the number of shares from conversion to shares outstanding to calculate Market Cap
„ Convertible Preferred shares are considered equity or debt, depending on whether they are in- or out-
of-the-money and also depending on the exact features of the underlying preferred shares
„ Options and warrants are as previously described in section 2.1.2 (warrants adjustments work in
exactly the same way as option adjustments) and are considered part of the Market Cap of the firm
depending on whether they are in-the-money or out-of-the-money
The treasury method (which is the preferred Credit Suisse method) assumes that the company buys back
its own shares (at market price) in the open market using these proceeds rather than reducing Net Debt.
Given that the market price is higher than the strike price (condition for the instrument being in-the-
money), the company is able to buy back fewer shares than it issues. If the instrument is in-the-money,
assume it is exercised and, therefore, included in the number of fully diluted shares outstanding.
„ Depending on the instrument, this effectively means that a certain number of new shares will be issued
and that the company will receive proceeds from the sale of these new shares. For options / warrants
the calculation is as follows:
§ Proceeds from exercising options / warrants = # of options x strike price
„ If convertible debt is in-the-money it is assumed it converts to equity at the strike price. The number of
new shares can be calculated as follows:
§ # New shares issued = Face value of debt / Strike price
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Fully Diluted Method of Calculating Shares Outstanding
Under the fully diluted method assume that all exercisable in-the-money instruments are exercised. The
proceeds are used to reduce Net Debt and the shares outstanding changes by the full amount of the new
issuance. The steps involved in this computation are outlined in the following example.
A company has 700m shares outstanding and 210m options in 3 tranches. The exercise price is €90, €86
and €80 per share for each of the 3 tranches respectively and the market price today is €85 per share,
implying that only tranche C options (85m) are in-the-money.
Step 2: Determine the Number of Shares Bought Using Proceeds from Exercise of Options
Using the treasury method, it is assumed that the firm issues 85m new shares at €80 each, raising
€6,800m. With these proceeds it buys back shares at the market price of €85, i.e. it buys back 80m
shares. Therefore, net addition to share capital is 5m shares, meaning the new number of shares is
705m. Net Debt is not adjusted.
Using the fully diluted method, the same example as above, 85m new shares would be included and Net
Debt would be reduced by €6,800m.
Gross Debt
Gross debt comprises all interest-bearing liabilities of the company. Typically, companies will separately
disclose both long- and short-term debt. Theoretically, market value of debt should be used, though in
practice this is often the same as book value of debt (this will, however, not be the case if companies do
not mark to market). The main exception to this are hybrid debt securities, where market and book values
can differ. Gross debt would normally include the following:
„ Long-term debt
„ Short-term debt
„ Preferred stock
39
Of these, only the latter are capitalised in the company’s Balance Sheet. However, if a company has use
of most of its assets via lease arrangements it may be appropriate to capitalise operating leases as well.
Typically this decision depends on a number of factors such as the length of time the lease is valid versus
the useful economic life of the asset, responsibilities of the lessee versus those of the lessor towards
maintenance and upgrade of the asset and value of lease versus fair value of underlying asset.
The most common situation is in the airline industry, where the airplanes are recorded as operating
leases but the airline captures the full benefit of owning the asset for its economic life, so the operating
leases are commonly capitalised (conventionally, using a specific capitalisation multiple). If operating
leases are deemed to be debt, the multiples should consistently reflect this in the numerator and in the
denominator, EBIT and EBITDA should, therefore, be adjusted by adding back the interest component of
the lease charge (e.g EBITDAR)
„ Contingent liabilities: most companies disclose the litigation they are involved in and the maximum
financial damage that can be suffered. Usually, these are not included in the debt of a company. But
may result in a future cash outlay
„ Future earn-outs: are incentive schemes which align the interests of the management with those of
shareholders. These are also used in M&A situations where the acquisition price is dependent on
achievement of certain pre-agreed performance standards. In situations where consideration is
contingent on future business performance (earn-outs), the consideration should theoretically assume
the level of the consideration anticipated at the time of announcement. Often it is difficult to determine
the expected level, but earn-outs are often based at zero if the business meets its projections; in such
cases, the anticipated value of the earn-out should be assumed to be zero. Adding a comment in the
commentary section with the adjusted multiple(s) including the earn-out at full value should be
considered
Note that rating agencies often view debt differently from equity research analysts. For valuation
purposes, it would be prudent to examine the broker approach and use that as guidance, but to also
consult team members on the treatment of more complex company-specific hybrid instruments.
A clear definition of what is included in Cash and Cash Equivalents is essential for consistency. It may
include the following:
„ Cash equivalents consist of many short-term cash items with varying levels of liquidity. It is important
to read the notes to the financial statements and exclude from the cash line anything that is not
sufficiently liquid, such as time deposits or restricted cash
Furthermore, cash equivalents often comprise marketable securities. It is critical to note that market value
(as opposed to book value) should be taken, as values can change significantly in a short space of time.
In the case of asset disposals, the amount of special dividend should be subtracted from the Market Cap
in the period between the announcement of the dividend and the actual payment of the dividend.
In the case of increased leverage, the net effect on the Enterprise Value is zero as the deduction of the
amount of the special dividend is matched by the increased leverage. There might, however, be an effect
on P/E multiples and FCF yields from the additional interest expense arising from the increased leverage.
40
Mechanics of a Compco Analysis
Associated Inputs
% of 52 week High Stock Price „ Current Stock Price
=
52 – Week High „ 52 Week High
Estimated EPS Growth Next Year EPS –Current Year EPS „ Current Diluted Earnings Per Share
=
Current Year EPS „ Projected Diluted Earnings Per Share
P/E to Est. 5-Year Growth P/E Ratio „ P/E Ratio (based on diluted EPS)
= „ Estimated 5 Year Growth Rate (IBES via
5 Year Average Annual EPS Growth Bloomberg)
Revenue Multiples Enterprise Value „ Enterprise Value
=
Revenues „ Trailing or Projected Revenues
Debt to Total Cap Total Debt (including Preferred Stock, excluding Minority „ Short Term Debt „ Minority Interest
Interest) „ Long Term Debt „ Preferred Stock
=
Short Term Debt + Long Term Debt + Total Preferred Stock + „ Shareholders’ Equity „ Convertible Securities
Minority Interest + Shareholders’ Equity
Debt to Market Cap Total Debt „ Current Stock Price „ Short Term Debt
= „ Long Term Debt „ Convertible Securities
Equity Market Cap
„ Diluted Shares Outstanding
2.3.4. Other Adjustments
Notwithstanding the adjustments described above, there are still further adjustments that theoretically can
be made. It is important to note that the adjustments below are made on a case-by-case basis, so
judgement is required to determine if they are relevant in the calculation for the particular set of
circumstances of industry or company being analysed:
„ Capital Increases: be aware of capital increases / rights issues, which change the number of shares
outstanding
„ Seasonality: Certain industries are seasonal in nature (e.g. due to the way clients are billed or revenue
is received over the course of the year, or because of working capital swings). As a result of this,
balance sheet items such as Net Debt can be higher or lower at certain times in the year, every year
In such a situation, rather than using Net Debt at a particular point in the year, it may be advisable to
use the average Net Debt over the most recent quarters
„ Share Splits: companies usually undertake share splits to ensure that the share price remains at an
absolute value that does not optically discourage investors (especially retail investors) from investing.
Theoretically, this should not affect Market Cap
„ Factoring of receivables: Many companies provide services in advance of receiving payment, thus
creating receivables on the balance sheet. These receivables can often be sold in return for cash that
can then be used for operations. This process of selling or factoring receivables can unlock cash for
the company. This source of financing will not appear as part of net financial debt (it will appear on the
balance sheet as receivables). To the extent that factoring of receivables is an important source of
financing, one should adjust for this
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2.4. Core Multiples – Approach to Calculating Multiples of Core Business
For companies that have many different lines of business, it is common practice to strip out non-core
businesses to arrive at the valuation of the core business. For example, typically telecommunications
incumbents operate a mobile business, a fixed line business and often a directories business. If the
telecom operations are to be valued on a multiples basis, the non-telecom businesses should be stripped
out.
Consider the case of telecom incumbents (example may apply to any operationally diversified business):
„ Calculate multiple
§ The pure telecom multiple is 6.25x 2006 EBITDA versus the whole company multiple of 7.5x
Core Multiple
€1,125m
€500m
€625m €625m
€150m
€50m
€100m €100m
Firm EBITDA Firm EV Telco EBITDA Telco EV
Core Telco Directories
43
3. Common Pitfalls
The list of the most common pitfalls in the preparation of the Compco analysis are:
„ Not normalising for unusual / non-recurring items such as restructuring charges and tax holidays
§ The purpose of the Compco analysis is to generate valuation benchmarks. Therefore, it is essential
to remove the effects of one-off items that impact the financials of a company for only a short period
of time. Compco analysis requires normalised financials so that short-term / one-off effects, such as
restructuring charges and tax holidays, are excluded (these can be valued separately)
„ Not adjusting for the impact of Share Buy Backs or stock split or changes in ADR / ADS ratio
§ Adjust the number of shares outstanding for stock splits or share buybacks. If using the ADR / ADS
price, the ratio to common shares should be checked and updated as appropriate
„ Special dividends
§ Special dividends not yet paid need to be adjusted for
„ Not checking all rows / columns are included in the average / median calculation
§ It is essential that the averages / median multiples on the output page include all companies. Often
companies that have been added later are inadvertently left out of the calculation of the averages
„ Hardcoded cells
§ Hardcoded cells should be avoided in nearly every circumstance in the output sheet. At times,
hardcoded numbers are used in the output sheet (most likely for negative multiples). However, the
hardcode is often no longer relevant because of a change in the underlying fundamentals of the
company. Therefore, it is extremely important to check for hardcoded numbers each time the
Compco sheet is updated
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„ Not spotting and examining differences when comparing to brokers reports
§ Some brokers use forward looking net debt
§ As sanity check it is useful to check calculated multiples vs. brokers for material differences
§ If there are differences, one should assume that one is wrong, but it may well be due to different
approaches
§ Differences should “raise a flag” and suggest extra care
Compco analysis is also useful in determining which stocks within a peer group are under / over valued.
While the most common reason for a stock to attract premium valuation with respect to peers is the
growth profile of the company’s financial projections in the near term, there may be other important
factors.
Always ensure that Compcos are internally consistent in terms of the metric in the denominator and the
valuation measure in the numerator. A fundamental adjustment that must be performed is the difference
between the consolidated results of companies and valuation, as captured by the market price (the
perfect market theory) – the scope of the two is often different.
Equally important is to pro forma for various corporate developments, such as:
„ M&A
„ Special dividends
„ Stock splits
„ Capital increases
A crucial component to Compco analysis is the necessity of using particular multiple(s) for particular
industries. This way, specific value drivers for specific industries can be identified and the relevance of
these to the market value of equity of the companies can be more readily understood.
5. Case Studies
The following case studies focus on the mechanics of Compco analysis, including are a basic example of
a Compco calculation and a slightly more complex exercise. Solutions can be found in the separate
Investment Banking Department Analysis Handbook – Solution Set.
45
The following information is required to complete this case study:
Basic Information
(In £m, unless specified)
Share Price 5.30
Net Debt 667
Associates (352)
Basic Shares Outstanding 1,808.62
46
Broker’s Model
(In £m, unless specified)
Cash Flow
EBITDA 982 1,058 1,195 1,328
Interest Expense (82) (66) (50) (23)
Tax Expense (246) (275) (326) (373)
Capex (200) (200) (108) (120)
as % of sales 4.5% 4.2% 2.1% 2.2%
Ch. In NWC 67 100 94 75
EFCF 521 617 806 887
Growth 18.6% 30.5% 10.0%
DPS 10 11 33 38
Dividend 191.5 200.8 579.2 663.7
Payout Ratio 35.0% 32.8% 79.9% 79.9%
47
Notes:
Where if applicable, adjust for pension costs (only if it has been possible to adjust Enterprise Value for
unfunded pension liabilities).
„ EV / EBITDA
„ EV / EBITA
„ P / E (Cash)
„ FCF Yield
„ Dividend Yield
„ EBITDA margins
„ EBITDA growth
„ Dividend growth
„ Dividend payout
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5.2. Advanced Comparable Calculation – Vodafone
Vodafone is one of the world’s largest providers of mobile telecommunication services. It is regarded as
the benchmark stock for the European mobile sector.
Vodafone operates in 27 countries and has varying stakes in each of its operating companies. The bulk of
Vodafone’s revenues are generated in Europe where it occupies #2 or #3 positions in most major
markets. Vodafone owns a 45% stake in Verizon Wireless (“VZW”) in the US. VZW is one of the largest
mobile telephony providers in the US with c.30m subscribers. VZW is unlisted and Vodafone’s stake is
worth approximately US$45bn (though this figure varies significantly by source).
Vodafone accounts for VZW using the equity method. Because of this minority stake, in addition to
preparing the consolidated accounts, which are a statutory requirement, Vodafone also provides key
metrics such as subscribers, revenues, EBITDA and Capex on a proportionate basis.
49
Share Price (£) 1.24
Basic Shares Outstanding (m) 60,135
USD / GBP Exchange Rate 1.45
Source: Factset, Company website
Additionally here is some further information that will be required to arrive at the correct multiple:
„ Divestiture of the Japanese business for £6,800 (net debt of £800m at the asset)
The CS research report is pro forma for all the above events that occurred after the balance sheet date of
30 September 2005 but before 28 February 2006, when the research report was published.
Details for the share buy back programme post the balance sheet date are as follows:
„ From 1 October 2005 to 14 November 2005 SBB programme returned £648m to share holders
„ Volume weighted average price (VWAP) from 15 November 2005 to 27 April 2006 was £1.24 per share
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„ Step 5 - Pro forma for the following:
§ Acquisitions in various emerging markets
§ Divestiture of Japanese business
§ Share buy back
§ Special dividend
On the basis of the above calculate EV / EBITDA for 2006, 2007 and 2008 on a consolidated and
proportionate basis – calendarised to December.
51
Comparable Acquisitions Analysis
53
Comparable Acquisitions Analysis
1. Overview
1.1.1. Applications
„ Determining sector valuation benchmarks
„ Determining the market demand for different types of assets (i.e. frequency of transactions and
multiples paid)
„ Identifying acquisitive companies in sector and historic valuation approaches (i.e. “bottom fishers” vs.
“paying a full price”)
„ Providing statistics on particular transactions as basis for discussion of industry trends and cycles
1.1.2. Advantages
„ Based on public information
„ Realistic in the sense that past transactions were successfully completed at derived multiples. The
analysis, therefore, indicates a range of plausibility for offered multiples or premia to unaffected stock
prices
„ May show trends within industry segments such as rapid consolidation of certain sub-segments,
foreign purchasers and financial purchasers
1.1.3. Disadvantages
„ Public data on past transactions can be limited and misleading
„ Not all aspects of a transaction can be captured in multiple valuation (e.g. commercial agreements,
governance issues, specific findings from due diligence, synergistic benefits)
„ Values obtained often vary over a wide range and, therefore, can be of limited use
„ Market conditions at the time of a transaction can have substantial influence on valuation (e.g.
business or industry cycle considerations, competitive environment at the time of the transaction,
scarcity of the asset at the time of the transaction)
The Compacq is an extremely useful piece of analysis that frequently attracts the focused attention of
clients. Preparers should, therefore, invest the time and effort to ensure the quality and completeness of
55
the data presented and should also consider which of the comparable acquisitions they believe to be most
relevant to the situation in hand.
The quality of comparables is far more important than the quantity of comparables. Check for
comparability of the business and operations in terms of product mix, revenue / operating income split,
size and geographic coverage. The quality of a Compacq analysis is materially influenced by the selection
of the most applicable precedent transactions.
Any announced transaction that provides an indication of valuation in the relevant sector should be shown
on the Compacq, including:
„ Withdrawn and pending deals (be aware that withdrawn transactions may not be relevant
comparables)
„ Minority stake investments (be aware that the consideration may not reflect a control premium)
„ Mergers of Equals (be aware that the consideration may not reflect a control premium)
It is advisable to begin with a complete list of deals and to eliminate transactions that do not match the
following criteria:
„ Size of the deal: transactions that are close in size to the company that is being evaluated are more
relevant
„ Timing: the more recent the data, the more relevant the benchmark
There is a wide variety of information sources that help in selecting the most relevant list of transactions
for a Compacq analysis:
„ Colleagues
Always make sure that the analysis has not been performed already (ask people in the relevant
industry team, check for previous presentations in the sector). In theory, transaction multiples need to
be prepared only once. However, it is the preparer’s responsibility that the multiples used are correct,
so all multiples used must be rigorously checked.
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„ Mergermarket
A mergermarket search may provide additional information, mainly on European M&A transactions (not
covered by traditional news searches).
„ Research reports
Look for larger industry pieces, in most cases Initiation of Coverage of a stock in the sector will have a
useful industry section. Use credible brokers and make sure it is clear how the research analyst defines
metrics (EBITDA, EBIT, Net debt, Enterprise Value, etc.). Multiples derived by equity research must be
used as cross-check only.
„ Annual Report/10K: may list recent transactions in the discussion of the competitive environment
SDC is a useful source for summary transaction information and to identify precedent transactions, but
cannot be relied upon as a reliable company or transaction specific data source. All information sourced
from SDC should be checked against other data sources to verify the accuracy of the information.
„ Pre- and post-announcement equity research reports on the target/parent and the acquiror
„ News run from 6 months prior to announcement to 1 month after closing (it is often very difficult to
obtain information on private deals; news articles may be the only available source)
„ Check whether Credit Suisse advised on the transaction. If so, the transaction team should have the
best insight into the multiple paid
„ 8K: must be filed to detail any material event; a large company that divests or acquires a small division
of assets may not file an 8K
„ S4: filed by acquirors who issue securities in connection with business combinations - so will only be
available for some proportion of stock deals
„ 14D1: tender offer document filed by the acquiror (sometimes referred to as "Offer to Purchase")
„ 14D9: recommendation statements filed in connection with tender offers, whether friendly or hostile
„ Merger Proxy: this document is filed in connection with transactions that require shareholder approval
(i.e. stock-for-stock mergers involving at least one public company)
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1.4. Sample Output Sheet
Freight Forwarding
16-Nov-2005 BAX Global (US) Deutsche Bahn (Germany) 100% 1,120 1,120 0.4x 9.5x 14.3x
15-Jul-2005 GeoLogistics (US) PWC Logistics (Kuwait) 100% 394 454 0.3x 16.2x 24.0x
11-Oct-2004 Kuehne & Nagel (Switzerland) Kuehne & Nagel (Switzerland) 20% 3,902 3,649 0.4x 9.9x 14.6x
05-Oct-2004 Menlo Worldwide Forwarding (US) UPS (US) 100% 150 260 0.1x 8.1x NM
11-Jun-2004 Wilson Logistics (Sweden) TPG (Netherlands) 100% 308 308 0.4x 9.8x 17.4x
03-Jul-2002 Stinnes (Germany) Deutsche Bahn (Germany) 65% 2,491 3,364 0.3x 5.8x 10.3x
10-Jan-2001 Fritz Companies (US) UPS (US) 100% 450 530 0.3x 8.6x 15.9x
02-Jul-2000 Circle Int. (US) EGL Inc (US) 100% 543 545 1.6x 11.7x 18.4x
14-Nov-1999 Air Express Int. (US) Deutsche Post - Danzas (Germany) 100% 1,100 1,116 0.7x 13.7x 18.5x
26-Jul-1999 Mark VII (US) Ocean Group (UK) 100% 226 226 0.3x 11.1x 12.4x
09-Dec-1998 Danzas (Switzerland) Deutsche Post (Germany) 100% 1,100 907 0.3x 8.8x 19.9x
High 100% 3,902 3,649 1.6x 16.2x 24.0x
Low 20% 150 226 0.1 5.8x 10.3x
Median 100% 543 545 0.3 9.8x 16.6x
Given the business profile of the target and particularly its primary focus on contract logistics activities,
Wincanton’s acquisition of P&O TransEuropean (2002) and Exel’s acquisition of Tibbett & Britten (2004)
represent the most relevant comparable transactions. Enterprise Value / EBITDA multiples are used as
primary valuation benchmarks in the contract logistics industry. Adding the announced run-rate cost
synergies to the targets’ EBITDAs would result in adjusted AMV / EBITDA multiples of 4.8x and 4.9x for
the Wincanton / POTE and Exel / T&B transactions respectively. Whereas Wincanton / POTE was a
privately negotiated transaction, Exel acquired T&B through a public takeover (all-cash), at a 36%
premium over the pre-rumour share price.
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2. How to Complete a Compacq Analysis
Column Comments
Announcement Date „ The announcement date is the date that the acquiror and the seller
declared their definitive intentions (i.e. when the transaction terms have
been finalised). Standard analysis is performed on the announcement
date, not on the closing date.
Acquiror „ List full name of ultimate acquiring company. Do not use an acquiring
subsidiary name
Target „ List full name of the target. When a company is selling a division,
subsidiary, or assets, list the business being sold followed by the parent's
name
Business Description of the Target „ Use full sentences
(optional, not part of the standard „ Begin with the company name (can abbreviate) followed by a verb
template)
„ Include a breakdown of sales if the company operates in multiple
business segments that could potentially be represented on different
Compacqs
„ For asset deals, begin with ‘Assets acquired comprise...’ or ‘Assets
acquired include...’ or ’Assets acquired consist of...’ or some variant
thereof
„ Example: ’Exel is the world’s largest integrated contract logistics (58% of
sales) and freight forwarding (42%) services provider’
In situations where an acquiror makes multiple bids or changes the economic terms of the transaction, the
announcement date should be the final bid date and the LTM period should be based on that date.
Example: Acquiror announces the acquisition of Target on 15 March 2006. Target's last published
financials were for quarter ended 31 December 2005. Target LTM financials used in calculation of
multiples should be for year to 31 March 2006, because the acquiror likely has financials up to early
March when determining the valuation of the target.
The preparer should ensure that these charges are appropriately tax-affected at different points on the
income statement. Pre-tax charges should be shown at the EBIT line and post-tax charges at the Net
Income line. The pre-tax and post-tax charges are generally disclosed in the financial statement
footnotes, but in the absence of this information use the overall statutory tax rate relevant for the
business.
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Example: Restructuring Charge
„ Acquisition
The acquiror will receive the full benefit of owning the combined entity. Financial statements should be
adjusted to reflect the combined financial statements assuming the two entities had been combined for
the full LTM period, including any synergies announced, to the extent such synergies are clearly
disclosed and identified.
„ Divestiture
The acquiror is not receiving the benefit of the discontinued operations, so the LTM financial
statements should exclude these operations. If these operations are not separately accounted for on
the income statement, they should be backed out using information in the footnotes and other sources
in relation to the given past transaction.
Example:
Target acquisition of Subsidiary: If the Subsidiary’s income statement is available, it should be added to
the Target’s LTM income statement. If the Target only provides pro forma sales, the full pro forma income
statement should be derived assuming the Subsidiary has the same margins as Target. Any such
assumption made must be clearly footnoted on the output sheet.
Acquiror includes the following statement in its press release: ‘This business combination is expected to
yield incremental sales of €100 in 2005, €150 in 2006 and €250 in 2007 and beyond.’
Full EBITDA Synergies = €250 * 12% = €30 (Assuming Target EBITDA margin of 12%).
2.2.6. Cyclicality
In the case of the industry sector having significantly cyclical characteristics (e.g. container shipping),
acquisition multiples will likely reflect the status of the cycle which, therefore, should always be highlighted
in the commentary to the analysis.
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2.3. Consideration Paid and Assumed Liabilities
The following table summarises the differences between the major transaction forms.
In theory, the share count and balance sheet would both be on the same date and as recently as possible
before the transaction closes. In practice, use the most recent information available for both and be
mindful of any major share issuances or buybacks that could affect the balance sheet.
Options are also an important consideration in this regard and are discussed below.
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Convertible Into
Common Equity At Mandatory Converts Into Common Not Convertible Into
Holder's Option Redeemable Upon Change Of Control Common Equity
„ Treat as equity if „ Treat as debt unless Change of Control „ Treat as debt. The
security is in-the- convertible at holder's Transaction security is not
money based on offer option. If mandatory „ Treat as equity. The
convertible, thus
price. The holder of redeemable the issuer security will convert should be treated as a
the security can can prevent holder into equity upon debt instrument
convert to equity and capturing deal change of control
capture the benefit of premium
the acquiror's offer Minority Stake
Transaction
„ Treat as debt. The
security does not
convert into equity as
no change of control
occurs
Liabilities
Short Term Debt(1) €1,800
Long Term Debt 4,400
Capitalized Lease Obligations 50
Total Liabilities €6,250
Note: Adjusted Net Debt = 1,800 + (4,400 - 3,000) + 150 + 50 - 1,000 - 100 = €2,300
Adjusted Shares Outstanding = 100 + (€3,000/€15) + (€1,000/€20) = 350 shares
The Treasury Method assumes all in-the-money options are liquidated and the holder receives common
stock equivalent to the premium of the transaction price over the option exercise price.
If no breakdown of the tranches is available, simply use weighted average strike price and options
outstanding.
Example: Offer Price = €70; Options outstanding: 25; Average exercise price: €58
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If tranches are disclosed, perform treasury method calculation on each tranche. For example, Acquiror
offers €50 per target share. Target has 100 shares outstanding plus the following options:
Diluted Share Count = Basic Shares Outstanding + Share Equivalent of Other Instruments
Note: The calculation is based on the tranches with average exercise prices below the offer price and is
based on options outstanding (not options exercisable). The €45-€55 tranche has no dilutive effect
because the average exercise price of the tranche is greater than the offer price.
„ Is the target public? If so, the acquiror must assume all of the target's debt
„ Is the deal an asset acquisition? If so, the acquiror often assumes some or no debt
„ Is the assumed debt materially different from the balance sheet debt? This question ultimately
determines the judgment call
Minority interests can be treated by including the minority interest from the balance sheet in Net Debt.
This is equivalent to the target buying out the other owners of the subsidiary at book value. If the
subsidiary is publicly traded the minority interest should, where practical, be capitalised in Net Debt at
market value rather than book value (because market value better represents the liability to the
subsidiary's other owners).
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Example: Target Owns 25% of Subsidiary:
The basic treatment of investments in associated companies assumes the subsidiary is strategically
related and should therefore be included in the valuation metrics. If the subsidiary is unrelated, similarly to
the treatment of Financial Fixed Assets (see section 2.3.13), it should be excluded from both the income
statement (i.e. Net Income pre Income from Associates) and balance sheet (i.e. deducted from Enterprise
Value at book value, or at market value if listed).
Please note that some businesses or industries need to maintain a minimum level of cash for working
capital purposes. Therefore, please use judgment and be consistent throughout all transactions included
in the Compacq when calculating Net Debt if 100% of cash is not offset against Net Debt.
Certain special situations require operating leases to be capitalised. Typical examples are the airline
industry (e.g. leased airplanes) and the retail industry (e.g. leased real estate), where assets are recorded
as operating leases but the operators capture the full benefit of owning the assets for their economic life.
These operating leases are commonly capitalised, using conventional methodologies specific to the
assets/sectors in question (e.g. capitalisation multiples for airplanes; assumed alternative usage yield for
real estate, etc).
If operating leases are deemed to be debt, the multiples should consistently reflect this in the numerator
and in the denominator. EBIT and EBITDA should, therefore, be adjusted by adding back the interest
component of the lease charge (e.g. EBITDAR).
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Example: Airline Sector Compacq
Target Stake Value Adj. AMV / EBITDAR
Date Acquiror Stake (US$ in millions) Status Historic Forecast
Mar-05 SN Brussels 100.0% 1,437.0 Pending 3.9x NA
Lufthansa
Dec-04 SN Brussels 100.0% NA Completed NA NA
Virgin Express
Nov-03 Spanair 41.0% 723.7 Completed 12.8x NA
SAS
Sep-03 KLM 100.0% 940.8 Completed 8.8x 8.8x
Air France
Nov-02 Spanair 49.0% 846.1 Completed 15.8x NA
SAS
Aug-02 British Midland 10.0% 67.5 Completed 10.7x NA
Lufthansa
May-02 Go 100.0% 531.1 Completed 10.5x NA
easyJet
Mar-02 Virgin Blue 50.0% 140.0 Completed 46.0x 5.5x
Patrick
May-01 Braathens 100.0% 121.5 Terminated 5.6x 5.7x
SAS
Mar-01 British Regional Airlines 100.0% 110.2 Completed 7.9x 6.8x
British Airways
Jan-01 Trans World Airlines 100.0% 500.0 Completed 19.8x NA
AmericanAirlines
May-00 US Airways 100.0% 4,300.0 Terminated 14.0x 11.3x
United Airlines
Apr-00 Air New Zealand 16.7% 136.4 Completed 8.2x 7.4x
Singapore Airlines
Apr-00 Sabena 35.0% 120.8 Terminated 8.2x NA
SAirGroup
Dec-99 Iberia 9.0% 248.0 Completed 6.4x 8.6x
British Airways
Dec-99 Virgin Atlantic 49.0% 960.0 Completed 8.0x NA
Singapore Airlines
Nov-99 British Midland 20.0% 148.2 Completed 11.1x 9.7x
Lufthansa
Mean 12.4x 8.0x
Median 9.7x 8.0x
High 46.0x 11.3x
Low 3.9x 5.5x
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Example: Acquisition of a Company with Significant Financial Fixed Assets
EBITDA €275
Note: Enterprise Value: 1,000 + 1,200 = €2,200
Adjusted EV (i.e. value of operational / “EBITDA generating” business) = 1,000 + 1,200 - 600 = €1,600
Adj. EV / EBITDA = 1,600 / 275 = 5.8x
If the liability is deemed to be operating (i.e. a normal part of the business, affects both debt and equity
holders), there are two possible ways to make consistent adjustments:
„ The Present Value of the liability (often estimated by US companies in the 10K filings) should be added
to the Equity and Enterprise Values (i.e. how much the acquiror would have paid if there had not been
a contingent liability) and no adjustment should be made to the P&L
„ An annual expense should be incorporated on the income statement above EBIT and the effect of this
expense should flow through to Net Income. The annual expense should approximate the Present
Value of the liability multiplied by the business WACC. The result is reduced EBIT and Net Income to
match the actual enterprise and equity consideration (which reflect the acquiror’s awareness of the
contingent liability)
If the liability is deemed to be non-operating (i.e. a cash flow to debt holders only), an interest-like
expense should be incorporated on the income statement, thereby affecting Net Income, but not EBIT.
The annual expense should approximate the Present Value (often estimated by US companies in the 10K
filings) of the liability multiplied by the cost of debt. The Present Value of the liability should also be
included as debt on the balance sheet.
2.4.2. Earn-Outs
In situations where consideration is contingent on future business performance (earn-outs) the
consideration should theoretically assume the level of the consideration anticipated at the time of
announcement. Often it is difficult to determine the expected level, but earn-outs are often based at zero if
the business meets its projections; in such cases, the anticipated value of the earn-out should be
assumed to be zero. Adding a comment in the commentary section with the adjusted multiple(s) including
the earn-out at full value should be considered by the preparer.
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2.4.3. Tax Basis Step-up
Transactions where the acquiror receives a tax basis step-up for the assets being acquired will require or
allow the acquiror to pay a higher price, and this information should be captured in the Compacq analysis.
A tax basis step-up will only occur in certain circumstances, mainly in asset transactions.
„ Old presentations
„ Industry team
67
4. Common Pitfalls
In addition to those noted under the corresponding section in Comparable Companies Analysis:
„ Completing the analysis despite lack of appropriate information (show “NA”, rather than a wrong result)
„ Getting the enterprise and equity considerations wrong (levered vs. unlevered consideration)
„ Not commenting on status of industry cycle (in case of cyclical industries) at time of the transaction
„ Not footnoting assumptions or unusual data items. It is important to create an audit trail which will allow
others to follow the methodology used
5. Example
The task is to perform a Compacq analysis on the acquisition of Debenhams plc (“Debenhams”), a UK
mid-market department store chain, by a private equity consortium consisting of CVC Capital Partners,
Texas Pacific Group and Merrill Lynch Private Equity (the “Sponsors”) in September 2003.
Note: It is important to source the right offering circular, i.e. the one that includes the parameters for the
completed transaction. In the case of the Debenhams transaction, there were a number of public offers
before the shareholders accepted the offer at 470p per share from the Sponsors. Therefore, the date of
the offering circular should be checked against other data sources (i.e. a detailed mergermarket report
lists the chain of events in the context of the transaction).
Besides the offering circular, the following data sources should be compiled in order to develop a
thorough understanding of the transaction:
„ Debenhams latest available annual and interim reports prior to or around the date of the transaction
„ News run 6 months prior to announcement to 1 month after completion, i.e. February 2003 to
January 2004
Acquiror Name CVC Capital / Texas Pacific Group / Merril Lynch Private Equity
Acquiror Country UK
Note: It is important to list the full name of the target and the acquiror. In case of this transaction, the
private equity groups formed a new entity called Baroness Retail Ltd. as bid vehicle, however the name of
this entity is an irrelevant technicality from the perspective of the Compacq analysis.
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Transaction Data Comment
Announced Date 23/10/2003 „ Use announcement date of the final successful offer
LTM Date 31/08/2003 „ Latest available historic information which were used for Compacq
Last Fiscal Year 31/08/2003 „ Date of latest fiscal year
The objective of the Compacq is to evaluate the offer for Debenhams plc in relation to the information
being used by the Sponsors at the time they valued the company. The offering circular and the annual
report 2003 include the consolidated financials for the financial year ended 30 August 2003, which is
closest to the announcement date and, therefore, the relevant LTM date for our analysis.
Target Financials
(100%, £ in millions)
Sales 1,810.2
EBITDA 258.5
% Margin 14.3%
EBIT 175.8
% Margin 9.7%
Net Interest (7.4)
Taxation (43.7)
Net Income 124.7
The financials in the offering circular / annual report 2003 have already been normalised for exceptional
costs of £17.4m consisting of advisory fees of £13.6m and £3.8m cost related to increased costs of share
schemes due to the takeover situation. An analysis of the notes further reveals that the above financials
include a profit from disposal of fixed assets of £1.6m, which needs to be excluded from the relevant
items of the income statement.
Adjusted Net Income (UK corporate tax @ 30%): 124.7 - 1.6*(1-0.3) = £123.6m
It is important to ensure that any income statement adjustments are appropriately tax-adjusted at different
points on the income statement.
The four factors that determine the transaction structure and the relevant answers are as follows:
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5.4.1. Calculation of Equity Consideration
To calculate the equity consideration, source the offer price and the number of shares in issue from the
offering circular. The notes of the annual report 2003 provide the necessary details to calculate the fully
diluted share count under the treasury method.
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5.4.2. Calculation of Enterprise Value
As this transaction was effected through a public tender, the acquiror had to assume all of the target’s
debts and other liabilities. The offering circular and annual report include the relevant balance sheet items
to calculate the total enterprise value. Besides the assumed debt for the transaction, also thoroughly read
the notes in the offering circular and annual report to account for any other financial items that would
affect the enterprise value (e.g. minority interest, investments in associated companies, leases, contingent
liabilities).
Cash (18.2)
Marketable Securities –
Total Cash & Equivalents (18.2)
Note: Always use the comments function in excel to footnote the exact source of each item (i.e. stating
the page number of the annual report where the information can be found) to ensure that the transaction
multiples can be audited and used easily by colleagues.
Note: Retailers can either own, rent or lease the properties they operate (retail stores, distribution
warehouses etc). As real estate is core to their business, the ownership status of the real estate portfolio
is mainly a financing decision (i.e. P&L impact is either in the form of depreciation or in the form of
lease/rent charges). Retailers’ ability therefore to generate EBITDAR (i.e. “pre-financing operating
income”) is seen by many market observers as more relevant to compare than EBITDA or EBIT.
Consequently, Adj. EV (i.e. EV + market value of leased/rented properties) / EBITDAR multiples may
better highlight differences in ratings. To estimate the “market value” of the leased/rented properties (i.e.
capitalised leases/rentals) a weighted average “opportunity cost” (i.e. yield) is usually assumed for the
property portfolio. Sources for this assumption could be various depending on the information disclosure
and the circumstances of the transaction.
No information has been disclosed by Debenhams in relation to the market value of its leased/rented
properties. However, the average yield of commercial real estate in the UK was estimated to be at around
7% at the time of the transaction.
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5.5.3. Resulting Multiples
The resulting transaction multiples of the Compacq analysis is shown below below.
(in £ millions except stated otherwise)
Date Acquiror Target Business of Target Equity Ent. Adj. Ent. Adj. EV / EV /
(1) (1)
Announced Value Value Value EBITDAR EBITDA P/E
23-10-2003 CVC Capital /Texas Pacific Group/ Debenhams UK mid-market department store chain 1,777 1,905 2,755 8.7x 7.4x 14.4x
Merrill Lynch Private Equity
17-06-2003 Baugur Group Hamleys UK-based toy retailer 59 67 67 8.2x 8.2x 17.4x
12-05-2003 Wittington Investments Selfridges Upmarket UK department store chain 598 628 631 10.7x 10.7x 21.1x
19-12-2002 Scarlett Retail (Minerva) Allders UK department and homeware store chain 135 162 546 10.0x 5.8x 11.5x
18-09-2002 Broadgain (Dickson Poon) Harvey Nichols Upmarket UK department store chain 69 143 216 9.7x 8.3x 16.1x
10-09-2002 Taveta (Philip Green) Arcadia UK clothing retailer comprising Topshop, 850 847 3,487 9.2x 4.4x 13.1x
Topman, Evans, Burton, Dorothy Perkins,
Wallis and Miss Selfridge
08-03-2002 JJB Sports PLC TJ Hughes Liverpool-based discount department store 42 46 49 5.8x 5.6x 12.5x
operator
(1) Each target based in the UK. Property leases capitalised assuming a 7% yield.
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Valuation Matrix
73
Valuation Matrix
1. Overview
1.1. Objectives
This chapter aims to answer the following key questions:
„ What are the common ratios used in a Valuation Matrix? How are they calculated?
„ The Valuation Matrix provides a sensitivity analysis to the company’s valuation parameters. It presents
key multiples at different valuations
„ The Valuation Matrix, while simple in its construction, is one of the most useful tools that investment
bankers use on a day-to-day basis. A Valuation Matrix should be completed for each and every
valuation analysis
„ Key items of historical and projected financial data (e.g. Sales, EBITDA, Net Income)
75
Valuation Matrix – Variation A
(€ in millions)
(4)
Enterprise Value / EBITDA LTM 225.0 5.3x 5.8x 6.2x 6.7x
FY 2006E 240.0 5.0x 5.4x 5.8x 6.3x
FY 2007E 260.0 4.6x 5.0x 5.4x 5.8x
Enterprise Value / EBIT (4) LTM 160.0 7.5x 8.1x 8.8x 9.4x
FY 2006E 180.0 6.7x 7.2x 7.8x 8.3x
FY 2007E 190.0 6.3x 6.8x 7.4x 7.9x
Equity Value / Net Income (4) LTM 105.0 9.5x 10.5x 11.4x 12.4x
FY 2006E 120.0 8.3x 9.2x 10.0x 10.8x
FY 2007E 126.0 7.9x 8.7x 9.5x 10.3x
Sources: Company information; I/B/E/S consensus estimates; CS IB analysis
(1) Assumes 40.0 million basic shares outstanding as of 31 December 2005
(2) Assumes there are no exercisable options outstanding
(3) Assumes Net Debt of €200.0 million as of 31 December 2005
(4) I/B/E/S consensus estimates (median) as of 1 August 2006
Comparable multiples of selected companies can be shown graphically (i.e. as shading) to help bracket
the selected value range.
Additional Variations
The Valuation Matrix is a very flexible analytical tool that easily allows customisation and has the ability to
show a significant amount of information for deal decision-making.
„ Implied stock price premiums can be added for publicity listed companies to allow benchmarks against
precedent sector or market deals
„ “Discount to DCF-derived equity value” can be added to illustrate whether or not the selected range
represents a standard trading discount to DCF for companies primarily valued on DCF
76
Valuation Matrix – Variation B
(€ in millions)
Metric 1,300 1,450 1,600 1,300 1,400 1,550 225 240 260 160 180 190 105 120 126
Source: Company information; I/B/E/S consensus estimates (median) as of 1 August 2006; CS IB analysis
(1) Based on 40.0 million basic shares outstanding as of 31 December 2005; asumes there are no exercisable options outstanding
(2) Assumes Net Debt of €200m as of 31 December 2005
The valuation matrix summarises critical information such as multiples at different prices and the implied share price of offer values. A shaded row highlights the suggested
mid-point of a valuation range and the table allows a quick overview of the valuation parameters.
2. How to Complete a Valuation Matrix
„ Alternatively, the client may refer to valuation levels (equity) of around €1.4 billion and infer that this
corresponds to an EV/EBITDA 2006E multiple of 6.7x. Referring to the Valuation Matrix grid, the team
may conclude that the implied multiples for an equity value of €1,550 million or €38.75 per share (1.1x
next year's revenue, 6.7x next year's EBITDA, 12.3x next year's earnings) seems high
2.2.3. Multiples
„ The multiples that are included in the analysis will depend on the industry in which the company
operates. Multiples can include, but are not limited to Revenues, EBITDA, EBIT and Net Income. Credit
Suisse industry or product groups often use standard sets of multiples with which to value clients in
certain industries. Check with team members, industry experts in the investment banking department,
published research reports and/or published research models. Similar to the Compco analysis, most
industry sectors have specific valuation metrics that need to be reflected in the Valuation Matrix.
Examples are set out in the Comparable Companies Analysis chapter. Consult with industry group
bankers to identify which multiples to use in a particular situation
„ However, keep in mind that any communication with CS Research needs to be in compliance with the
firm's policies and procedures, which requires, among other things, pre-clearance with Compliance
and/or Compliance chaperoning. If in doubt, please contact the Legal and Compliance Department
(LCD) or a senior team member
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„ Calculate multiples
„ Calculate what percentage of the company must be sold to raise X million (e.g. Euros). Complete the
following calculation for each column in the model:
„ Calculate how many shares must be sold. Complete the following calculation for each column in the
model:
% of Company Sold
# of Shares sold = Shares Outstanding x
( 1-% of Company Sold )
„ Calculate diluted per share value. Complete the following calculation for each column in the model:
„ Interpret the Valuation Matrix and answer questions from team members and the client
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Key Outputs and Associated Inputs
3. Common Pitfalls
Getting the valuation range wrong is probably the most common pitfall. A good approach is to start with a
“football field” graph (also called floating bars) where the multiple ranges of comparable companies as
well as comparable acquisition analysis will provide an indication how a suitable range should be framed.
Also refer to the Comparable Companies Analysis chapter for additional common pitfalls that may also
apply to the Valuation Matrix.
34.0 34.0
33.0 33.0
32.5 32.5
28.5
28.0
26.0
Trading Range DCF Comparable Comparable LBO Analysis Selected Range Analyst Price Targets
Company Analysis Acquisition Analysis
Equity Value 1,120m - 1,320m 1,200m - 1,360m 1,040m - 1,300m 1,200m - 1,400m 1,140m - 1,320m 1,200m - 1,300m 1,200m - 1,360m
Enterprise Value 1,320m - 1,520m 1,400m - 1,560m 1,240m - 1,500m 1,400m - 1,600m 1,340m - 1,520m 1,400m - 1,500m 1,400m - 1,560m
EV/Sales 2006E 0.94x - 1.09x 1.00x - 1.11x 0.89x - 1.07x 1.00x - 1.14x 0.96x - 1.09x 1.00x - 1.07x 1.00x - 1.11x
EV/EBITDA 2006E 5.50x - 6.33x 5.83x - 6.50x 5.17x - 6.25x 5.83x - 6.67x 5.58x - 6.33x 5.83x - 6.25x 5.83x - 6.50x
EV/EBIT 2006E 7.33x - 8.44x 7.78x - 8.67x 6.89x - 8.33x 7.78x - 8.89x 7.44x - 8.44x 7.78x - 8.33x 7.78x - 8.67x
P/E 2006E 9.3x - 11.0x 10.0x - 11.3x 8.7x - 10.8x 10.0x - 11.7x 9.5x - 11.0x 10.0x - 10.8x 10.0x - 11.3x
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Illustrative Football Field / Floating Bars – Variation B
(In € per share)
Trading Range 0.94x - 1.09x 5.50x - 6.33x 7.33x - 8.44x 9.3x - 11.0x 28.0 33.0
DCF 1.00x - 1.11x 5.83x - 6.50x 7.78x - 8.67x 10.0x - 11.3x 30.0 34.0
Comparable Companies Analysis 0.89x - 1.07x 5.17x - 6.25x 6.89x - 8.33x 8.7x - 10.8x 26.0 32.5
Comparable Acquisition Analysis 1.00x - 1.14x 5.83x - 6.67x 7.78x - 8.89x 10.0x - 11.7x 30.0 35.0
LBO Analysis 0.96x - 1.09x 5.58x - 6.33x 7.44x - 8.44x 9.5x - 11.0x 28.5 33.0
Selected Range 1.00x - 1.07x 5.83x - 6.25x 7.78x - 8.33x 10.0x - 10.8x 30.0 32.5
Analyst Price Targets 1.00x - 1.11x 5.83x - 6.50x 7.78x - 8.67x 10.0x - 11.3x 30.0 34.0
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4. Case Studies
The following case studies demonstrate the mechanics and uses of the Valuation Matrix. Each case is
presented and provides worksheets to assist in performing the calculations. Solutions can be found in the
separate Investment Banking Department Analysis Handbook – Solution Set.
Merger Application
Assume that a private company, Premium Cars AG, wishes to compare potential IPO valuations with
outright sale valuations.
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Merger Application Worksheet
Directions: Now that the information is available, the Valuation Matrix is ready to be calculated. In order to simplify things, the Valuation Matrix format has already been set up.
It is now necessary to input the information for Premium Cars AG into the Valuation Matrix. Perform the relevant calculations to complete the Valuation Matrix output.
(€ in millions)
Equity Consideration (€ m) Metric
Net Debt
Levered Consideration (€ m)
Multiple of Revenue (Leveraged) (x)
2006E
Multiple of EBITDA (Leveraged) (x)
2006E
2007E
Multiple of Net Income (x)
LTM
2006E
2007E
1) Enter the Price Range for the Valuation Matrix Grid
Consult the team leader to get an appropriate range for the Valuation Matrix. The user should try to have
the relevant valuation range and multiples print within the Valuation Matrix grid. In this case, use a equity
consideration range of €1,200 to €1,650 million.
Enter the financials for the accounts for which the multiples are to be calculated. Typical financial items
include Sales, EBITDA, EBIT, Net Income and Tangible Book Value.
Calculate the multiples for relevant company financials. Ensure that the multiples for financial data before
interest expense (e.g. Sales, Gross Profit, EBITDA and EBIT) use levered consideration (Enterprise
Value). Also make sure that the multiples for financial data after interest expense (e.g. Net Income) use
equity consideration.
Metric 1,200 1,250 1,300 1,350 1,400 1,450 1,500 1,550 1,600 1,650
Net
Income
LTM
2006E
2007E
Verify that a reasonable equity value range has been chosen. Do the multiples represent an appropriate
range, given where comparable companies are trading?
„ What is the approximate price range implied from the multiples from other valuation models (Compco,
DCF Analysis and Compacq)?
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4.2. IPO Application
„ The owners of Premium Cars AG wish to analyse potential IPO valuations for its privately-owned niche
automotive company. Using the assumptions about Premium Cars AG, create a Valuation Matrix and
determine the following:
§ What is the post-offering Market Cap of the company?
§ What percentage of the company must be sold to raise €400 million?
§ How many shares must be sold?
§ What is the approximate price per share at which the company can go public?
Premium Cars AG, a private company, wants to raise approximately €400 million by issuing primary
shares (i.e. new shares. A secondary offering represents sales of shares by an existing shareholder to a
new shareholder and has no impact on the company’s financial statements or common stock). It will use
the proceeds to pay down debt that has an interest rate of 5%. There are currently 40 million ordinary
shares outstanding to the current owners.
„ Upon completion of this example it should be possible to answer the following questions:
§ What is the post-offering Market Cap of the company?
§ What percentage of the company must be sold to raise €400 million? How many shares must be
sold?
§ What is the approximate price per share at which the company can go public?
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IPO Application Worksheet: Premium Cars AG
Directions: Now that the information is available, the Valuation Matrix is ready to be calculated. In order to simplify things, the Valuation Matrix format has already been set up.
It is now necessary to input the information for Premium Cars AG into the Valuation Matrix. Perform the relevant calculations to complete the Valuation Matrix output.
The fully distributed price is the expected price at which shares would trade in the market, before any IPO discount.
1) Pro Forma Earnings
Calculating pro forma Net Income examines the company's valuation relative to its earnings after taking
into consideration what the company will do with the proceeds from the offering. In this case, assume they
will use the proceeds to pay down debt with an interest rate of 5%.
Hint: As a first guess, build a range around this number in increments of €50 million. Input from
team members can be helpful when determining the range.
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Range Of Post-Offering Equity Value
(€ in millions)
Metric 1,200 1,250 1,300 1,350 1,400 1,450 1,500 1,550 1,600 1,650
Net Income
(Pro Forma)
LTM
2006E
2007E
Verify that a reasonable post-offering equity value range has been chosen. Do the multiples represent an
appropriate range, given where comparable companies are trading?
Amount to Raise
% of Company sold = %
Post-Offering Equity Value
1,200 1,250 1,300 1,350 1,400 1,450 1,500 1,550 1,600 1,650
% of Sold
Example: For a post-offering equity value of €1.4 billion, 28.57% of the company will have been sold
(€400 million ÷ €1.4 billion).
% of Company Sold
# of Shares sold = Shares Outstanding x
( 1-% of Company Sold )
Shares Outstanding: _____________________
1,200 1,250 1,300 1,350 1,400 1,450 1,500 1,550 1,600 1,650
% of Sold
# Shares
Example: If Post-Offering Equity Value = €1.4 billion, then 28.57% (or €400 million / €1.4 billion) of the
company needs to be sold in order to raise €400 million. If 40 million shares are outstanding
before the offering, 16.0 million shares will need to be sold [40 x (0. 2857 / (1 - 0. 2857))].
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Range Of Post-Offering Equity Value
1,200 1,250 1,300 1,350 1,400 1,450 1,500 1,550 1,600 1,650
% of Sold
# Shares
Value / Share
Example: If Post-Offering Equity Value = €1.4 billion, then 28.57% (or 16.0 million shares) of the
company needs to be sold in order to raise €400 million. If the post-offering shares
outstanding is 56.0 million, then the per share value fully distributed is €25.00.
Example: If the company can go public at 10.0x 2007E Net Income, it will have a Market Cap of €1.4
billion, and an IPO price of €25.00 per share. The public will own 28.57% of the stock after the offering.
„ What percentage of the company must be sold to raise €400 million? How many shares must be sold?
„ What is the approximate price per share at which the company can go public?
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Merger Consequences Analysis
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Merger Consequences Analysis
1. Overview
„ Income statement / earnings impact (Revenue growth, EBITDA growth and margin, EBIT growth and
margin, Net Income growth and margin, Earnings per share)
„ Balance sheet / credit impact (Gross Debt / EBITDA, Net Debt / EBITDA, EBITDA / Interest, Net Debt /
Total Cap)
Merger Consequence Analyses are important tools in supporting views on the potential market reaction to
a transaction. Given the importance of P/E multiples for investors and the straight mathematical
relationship between P/E multiples and the EPS impact of a transaction, the primary focus of the analysis
relates mainly to EPS accretion / dilution. However, the impact of a transaction on Revenue and EBITDA /
EBIT growth (or other metrics’ growth depending on the industry) may be equally important when
considering potential market reactions. It must be noted that the analysis of EPS impact is only one of the
parameters used by investors to assess the merits of a transaction which is also generally judged on the
basis of strategic rationale, potential synergies, economic returns (when does return on investment
exceed WACC?) and quality of earnings (in particular with reference to execution risks and overall risk
profile of the combined entity).
„ Buy-Side Application
§ Buyer’s financial capacity / rating constraints
§ Accretion / dilution analysis at a given price / consideration mix / growth rates
§ Synergies required for EPS neutrality
§ Interloper analysis
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1.2.1. Form of Consideration (Cash, Stock, Mix)
Companies can finance the acquisition through cash (debt), stock, other types of securities or a mix of
these. It is typically useful to be able to vary the forms of financing in models.
„ Cash / Debt
§ Cash may come from either the buyer’s balance sheet or be borrowed from a third party
§ Adjustment is required for interest paid on the debt raised (or interest foregone on an existing cash
balance)
„ Stock
§ The value of each share issued is equal to the buyer’s stock price at the time of issue
– An important element of analysis for both buyer and target is represented by the analysis of the
fair value of the stock issued, in order to understand real value transfer associated with the
execution of the transaction
§ Adjustment is required for the issuance of shares as it dilutes pro forma EPS
§ For modelling purposes, it does not matter whether shares are issued to the vendor as consideration
or if they are issued to the market to raise funds for a cash deal
„ Other
§ Additional securities that can be issued as acquisition currency include:
– Bonds – standard, convertible or exchangeable
– Warrants
– Preferred stock
– Vendor notes
§ The calculation of total consideration paid also needs to factor in potential deferred payments (e.g.
in the form of earn-outs)
„ Mix
§ A combination of cash / stock and other securities can be used
„ Buyer
In the case of stock consideration, the current share price of the buyer should be used unless (i) such
share price is not representative (see above) in which case a fair or unaffected price should be used as
the basis of the analysis, or (ii) the terms of the deal are specifically based on a different share price
(e.g. 30 day average).
If modelling an equity issue to raise funds, a placing discount may need to be included.
Valuations of target and buyer stock are ultimately subject to negotiations between the parties.
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1.2.3. Buyer / Target’s P&L / Balance Sheet / Cash Flow Historical and Projected
Statements
Historical financial information should be extracted from primary sources (annual report, interim report and
other company filings).
For public companies, projections can either be based on single / multiple broker reports (available online
on Thomson Research) or on Reuters / IBES consensus estimates. Usually Reuters / IBES consensus
estimates include the most recent estimates and are more objective (e.g. in a public deal they can be
quoted as third party official database) but contain fewer details and do not allow for an understanding of
underlying assumptions. It would, therefore, be advisable to create projections on the basis of a
consensus of brokers reports obtained by selecting reports which are recent (at least published after the
issuance of the latest financial statements or profit updates or in any way reflecting material events
disclosed to the market) and issued by primary brokerage houses. As an important check, such
consensus would need to be compared to Reuters / IBES consensus estimates.
For private companies, projections will generally be provided by the client or will come from information
provided during the due diligence process.
Assumptions
„ Key Assumptions
§ Company A Net Income: $650 million
§ Company B Net Income: $300 million
§ Pre-tax synergies: $20 million
§ Debt consideration: 50% of total consideration
§ Cost of new debt 6%
§ Effective tax rate 30%
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The following example shows the EPS accretion / dilution on the combined entity.
(In USD millions, unless otherwise stated)
„ Merger
The two companies combine all existing assets and liabilities. One legal entity will survive, the other
being incorporated in the former.
„ Stock Purchase
The buyer acquires the stock of the target thus achieving control and/or access to all existing assets
and liabilities.
„ Asset Purchase
The buyer acquires explicit assets (listed separately) that form either part of the business or its totality.
In this case, the buyer will only assume the assets and liabilities that have been specifically
determined.
The decision whether to structure a transaction as an asset purchase or share purchase depends on:
„ Nature of liabilities: if there are potentially significant hidden liabilities (e.g. environmental), it may be
preferable to acquire assets only
„ Tax considerations: the buyer and/or the target will try to optimise taxes on the transaction. A conflict
may arise between the two, as a share sale is often more beneficial for the target, in that any capital
gain arising may be partly or wholly tax exempt. However, an asset acquisition may allow a step up in
value for tax purposes (tax basis) of the assets acquired and allow for enhanced leverage of the
acquisition by the buyer
„ Complexity of the process: an asset purchase is generally more cumbersome compared to a stock
purchase
„ Structure of the target: are the assets sought only part of the target’s entity assets?
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2.1.2. Considerations on Accounting Treatment – IFRS Regime – and Tax Implications
The accounting treatment of the transaction is regulated by IFRS 3 Business Combinations, which
replaced IAS 22 in January 2005. As with US GAAP, IFRS now requires the application of the purchase
method of accounting for all transactions and that consequent goodwill is not amortised but tested for
impairment on, at a minimum, an annual basis.
The purchase accounting method allocates the difference between the amount paid on the date of the
acquisition, and the book value of the net assets, to individual assets / liabilities. The acquired identifiable
assets and liabilities are measured at their fair values as at the acquisition date. Any excess of the
purchase price over the fair market value of the individual assets, less liabilities, is allocated to goodwill.
Depreciation and amortisation of asset values will be calculated based on these fair values and included
in the consolidated income statements in subsequent periods. Goodwill is not amortised. The goodwill is
tested for impairment firstly at the end of the reporting period in which the business is acquired and then
annually or more frequently if events or changes in circumstances indicate that it might be impaired.
Usually, in a stock purchase deal, the incremental depreciation and amortisation charges, relating to the
write-up of the assets or newly identified intangible assets, will not be tax deductible.
In an asset purchase, the resulting incremental depreciation and amortisation for any asset write-up may
be depreciated or amortised (for tax purposes) over a range of years and is generally tax deductible.
Fiscal rules vary from jurisdiction to jurisdiction so it is important to verify the correct treatment of such
items with a tax consultant.
An intangible item acquired in a business combination, including an in-process research and development
project, must be recognised as an asset separately from goodwill if it meets the requirements for
recognising an intangible asset (it is controlled and provides economic benefits, it is either separable or
arises from contractual or other legal rights, and its fair value can be measured reliably).
Finally, a buyer must recognize contingent liabilities assumed in the business combination, if their fair
value is reliably measurable.
Goodwill
Goodwill is the amount by which the purchase price exceeds the total value assigned to the assets
acquired less the present value of the liabilities assumed. Theoretically, it represents the price paid for the
unidentifiable intangible assets and the future earnings potential of the company. Practically, it represents
the amount of the transaction price that exceeds the fair value assigned to the assets and liabilities
acquired:
Goodwill is recognised by the buyer as an asset from the acquisition date. IFRS 3 prohibits the
amortisation of goodwill. Instead, goodwill must be tested for impairment at least annually.
In an asset purchase, goodwill will arise in the normal way where the acquisition is regarded as a
purchase of a business rather than as the purchase of separate individual assets. In such a transaction
the assets acquired are carried at fair value.
If the transaction was not regarded as the purchase of a business, but rather the purchase of separate
individual assets, then the assets acquired should be recorded at cost with no goodwill arising.
Negative Goodwill
If the buyer's interest in the net fair value of the acquired identifiable net assets exceeds the cost of the
purchase price, the excess must be recognised immediately in the income statement as an extraordinary
loss, typically in the period in which the transaction is completed. Before concluding that negative goodwill
has arisen, however, IFRS 3 requires that the buyer reassesses the identification and measurement of the
target’s identifiable assets, liabilities, and contingent liabilities and the measurement of the transaction
price, as it presumes that in most circumstances negative goodwill will not genuinely arise.
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2.1.3. EPS Accretion / Dilution
The Merger Consequence Analysis examines the impact of the transaction on the buyer’s projected EPS.
The impact will either be:
Since many public companies trade on earnings (amongst other metrics), dilution to earnings may have a
negative impact on the buyer’s stock price. As a result, the level of earnings accretion / dilution created by
a transaction is a critical issue for public buyers. The level of dilution that a company is willing to accept
from a merger depends on a number of factors, including in particular, the strategic value of the
transaction.
To measure whether the transaction is accretive / dilutive, the buyer’s current EPS is compared with the
pro forma EPS (EPS of the combined entity).
Pro Forma (Buyer NI(1) + Target NI(1) – Incremental D&A+ Post Tax Impact of Synergies – Post Tax Impact of New Debt)
EPS = (Buyer’s Fully Diluted Shares Outstanding + Buyer’s Newly Issued Shares)
(1) Represents Normalised Net Income
Although, the IFRS standard on EPS requires that EPS is shown based on total earnings for the period on
the company’s filings, it is common practice in financial markets to focus on earnings that exclude
significant one-off and non-trading items (net of tax impact) and show additional EPS measures based on
these adjusted earnings. A discussion and examples of adjusting for significant one-off items can be
found in section 2.2.7 of the Comparable Companies Analysis chapter.
The Merger Consequence Analysis can also examine the impact of the transaction on the target’s
projected EPS in the case of a 100% stock transaction. The target’s shareholders will remain investors in
the combined entity, as such it is important to assess the EPS impact on them and their willingness to
receive buyer’s stock as a consideration.
Numerator Adjustments
Synergies
Synergies are defined as the economic / financial benefits achievable through the transaction from greater
economies of scale or critical mass.
Unless a detailed synergies analysis is available from the client, synergies are typically calculated by
Credit Suisse as a percentage of target / combined entity sales, costs or EBITDA (based on comparable
transactions) and not as a percentage of the combined Market Cap.
Synergies are differentiated between cost synergies and revenue synergies. The latter are harder to
measure and, therefore, are not usually included in the analysis.
In the Merger Consequence Analysis, synergies to breakeven reflect the additional synergies, on a pre-
tax basis, which must be generated to prevent the transaction from being dilutive to the buyer’s EPS.
Debt Financing
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„ Cost of borrowing
The cost of borrowing is dependant on the buyer’s current financing cost as well as the leverage /
credit rating of the pro forma entity following the transaction. Some, if not all, of the acquisition
consideration could also be financed through the buyer’s existing cash. In this case, the interest
foregone on this cash represents the assumed cost of financing.
The write-ups of the revalued assets (difference between fair value and book value), and the newly
identified intangible assets, should be depreciated on the remaining useful life of the asset. This extra
annual depreciation needs to be reflected in the adjustments to the consolidated pro forma earnings.
Usually, in a stock purchase deal, the incremental depreciation and amortisation charges relating to the
write-up of the assets or newly identified intangible assets will not be tax deductible.
In an asset purchase, the resulting incremental depreciation and amortisation for any asset write-up may
be depreciated or amortised (for tax purposes) over a range of years and is generally tax deductible.
Fiscal rules vary from jurisdiction to jurisdiction, so it is important to verify the correct treatment of such
items with a tax consultant.
Goodwill
Taxation
Synergies should be taxed at the tax rate of the jurisdiction where they arise geographically.
Interest cost on incremental borrowings should be taxed at the marginal tax rate of the jurisdiction in
which it is incurred. For example, in a cross-border transaction, any debt push down at the target level
would require the incremental interest cost to be taxed at the target’s rate. Loss of interest income due to
use of cash balances as part of the consideration should trigger a tax benefit calculated at the tax rate of
the entity (buyer or target) which employs the cash balances.
The structure of the transaction also has tax implications. As discussed above, in a stock purchase,
generally neither the incremental D&A from the asset write-up nor newly identified intangible assets, nor
the goodwill resulting from the transaction will be tax deductible for fiscal purposes. In an asset purchase
deal, generally both can be deductible.
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Fiscal rules vary from jurisdiction to jurisdiction so it is important to verify the correct treatment of such
items with a tax consultant.
Denominator Adjustments
The number of shares used in the denominator should be the latest available fully diluted shares
outstanding. This number includes the equivalent number of shares of in-the-money exercisable stock
options / warrants and other dilutive securities. A discussion and examples of calculating number of
shares outstanding can be found in section 2.3.1 of the Comparable Companies Analysis chapter.
„ Options / Warrants
In-the-money exercisable options and warrants of the buyer should be treated as per the treasury
method (proceeds from exercise of stock options used by the company to buy-back shares) or the fully
diluted method (shares from exercise of stock options accounted for in the number of fully diluted
shares outstanding, proceeds from exercise of stock options accounted for in the net financial position).
„ Convertible debt
Convertible securities allow the holder to convert the security into common voting shares or, less often,
preferred stock or warrants. These are to be treated as stock if in-the-money, if not, they will be treated
as debt. If treated as stock, P&L interest expenses should be adjusted to exclude interest expenses
(net of taxation) related to the convertible.
The number of new shares issued will depend on the mix of consideration (cash vs. stock) and the
exchange ratio, as well as the treatment of the target’s dilutive securities.
When a transaction involves some share consideration, the exchange ratio will be defined as the number
of buyer shares to be offered per each target share. To determine the total amount of new shares to be
issued by the buyer, multiply the fully diluted shares outstanding by the exchange ratio, and the result by
the percentage of the transaction paid in shares.
All decisions regarding the treatment of outstanding dilutive securities depend on the objectives of the
parties and the specific situation. Generally, for options:
„ In-the-money options of the target should be treated as per (a) the treasury method or (b) the fully
diluted method (as discussed above)
„ For convertibles, if the holder cannot roll over the convertible, the holder will face an economic decision
to either cash out as debt holder or accelerate the exercise and thus become an equity holder. When
the security is trading in-the-money, the holder will typically convert the bond into the underlying stock
of the target, thus receiving the same consideration and treatment as the target’s ordinary shareholders.
If, however, the security is trading out-of-the-money, the bond will not be converted and the bond
holder will receive the redemption value of the bond in cash. In this case, the bond should be treated
as normal financial debt and included in the overall target company’s Net Debt and Enterprise Value
For both options and convertibles, other treatments (which allow convertible or option holders not to
forego any option value embedded in the convertibles / options) can also be considered.
„ Roll over
If all or a portion of the merger consideration is paid in buyer’s stock, holders of convertible securities of
the target will often be allowed (and usually required) to roll over their convertible securities into similar
convertible securities of the buyer (i.e. the surviving entity).
In this case, the strike price of the convertible (i.e. the price at which the holder will be able to convert
the bond into shares) would be adjusted so that the value of the stock into which the security is
convertible is the same as before (i.e. target’s stock) and after (i.e. buyer’s stock) the transaction.
Generally, convertible holders will also benefit from a change of control adjustment of the strike price in
the form of additional shares receivable upon conversion. The principal amount and interest rate on the
convertible security would generally remain unchanged.
When target options are rolled over, the buyer issues new options on its stock in exchange for the old
options on target stock. The number of shares issued upon exercise and the strike price of the new
options are typically set such that the option holder remains in an economic position similar to that
when holding the target’s original options.
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„ Liquidation
When options are liquidated, the option holders receive cash from the acquiring company in return for
extinguishing the securities. The value of the liquidated options is based on market value, if such
options are listed, or mathematical formulas (e.g. Black-Scholes). In any event such value is ultimately
subject to negotiations between the parties.
Acquisition of a Stake Below 20% – Buyer has Neither Control nor Significant Influence
„ In the case of an acquisition of a stake in the target below 20% of the voting stock, the acquisition will
most often be accounted for as an investment
„ When acquiring less than 20% of the voting stock, there is a presumption that the buyer will have
neither significant influence nor control over the target
„ “Significance influence” means ‘the power to participate in the financial and operating policy decisions
of the investee but not in control or joint control over those policies’ (IAS 28)
„ “Control”, in accounting terms, means ‘the power to govern the financial and operating policies of an
entity so as to obtain benefits from its activities’ (IAS 27)
„ The presumption can be rebutted if the buyer has significant influence over the operations of the target
through a means other than the voting stock – for example, through a right to appoint members to the
board, or through other contractual arrangements
„ IFRS requires the particular circumstances of each acquisition to be considered when deciding how
much influence is with the buyer
„ If the acquisition is accounted for as an investment, under IFRS it will be carried in the balance sheet at
fair value, with gains and losses in fair value taken directly to equity (or through the income statement
when the investment is linked to a trading activity)
„ Upon acquisition, the cash on buyer’s balance will be reduced by the purchase price and investments
increased by the fair value of the investment on acquisition
„ The target’s dividends will be recorded as investment income in the buyer’s P&L below EBIT. Such
dividends may be subject to taxation
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Example
„ Assuming 50 is fair value for 10% of Target, Buyer will recognize an investment in its balance sheet at
50
Target
Net Assets 500 500
Equity 500 500
Acquisition of a Stake Above 20% and Below 50% – Buyer has Significant Influence, but not
Control
„ In the case of an acquisition of a stake in the target above 20% and below 50% of the voting stock, the
acquisition will most often be accounted for as an associate
„ When acquiring more than 20% of the voting stock there is a presumption that the buyer will have
significant influence over the target, but will not be able to control the operation of the target – the
target will therefore be an associate. Usually board representation is required to evidence significant
influence
„ As above, this presumption can be rebutted if the circumstances of the acquisition indicate that either
the buyer is able to control the target or that the buyer is not able to exercise significant influence. In
such cases, the accounting treatment would be consolidation or accounting as an investment
respectively
„ An associate is accounted for under the equity method, with the buyer’s share of the associate
reflected as a one line entry in the income statement and the balance sheet of the group accounts
„ The balance sheet includes an investment in associates in fixed assets which represents the
percentage owned of fair value of the net assets of the associate plus the goodwill
„ The income statement includes the group share of the associate net income (recorded before Group
Operating Profit). It should be noted that the accounting treatment does not impact the tax treatment of
dividends received, which may be subject to taxation
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Example
Target
Net Assets 500 500
Equity 500 500
Acquisition of a Stake Above 50% and Below 100% – Buyer has Control
„ In the case of an acquisition of a stake in the target above 50% and below 100% of the voting stock,
the target is likely to be accounted for as a subsidiary
„ It is presumed that a stake of 50% or more of the voting stock will give the buyer control of the target.
The target will therefore become a subsidiary of the buyer
„ The presumption can be rebutted in exceptional circumstances if it can be clearly demonstrated that
such a stake does not give the buyer control
„ Conversely, as noted above, a stake of less than 50% may give the buyer control over the target. This
may be through, for example, the ability to appoint a majority to the board of the target, or the power to
direct the operations of the target through agreement with the other investors
„ All the assets and liabilities of a subsidiary are consolidated on a line by line basis in the group
accounts of the buyer
„ Minorities from Net Income (equal to the minority share of the target Net Income) and from the
shareholder equity (equal to the minority share of the target shareholder equity) have to be stripped-out
„ In the balance sheet, the minority interest account in the shareholders’ equity is used to capture the
assets that have been consolidated and that are not actually owned by the holding company
„ In the income statement, the minority interest is a deduction to the consolidated earning to reflect the
deduction made for earnings not owned by the holding company
Example
„ Buyer pays 600 for an 80% stake in Target and achieves control
„ Buyer recognises all assets and liabilities of Target on a line by line basis in its group financial
statements, at fair value (for convenience in the table below these are shown in one line as Other Net
Assets)
„ The fair value of the assets of Target is 550 – after recognizing 50 of intangible assets
„ Buyer recognises Goodwill as the difference between the assets acquired and purchase price: 600 –
(550 * 80%) = 160
„ Minority interest is recognized for the 20% of Target that Buyer does not own (550 * 20% = 110)
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Opening B/S Buyers 80% Stake In Target Closing B/S
Buyer – Group Balance Sheet
Investments
Goodwill 160 160
Other Intangibles 50 50
Cash 600 (600) 0
Other Net Assets 100 500 600
Equity 700 700
Minority Interest 110 110
Target
Net Assets 500 500
Equity 500 500
Treasury Stock
„ In the case that buyer or target have treasury shares on their balance sheets, these should be
assumed as cancelled for EPS analysis purposes. The accretion / dilution should therefore be carried
out on the total number of shares outstanding net of any treasury shares
„ The target’s tax losses or tax assets may be utilised to reduce the buyer’s tax costs (or vice-versa)
subject to tax legislation. Fiscal treatment will depend upon jurisdiction and it is important to note that
there are frequently restrictions on the ability to use such losses / assets after a change of control. In
addition, historic tax losses may be trapped in the entity in which they arose and not able to be offset
against profits in the acquiring group
Contingent Liabilities
„ Under IFRS, contingent liabilities of the target must be recognised in the balance sheet at fair value – if
the fair value can be reliably determined. Recognition of contingent liabilities will increase the value of
the purchase price attributed to goodwill
Dividend Policy
„ Differences in the dividend pay-out ratio between buyer and target should be considered when
combining the businesses
„ Usually dividend policy is aligned to the buyer. However, it is necessary to assess potential change due
to, for example, a high leverage of the combined entity post-acquisition or specific features of the
target’s shareholder base (e.g. interest in high dividends)
„ Cash-flow of the combined entity should be adjusted to reflect the combined entity dividend policy
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2.2. What are the Inputs / Where Do I Find the Information?
Transaction Data
Borrowing Cost Historical financials and discussion with DCM
Opportunity Cost of Cash for the Buyer Historical financials and discussion with DCM
Synergies Client, estimates based on precedent transactions
Tax Rate In general, statutory tax rate
Asset Write-Up / Newly Identified Intangible Assets Client, accountants or estimates
„ Keep the existing facilities and adjust evolution of debt in the balance sheet / cash flow statement for
the acquisition debt (if any) and other cash flow impacts including:
§ Synergies (net of taxes) – positive cash flow contribution
§ Interest from acquisition debt (after tax) – negative cash flow contribution
§ Difference in dividends (delta between the combined entity dividends and the sum of the buyer and
target dividends) – if dividends of the combined entity are higher than the sum of the buyer and
target dividends negative cash flow contribution
„ Sometimes, especially in transformational transactions, the existing facilities may have to be refinanced
in order to establish a new / optimal capital structure for the combined entity – in this case, the selected
facilities will have to be modelled (including one or more facilities to finance the acquisition if there is a
cash consideration)
„ Adjust the total number of shares of the buyer for the newly issued shares (if any)
§ Total stock consideration value / value of buyer share
„ For a quick analysis, all the adjustments listed above can be made directly at a per share level without
the need of a working model
105
§ EPS of buyer and target can be added together and adjusted as described above on a per share
basis
„ The results of the analysis should be analysed critically, considering the impact on the combined entity
market perception of the following:
§ Strategic rationale – scale? market leadership?
§ Quality of earnings – growth? risk?
§ Fair vs. market valuation of standalone companies
§ Premium paid – appropriate? aggressive?
§ Value uplift from synergies – synergy deal?
§ Multiple re-rating – would the combined entity multiple expand?
§ Optimal capital structure – credit rating impact?
§ Dividend policy – in line with the buyer?
3. Common Pitfalls
3.1. Calendarisation
„ Both buyer and target financials should be on the same calendar year to be comparable and
consequently consolidated on a like-for-like basis. The selected calendar year will, in most cases, be
the one of the acquiring company
3.2. Currency
„ Both buyer and target financials should be in the same currency to be comparable and consequently
consolidated on a like-to-like basis. The selected currency will, in most cases, be the one of the
acquiring company. Generally a spot exchange rate is used. However, for more precise analysis, the
use of a forward rate for each forecast year is recommended
„ Goodwill is not amortised but tested for impairment at least on an annual basis
„ Goodwill in a stock purchase is generally not tax deductible. However, it is recommended to check with
a tax consultant as tax rules vary depending on jurisdiction
„ The amount of goodwill is reduced by the write-up of assets or value of newly identified intangible
assets which are subsequently depreciated
„ Need to check whether outstanding bonds and other debt and credit facilities of the target have change
of control provisions
„ Are interest assumptions reasonable? What is the credit rating of the surviving entity?
„ Need to consider financing and advisory expenses for both buyer and target – if amortised and fully
expensed in year of the transaction, exclused from EPS calculation as exceptional items
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3.5. Options and Other Dilutive Securities
„ Need to be included in the equity purchase price
„ Usually dividend policy is aligned to buyer’s (e.g. buyer’s dividend per share). However, it is necessary
to assess potential change due to, for example, a high leverage of the combined entity post-acquisition
or specific features of the target’s shareholder base (e.g. interest in high dividends)
3.7. Synergies
„ Synergies, if being estimated by Credit Suisse, are calculated as a percentage of target / combined
entity sales, costs or EBITDA and not as a percentage of the combined Market Cap
„ Cash transaction
§ Cash has a P/E of: 1/(after-tax interest rate)
§ Use the same shortcut as above when considering whether a cash transaction would be accretive to
the buyer
§ If the P/E of cash is greater than the target P/E (at acquisition price), the transaction will be accretive
to the buyer’s shareholders
§ If the P/E of cash is higher than the buyer’s P/E, a cash transaction will be more accretive / less
dilutive than a stock transaction to the buyer’s shareholders, and vice versa
4. Examples
In the following example, the buyer acquires the shares of the target at a 10% premium to its current
share price. The implied purchase price of €49.5 billion is financed through three different financing
considerations: 100% cash, 100% stock and 50% cash / 50% stock.
The following data is used to assess the impact of the merger on the buyer’s projected financial
performance:
107
Valuation Metrics
Synergies
Dividends
„ The proposed dividend of the combined entity is equal to the dividend per share of the buyer
Financials
Target Summary Financials
(€ in millions, December year end)
108
4.1. 100% Cash Transaction
In a cash transaction, care should be taken of the treatment of the acquisition debt and its evolution over
the projected period. The amount of debt utilised will impact the interest expense as well as the taxes of
the company.
The following schedules layout not only the financials of the combined entity (including the impact of the
transaction: cost of financing, synergies, their tax implications and the dividend policy of the new entity)
but also the evolution of the acquisition debt and the implied leverage of the company.
Combined Entity
(€ in millions, December year end)
The following schedule analyses the impact of various share premia on the resulting accretion / dilution of
the deal for the Buyer’s shareholders as well as a contribution analysis.
109
Contribution Analysis
Combined Entity
(€ in millions, December year end)
The following schedule analyses the impact of various share premia on the resulting accretion / dilution of
the deal for the buyer’s shareholders. The accretion / dilution analysis can also be carried out on the
Target’s shareholders’ EPS as stock if offered as consideration, and therefore the target’s shareholders
remain invested in the combined entity. Contribution analysis remains the same.
110
Accretion / Dilution Analysis
Combined Entity
(€ in millions, December year end)
The following schedule analyses the impact of various share premia on the resulting accretion / dilution of
the deal for the buyer’s shareholders. Contribution analysis remains the same.
111
4.4. Acquisition of Minority Stake in a Consolidated Company
When dealing with the acquisition of a minority stake in a company already consolidated by the buyer, pay
attention not to duplicate the buyer and target’s financials in the combined entity financials.
Assuming the buyer already owns 80% of the target, the P&L financials will be equal to the buyer’s
financials – not to the sum of the buyer’s and target’s financials – with the exception of the adjustment
lines for the acquisition (acquisition debt interest and relative tax shield, synergies and taxes on
synergies) and the buyer net income minorities – equal to the share of the target net income not owned by
the buyer.
Higher or lower dividends paid by the combined entity should be calculated as the difference between the
combined entity dividends less the dividend paid by the buyer before the transaction and the dividend
paid by the target to the minorities before the transaction (effectively the cash leakage to the minorities).
The higher or lower dividends should be included in the acquisition debt schedule as they represent an
incremental positive or negative cash-flow to the buyer.
The following example assumes a 100% cash transaction on 20% of the target share capital, being 80%
already owned by the buyer. In the case of a cash and stock, or stock only transaction, the amount of
acquisition debt will decrease and buyer’s new shares will be issued to the target minorities.
112
Combined Entity
(€ in millions, December year end)
The following schedule analyses the impact of various share premia on the resulting accretion / dilution of
the deal for the buyer’s shareholders.
113
5. Case Studies
Please note that goodwill and asset write-ups are not cash tax deductible in any of the following
examples. There are no synergies assumed. Solutions can be found in the separate Investment Banking
Department Analysis Handbook – Solution Set.
5.1.1. Assumptions
Purchase Price Allocation
Tangible Identifiable
Stock Book Asset Intangible Unidentifiable
Price EPS P/E Shares Value Write-Ups Asset Write-Ups Intangibles
„ $12.50
„ $15.00
5.1.4. Scenarios
„ 100% stock financed
114
Pro Forma EPS Worksheet
Scenario 1: 100% Stock Financed
(in $, unless otherwise stated)
5.2.1. Assumptions
Buyer expects to pay $5.00 per share for each of Target’s 80 million shares (total of $400 million). Buyer
will assume Target’s liabilities of $50 million composed of current liabilities equalling $30 million and long-
term liabilities of $20 million. Additionally, Target’s current assets are composed of cash and liquid
115
investments equalling $30 million and other current assets of $40 million. The transaction would close on
31 December 2005. The expected tax rate is 30%.
„ Buyer purchases Target for $400 million in cash, using $200 million of existing cash and liquid
investments and borrowing the remaining amount through a long-term bank facility
„ Target has certain fixed assets on its books for $60 million that have a fair market value of $80 million.
Buyer has fixed assets on its books for $200 million, other current assets of $150 million, current
liabilities of $180 million and long-term liabilities of $140 million
„ Identifiable intangible assets are assumed to be $40 million post transaction (zero pre-transaction), and
are amortised over 20 years
„ Depreciation on write-ups of tangible assets and amortisation of identifiable intangible assets assumed
not to be tax deductible
Balance Sheets
($ in millions, unless otherwise stated)
Target Buyer
Dec 31, 2005 Dec 31, 2005
Assets
Cash/Liquid Investments 30 300
Other Current Assets 40 150
Fixed Assets 60 200
130 650
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Balance Sheet Impact Worksheet
($ in millions, unless otherwise stated)
Combined
Target Buyer Target / Transaction Entity
Dec 31, 2005 Dec 31, 2005 Adjustments Dec 31, 2005
Assets
Cash/Liquid Investments _______ _______ _______ _______
Other Current Assets _______ _______ _______ _______
Fixed Assets _______ _______ _______ _______
Identifiable Intangible Assets _______ _______ _______ _______
Goodwill _______ _______ _______ _______
_______ _______ _______ _______
117
Contribution Analysis
119
Contribution Analysis
1. Overview
„ A comparison of the contributions of the parties to the value of the shares received by each of them in
the NewCo
Conceptually, Contribution Analysis fits with Merger Consequences Analysis. While the Merger
Consequences Analysis will focus on the pro forma evaluation and thus help determine the size of the
merged entity (i.e. “size-of-the-pie”), the Contribution Analysis determines the exchange ratio and helps
determine the ownership split of a NewCo (i.e. how to “split the pie”).
The output of the Contribution Analysis shows the relative contribution of each party in a merger (based
on the financial benchmark selected) and the resulting implied equity ownership. Thus, Contribution
Analysis provides a framework to determine the exchange ratio and the right ownership percentage for
the respective merger parties in a NewCo based on a fair value consideration.
Item Source(s)
Historical Financial Statements „ Annual reports / company filings (IBD Library, company website,
Edgar, Perfect Information Pioneer)
„ Information memorandum / dataroom (buy-side)
Forecasts „ Client
„ Information memorandum / dataroom (buy-side)
„ Published equity research / industry / market research
„ CS equity research models (be aware of policies on communicating
with research analysts)
Industry multiples „ Compco Analysis (IBD Coverage Groups, CS Research)
121
1.4. What Does a Contribution Analysis Look Like?
The following table provides an illustration of a generic Contribution Analysis.
EBITDA (5)
„ Refer to Section 1 of Merger Consequences Analysis for detailed list of sources of information
122
2.2. What are the Inputs?
„ Multiple Drivers
§ Determining the multiple drivers to calculate the equity consideration (acquiror multiples, target
multiples, weighted average multiples, industry average multiples). Industry specific multiples based
on the Comparable Company Analysis usually provide a sound basis for this analysis
„ Time Periods
§ The time periods included in the analysis will be trailing (usually LTM), projected, or a combination of
the two. Usually a combination of LTM and projected data is preferable for the analysis
„ Multiples
§ The multiples that are included in the analysis will depend on the industry in which the company
operates. Multiples can include, but are not limited to, Sales, EBITDA, EBIT and Net Income.
Individual teams often use standard sets of multiples to value clients in certain industries. Refer to
the Comparable Companies Analysis chapter for examples of multiples used in different industries,
or alternatively, check proposed multiples against those used in recent equity research reports
123
3. Common Pitfalls
„ Impact of Growth
§ For companies with dramatically different growth projections, direct comparison can present a
problem. Implied equity based on near term financial metrics may understate the fair ownership of
the faster growing company, as future years will imply higher equity ownership for the fast grower, all
else being equal. Therefore, consider growth projection differentials when determining which
forecast year to use for base calculations
„ Capital Structure
§ Shifts in capital structure can skew the implied equity for a given multiple assumption because the
contribution analysis calculates an implied equity ownership based on multiples applied to Sales,
EBITDA, EBIT and so on. Net debt is subtracted from Enterprise Value to arrive at implied equity
contribution; thus temporary changes in capital structure (increasing or decreasing Net Debt level)
can have significant impact on implied ownership. If one of the companies in the analysis exhibits a
temporarily high or low gearing relative to historical or target capital structure, it may be worth
considering the use of a target optimal level of debt in the analysis
„ Number of Shares
§ A common mistake when calculating the exchange ratio is to use an incorrect number of shares
outstanding for acquiror and/or target. For the purposes of this calculation, the fully diluted number
of shares must be calculated. The dilution effect should take into account any financial instruments
convertible into shares that are exercisable at the transaction date (e.g. convertible bonds, share
options)
„ Sensitivity Analysis
§ As the contribution analysis depends on multiples assumed, capital structure and growth trajectories,
differences between the two companies on these metrics may drive different implied equity
ownerships. It is important to realise that the contribution analysis is only a tool for analysing the
contemplated exchange ratio. It is thus useful to perform a sensitivity analysis with different
exchange ratios to analyse implied ownership at various ratios and interpret the output in the context
of the companies’ specific multiple, capital structure, growth projections and the resulting implied
exchange ratio
4. Case Study
This case study demonstrates the mechanics of a Contribution Analysis. Solutions can be found in the
separate Investment Banking Department Analysis Handbook – Solution Set.
Acquiror, a public company, is considering a merger with Target by issuing primary shares of common
stock.
124
4.1. Case Study Inputs
Assume the following to calculate pro forma Enterprise Values and exchange ratios:
125
Pro Forma EBITDA
Calculate Target’s Enterprise Value and Equity Value using industry average EBITDA multiples.
Calculate Acquiror’s Enterprise Value and Equity Value using industry average EBITDA multiples.
„ Complete similar calculations for Enterprise Value based on industry Sales multiples and for Equity
Value based on industry Net Income multiples
„ Calculate implied equity contribution using the equity values calculated above and complete the
Contribution Analysis sheet below
EBITDA
LTM
FY 2006E
FY 2007E
Net Income
LTM
FY 2006E
FY 2007E
Enterprise Value
Directions: Complete the Contribution Analysis using the outputs calculated on the previous pages.
126
Discounted Cash Flow Analysis
127
Discounted Cash Flow Analysis
1. Overview
„ By determining the NPV of the expected future cash receipts and outflows (i.e. cash flow) generated by
such enterprise or asset to all providers of capital (i.e. the unlevered FCF)
„ Using the weighted average cost of capital (“WACC”) as a discount rate to reflect the time value of
money and the riskiness of the cash flows
Advantages Disadvantages
p Provides intrinsic value as opposed to market- q Highly sensitive to assumptions used to derive
based value, i.e. less influenced by volatile projected cash flows (potential issue of “garbage
public market conditions in, garbage out”)
p Allows reflection of company/asset-specific q Highly sensitive to assumptions used to derive
factors terminal value – terminal value typically represents
a substantial component of total value
p Best captures businesses in transition
p Allows a valuation of the different value
components of a business or of synergies
separately from a business
p Allows a detailed assessment of alternative
strategies through formulation of alternative
cash flow projections
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DCF Valuation Output – Example
Projections Normalised
Step 1
2006E 2007E 2008E 2009E 2010E 2011E 2012E 2013E 2014E 2015E 2015E
Net Sales 1,945.1 2,091.0 2,237.3 2,385.0 2,536.3 2,688.5 2,836.4 2, 978.2 3,127.1 3,283.4 3,349.1 Information Gathering
Growth 7.5% 7.0% 6.6% 6.3% 6.0% 5.5% 5.0% 5.0% 5.0%
EBITDA 278.1 305.3 335.6 357.7 380.4 403.3 425.5 446.7 469.1 492.5
Adjustments 1.6 1.6 1.7 1.7 1.8 1.8 1.9 2.0 2.0 2.1
EBITDA (adjusted) 279.7 306.9 337.3 359.5 382.2 405.1 427.3 448.7 471.1 494.6 502.4
% of sales 14.4% 14.7% 15.1% 15.1% 15.1% 15.1% 15.1% 15.1% 15.1% 15.1% 15.0% Step 2
Depreciation (74.6) (77.9) (81.7) (86.2) (91.3) (97.1) (103.6) (110.8) (118.6) (127.0)
Forecasts
EBITA 205.1 229.0 255.6 273.3 290.9 308.0 323.7 337.9 352.5 367.5
+/- Other (non-operating) income/expense
% of sales 10.5% 11.0% 11.4% 11.5% 11.5% 11.5% 11.4% 11.3% 11.3% 11.2%
Adjusted EBITA (tax base) 205.1 229.0 255.6 273.3 290.9 308.0 323.7 337.9 352.5 367.5 359.2
% of sales 10.5% 11.0% 11.4% 11.5% 11.5% 11.5% 11.4% 11.3% 11.3% 11.2% 10.7%
Tax on Adjusted EBITA (61.5) (68.7) (76.7) (82.0) (87.3) (92.4) (97.1) (101.4) (105.8) (110.3) (107.8) Step 3
Marginal tax rate 30.0% 30.0% 30.0% 30.0% 30.0% 30.0% 30.0% 30.0% 30.0% 30.0% 30.0% Terminal Year
NOPAT 143.6 160.3 178.9 191.3 203.7 215.6 226.6 236.5 246.8 257.3 251.4 Normalisation
+ Depreciation 74.6 77.9 81.7 86.2 91.3 97.1 103.6 110.8 118.6 127.0 143.2
% of capex 82.9% 82.8% 81.1% 80.3% 80.0% 80.3% 81.2% 82.6% 84.2% 86.0% 95.0%
- Capital Expenditure (90.0) (94.1) (100.7) (107.3) (114.1) (121.0) (127.6) (134.0) (140.7) (147.8) (150.7)
% of sales 4.6% 4.5% 4.5% 4.5% 4.5% 4.5% 4.5% 4.5% 4.5% 4.5% 4.5%
+ Decrease / (Increase) in NWC (36.2) (36.0) (36.5) (35.8) (36.6) (36.8) (35.8) (34.3) (36.1) (37.9) (15.9) Step 4
% of Absolute Change in Net Sales (25.1%) (24.7%) (24.9%) (24.2%) (24.2%) (24.2%) (24.2%) (24.2%) (24.2%) (24.2%) (24.2%) Terminal Value
+/- Change in Other Non-Cash Items – – – – – – – – – – – Calculation
+ Decrease / (Increase) in Provisions 0.5 1.1 1.1 1.1 1.2 1.2 1.3 1.3 1.3 1.4 –
Unlevered Free Cash-flow 92.0 108.1 123.4 134.4 144.2 154.9 166.8 178.9 188.5 198.7 228.0
Period discounted (years) 0.25 1.0 2.0 3.0 4.0 5.0 6.0 7.0 8.0 9.0
Participation in Yearly Cash Flow 50.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%
WACC 8.5% 8.5% 8.5% 8.5% 8.5% 8.5% 8.5% 8.5% 8.5% 8.5%
Discount factor 0.98x 0.92x 0.85x 0.78x 0.72x 0.66x 0.61x 0.56x 0.52x 0.48x Step 5
Discounted Unlevered Free Cash-flow 45.1 99.6 104.8 105.2 104.0 103.0 102.2 101.1 98.1 95.3 Determining WACC
Calculation of Enterprise Value (EBITDA Exit Multiple) Calculation of Enterprise Value (Perpetuity Growth Rate)
EBITDA 502.4 Unlevered Free Cash Flow 228.0
EBITDA Exit Mult iple 7.0x Perpetuity Growth Rate 2.0%
Terminal value 3,516.6 Terminal Val ue 3,653.5
Discount factor 0.46x Discount fact or 0.46x
Step 6
Discounted Terminal Value 1,619.6 Discounted Terminal Value 1,682.6 Calculation of
Enterprise Value
Sum of PV of Free Cash Flows 958.4 Sum of PV of Free Cash Flows 958.4
Enterprise Value 2,578.0 Enterprise Value 2,641.0
Calculation of Equity Value (EBITDA Exit Multiple) Calculation of Equity Value (Perpetuity Growth Rate)
Enterprise Value 2,578.0 Enterprise Value 2,641.0
- Existing Debt (399.2) - Existing Debt (399.2) Step 7
- Pension Liabilities (35.5) - Pension Liabilities (35.5) Calculation of
- Minority Interest (26.3) - Minority Interest (26.3) Enterprise Value
- Preferred – - Preferred – Adjustments and
+ Existing Cash & Cash Equivalents 188.5 + Existing Cash & Cash Equivalents 188.5
Equity Value
+ Book Value of Unconsolidated Assets – + Book Value of Unconsolidated Assets –
Total Adjustments (272.4) Total Adjustments (272.4)
Implied Equity Value 2,305.6 Implied Equity Value 2,368.6
2. How to Complete a DCF Analysis
2.1.1. Forecasts
The DCF analysis aims at deriving the present value of expected future cash flows generated by an
enterprise / asset. Towards this aim, project the series of future cash flows expected to be available to all
providers of capital (i.e. the unlevered FCF) over the explicit forecasting horizon.
Unlevered FCF
The schedule below outlines the key building blocks of unlevered FCF. It should be noted that the
specifics of the individual case will need to be reflected. It is important to include in the derivation of
unlevered FCF all projected cash flows which are i) not related to the financing of the asset / enterprise or
ii) not related to items treated as Enterprise Value adjustments (e.g. non-operating assets and minority
interest). Also appropriately account for deferred taxes and provisions (see the section “Selected Special
Items / Adjustments” for a detailed discussion on those items).
1.
+ Revenues Price and volume forecast
Revenue Model
– Variable Costs
= Gross Profit
= EBIT
Planned Investments
Average useful life of
– Corporate Tax (on EBIT) existing and new fixed
assets
4. = Unlevered Net Income
Dpn and
Capex Matrix Effective tax rate
Existing tax relief's
+ Depreciation and Amortisation
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Forecasting
The key to forecasting is to understand the industry and to understand the business. Briefings from senior
team members and a review of research reports on the sector and on peers will provide a good grounding
on which to build. Further, undertake a detailed analysis of historical financials – 3 years is good, 5 years
better – to understand growth rates, margin development (when forecasting, drive EBITDA margin, not
EBIT margin to avoid implausible reactions of the model to sensitivities in revenue growth), one-off items,
cost reduction programs, working capital development, capital expenditure levels and so on.
When developing projections, typically aim to separate costs which are variable by nature (i.e. they are
linked to activity levels) and costs which are essentially fixed by nature (i.e. at least in the short term they
are not impacted by changes in activity level). Variable costs (i.e. primarily cost of goods sold) are
typically projected as a percentage of sales, whereas fixed costs (i.e. primarily selling, general and
administrative expenses), are typically projected via a relevant growth rate (e.g. inflation, salary inflation).
The resulting positive impact of revenue growth on profit margins is called operating leverage. Bear in
mind however, that in the long run even fixed costs will be impacted by activity levels (i.e. operating
leverage has its natural limits). Hence, depending on the specifics of the situation, it may be appropriate
to at least partially link fixed costs to the development of revenues.
For key drivers, also consider scenarios / sensitivity analyses to the base case forecast to derive further
data points for valuation conclusions.
Once the forecasts have been developed, ensure that assumptions are critically questioned and an
explanation of the development of key items can be provided. In particular, ask questions such as the
following:
„ Do the projections overall appear reasonable and not overly optimistic or pessimistic?
„ Is there sound reasoning for any unusual changes in growth rates and margins (i.e. fluctuations in
ratios between years) - beware of “hockey sticks”?
„ If the business operates in a cyclical sector, do the projections reflect the cyclical nature of the sector
(i.e. continuously growing revenues and operating profits are likely not realistic)?
„ Does the business undertake sufficient Capex to support the projected growth? Is any expansion in
asset productivity (sales / fixed assets) realistic?
„ Does the business have sufficient working capital and are any projected improvements in working
capital management (i.e. reduction in working capital days) realistic?
„ Are the business’s returns on capital consistent with the competitive dynamics of the overall sector?
Projection Period
The first step is to decide on the length of the explicit projection period, which should reflect a reasonable
trade-off between the ability to develop meaningfully detailed assumptions (e.g. availability of forecast
data from management or other sources such as equity research analysts) vs. having a sufficiently long
period to reach a performance level characteristic of a steady state (i.e. where growth rates and margin
levels have reached what is considered a long-term sustainable level and where the expected return on
incremental invested capital is equal to the cost of capital). Key factors which impact on the time required
to reach a steady state include:
„ High growth: in less mature industries, growth rates tend to be significantly above the long-term growth
rates that can be expected once maturity has been reached. The projection period should be long
enough to allow for a gradual decline in growth rate towards steady state and thus to capture the value
of the above-average growth
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„ Cyclicality: the forecast period should be long enough to allow the cycle to play out over an up- and
down-cycle before reaching a mid-cycle level at the end of the projection period
„ Known extraordinary influences or fundamental changes in the cash flow profile which could not be
captured in the terminal value: the projection period should be long enough to capture such changes
before the terminal year
„ Finite asset life (e.g. individual oil fields, mines, nuclear power plants, licences): cash flow projections
are typically generated for a period capturing the entire life span of such assets
Credit Suisse typically uses a 10-year projection period, however, individual cases may justify a shorter or
longer period.
Level of Detail
The key task in deriving projected cash flows is to identify and project growth rates and/or levels of key
value drivers relevant to the business. As such, the forecast model should be sufficiently detailed to
reflect all key drivers with which to develop reasonable assumptions, while not being overly detailed and
thereby detracting from what really matters. Remember that a clear and credible explanation of the model
will be expected by senior team members and the client.
Prepare financial forecasts in nominal terms (i.e. the development of revenues and costs includes inflation
in future years), if at all possible and discount such cash flows at a nominal discount rate:
„ Financial statements typically stated in nominal terms (in particular relevant for depreciation)
Nominal cash flows grow at the compound product of the actual inflation rate and the real rate of growth.
The “nominal cash flow / nominal discount rate” approach will typically allow for the capture of economic
aspects of the relationship between depreciation and taxes.
„ For most jurisdictions, and in particular where inflation accounting is not applicable, the nominal cash
flows / nominal discount rate approach captures the distortion whereby historical cost assets cause
cash flows to be less than they would be with current cost assets due to the lower tax shield afforded
by lower depreciation. Depreciation is tied to historical costs (not to the inflation-adjusted current
value); as inflation rises, firms may not deduct enough depreciation expense to replace assets (even
4
though Capex grows with inflation)
„ Consequently, firms may overpay taxes – this is an actual economic cost to investors, which tends to
be ignored by the real cash flows / real discount rate approach
There may be situations where forecasting in real terms can be appropriate (e.g. in hyper-inflation
economies), however discuss with team members before deciding on forecasting in real terms. Note that
if financial projections are forecast in real terms, it will be necessary to adjust factors such as terminal
multiples, terminal growth rates and the cost of capital to remain consistent in the valuation approach.
Base case forecasts for the business should in most cases be prepared on a stand-alone basis, i.e. the
base case should ideally be a business plan which the company is expected to be able to achieve on its
own.
Synergies, i.e. value creation made possible only through a change in ownership or business combination
should, to the extent possible, be excluded from the base case. Their value should be determined as a
separate exercise.
4
This may not be relevant in jurisdictions where taxation is not calculated based on historical depreciation
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improved management skills either internally or through external recruiting or whether the specific
management skills are proprietary to a prospective new owner or merger partner.
Any scale economies (i.e. improvements in revenues or costs which derive from enhanced scale) and
cost of capital economies should be considered true synergies and evaluated separately from the base
case.
„ Synergies often require restructuring measures or other adaptations of the business model which lead
to one-time costs before synergies are realized
„ The implementation of synergies often takes time, i.e. the benefits often only materialize over time
„ In certain situations (e.g. consolidating sectors, regulated businesses, contracting sectors) synergy
benefits are often passed on to customers in the form of price reductions over time, i.e. synergies do
not always have a terminal value
Synergies can be valued either in a separate, simplified cash flow model or as part of a synergy case,
where the value of the synergies is the delta between the EV of the synergy case and the EV of the base
case.
When evaluating synergies in a simplified cash flow model, it is important to bear in mind that synergies
are typically projected on a pre-tax basis and need to be tax-effected for valuation purposes. Also, bear in
mind that Capex synergies lead to a reduction in D&A in the future and hence to an increase in tax
payments.
Note that the synergy value derived via the two approaches will differ. This difference can sometimes be
significant, as a simplified model will typically not capture all the impacts synergies have on the business’s
cash flow. The key drivers of such difference will typically be the failure to fully capture the impact of:
„ Capex
§ Capex is typically directly linked to future sales expectations, as growth needs to be supported by
capacity. Revenue synergies will typically require upfront Capex spend, which may not be captured
in a simplified model
In a typical DCF analysis, the terminal value will often account for more than 50% of the total value. It is,
therefore, essential to treat the terminal value calculation as a separate valuation exercise and to properly
consider the factors entering the terminal value calculation. In an ideal DCF analysis, financials are
projected into the future long enough so that they will have reached a steady state by the final explicit
forecast year. In practice, it may, however, be necessary to make normalisation adjustments to the
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financial results projected for the final year of the projection period before using such results as basis for
the terminal value calculation (see the section “Terminal Year Normalisation”).
Use two primary methods to calculate terminal value, the mechanics of which are discussed in detail
further below:
„ Multiple method
Note that the WACC to be used in a DCF analysis is specific to the asset being valued, and should not, in
theory, depend on the potential buyer’s or seller’s cost of capital. Further, the WACC should be based on
the optimal capital structure for the asset rather than on how the asset will be financed in practice. The
optimal capital structure is one which minimises the overall cost of capital by balancing the positive impact
of increased leverage (higher proportion of cheaper debt financing) vs. the negative impact of increased
leverage (increasing riskiness of debt financing leading to increasing cost of debt financing). Note that the
optimal capital structure is not readily observable. Seek guidance from the benchmarking of comparable
companies’ capital structures and the analysis of the impact of increased leverage.
In certain instances, in particular where a company’s lifecycle is projected to enter a new stage towards
the end of the explicit forecast horizon, it may be appropriate to consider discounting the terminal value
using a different WACC than that used for the discounting of the cash flows in the explicit forecast
horizon. This would reflect a potentially different risk profile of the business after it has entered a new
phase of the lifecycle. This may also reflect the more stable nature of companies located in some
emerging economies, where going forward one may expect a significant economic convergence with
mature economies. Bear in mind however that i) the appropriateness of such approach is subject to
considerable debate and ii) such approach is often quite difficult to rationalize vis-à-vis clients. Therefore,
if considering applying such approach, discuss in detail with the team.
„ Financial debt
„ Minority interest(s)
„ Non-operating assets and investments, to the extent cash flow from such non-operating assets has
been excluded from the unlevered free cash flows
If in doubt about the appropriate treatment of any item, the primary question should always be whether
the positive or negative value contribution of such item is already economically captured in the cash flows
used to derive the Enterprise Value.
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2.1.5. DCF Matrix
The results of the DCF analysis are typically presented in the form of a DCF matrix, in which Enterprise
Value is shown for a range of discount rates as well as a range of terminal value multiples / growth rates.
(€ in m illions, FYE December 31)
9.00% 938 39.4% 938 37.7% 938 36.1% PV of Unlevered FCF (2006E - 2015E) 938 39.3% 938 38.5% 938 37.6% 9.00%
1,440 60.6% 1,550 62.3% 1,661 63.9% PV of Terminal Value 2015E 1,447 60.7% 1,499 61.5% 1,555 62.4%
2,377 2,488 2,599 Enterprise Value 2,385 2,437 2,492
(272) (272) (272) EV Adjustments (current) (272) (272) (272)
2,105 2,216 2,326 Equity Value (m) 2,113 2,165 2,220
27.0 28.4 29.8 Value per Share 27.1 27.8 28.5
6.9x 7.2x 7.6x Implied EV / 2007E EBITDA Multiple 7.8x 7.9x 8.1x
1.7% 2.2% 2.6% Implied FCF perpetuity growth rate / 6.5x 6.8x 7.0x
Implied 2015E EV / EBITDA multiple
8.50% 958 38.9% 958 37.2% 958 35.6% PV of Unlevered FCF (2006E - 2015E) 958 37.2% 958 36.3% 958 35.4% 8.50%
1,504 61.1% 1,620 62.8% 1,735 64.4% PV of Terminal Value 2015E 1,620 62.8% 1,683 63.7% 1,750 64.6%
WACC
2,462 2,578 2,694 Enterprise Value 2,579 2,641 2,708
WACC
7.50% 980 38.4% 980 36.7% 980 35.1% PV of Unlevered FCF (2006E - 2015E) 980 34.9% 980 34.0% 980 33.1% 7.50%
1,571 61.6% 1,692 63.3% 1,813 64.9% PV of Terminal Value 2015E 1,824 65.1% 1,900 66.0% 1,983 66.9%
2,551 2,672 2,793 Enterprise Value 2,804 2,880 2,963
(272) (272) (272) EV Adjustments (current) (272) (272) (272)
2,279 2,399 2,520 Equity Value (m) 2,531 2,607 2,690
29.2 30.8 32.3 Value per Share 32.5 33.4 34.5
7.4x 7.8x 8.2x Implied EV / 2007E EBITDA Multiple 9.1x 9.4x 9.7x
0.8% 1.3% 1.7% Implied FCF perpetuity growth rate / 7.5x 7.9x 8.2x
Implied 2015E EV / EBITDA multiple
„ Margins
„ Capex
The list of potential sensitivity variables is endless. However, the focus should be on those factors which
have the greatest uncertainty and/or the greatest value impact.
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2.2. What Are the Inputs / Where Do I Find the Information?
The following table provides an overview of the DCF inputs and their sources.
Item Sources
Historical Financial Statements „ Annual reports / company filings (IBD Library, company web
site, Edgar, perfect Information)
„ Information memorandum / dataroom (buy-side processes)
Projected Financial Statements „ Client
„ Information memorandum / dataroom (buy-side processes)
„ Published equity research reports (use individual forecasts of
highly rated research analysts to construct consensus estimates
– don’t use IBES consensus without understanding the
underlying individual projections)
„ CS equity research models (be aware of policies on
communicating with research analysts)
„ Macroeconomic research
„ Industry / market research
WACC – Cost of Equity Beta
„ Barra
„ Bloomberg
Equity Risk Premium
„ CS equity research (weekly ERP sheet)
„ Ibbotson
„ Discuss with team members
Risk free rate
„ Spider
„ DCM
„ FT
WACC – Cost of Debt Risk free rate
„ See above
Borrowing spread
„ DCM
WACC – Target Capital Structure „ Compco analysis
„ Discuss with team members
„ Ratings advisory team
Terminal Value – Perpetual Growth Rate „ Long-term inflation
„ Long-term GDP / market / industry growth estimates
„ Equity research
Terminal Value – Normalized Multiple „ Compco Analysis
„ Comparable Transactions Analysis
„ Enterprise Value and Equity Value calculation listing all Enterprise Value adjustments
„ DCF matrix
„ Sensitivity tables
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2.4. Mechanics of the Analysis – Best Practices
The standard NPV formula in Excel as well as the standard approach to discounting individual cash flows
implicitly assumes that cash flows are received at the end of the period (normally each year). In the
majority of businesses this assumption is incorrect, as in reality cash flows are typically received in a
smoother pattern throughout the period. The mid-year convention addresses this issue by adjusting the
present value formula to accelerate the receipt of cash flows by half a period. Mathematically, this
approximates spreading out the cash flow across the period on the assumption of a uniform distribution of
cash flows throughout the period.
(€ in millions)
22 23 24
Actual Cash Flow 12 10 13 11 12 14 10 11 13
Profile
175
Implicit Profile of
Year-end
Discounting
J an Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
175
Implicit Profile of
Mid-year
Discounting
Jan Feb Mar Apr May Jun J ul Aug Sep Oct Nov Dec
The conversion of end-year cash flows to mid-year cash flows is a simple reversal of the effect of
discounting for half a year:
0.5
Mid-year Cash Flow = End-year Cash Flow
* (1+r)
where r = cost of capital
In many instances, the valuation date will not coincide with the start of the financial year of the business
being valued. Also, by the valuation date a portion of the first year’s cash flow will already have accrued
to the business and as such will already be captured in the Enterprise Value adjustments (Net
Debt/Cash).
It is, therefore, important to ensure that cash flows are discounted back to the appropriate point in time
and that any portion which has already accrued to the business is excluded from the first year’s cash flow.
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Partial Year Valuation – Illustration of Concept
Cash Flow
Valuation date:
01.08.06
End-Year
Cash Flow
Exclude Discount Discount Discount
5 months 17 months 29, 41, etc. months
Or
Mid-Year
Cash Flow
Exclude Discount Discount Discount
2.5 months 11 months 23, 35, etc. months
Where the valuation date (i.e. assumed transaction effective date) falls within the first forecast year as
opposed to the beginning thereof, the first year cash flow must also be adjusted to exclude any cash flow
occurring before the valuation date. Unless there is a known seasonality or a significant one-off cash flow
event (e.g. a large one-off Capex spend before or after the valuation date) which would dictate otherwise,
this is simply done by reducing the first year cash flow pro rata for the time.
As a first step, the cash flow occurring prior to the valuation date should be deducted from the first year
cash flow to arrive at a pro forma cash flow for valuation purposes.
As a second step, it is necessary to understand what happens with such cash flow by the valuation date,
i.e. whether it stays with the enterprise or whether it is returned to the owners (e.g. by way of a special
dividend). If it stays with the enterprise, it will lead to a reduction in Net Debt / increase in Net Cash
relative to the Net Debt/Cash position at the start of the year so ensure that the Enterprise Value
adjustments adequately capture the cash flow.
To discount back to the appropriate time, two approaches can be taken depending on the method used
for discounting:
If using the NPV formula, it is necessary to partly reverse the discount for the difference in time between
the start of the first forecast year and the valuation date. As an example, if the first forecast year starts on
1 January 2006 and the valuation date is 1 August 2006, reverse the effect of discounting by 7/12 of one
year:
7
PV = NPV (r, Cash Flows ) ∗ (1+ r )12
where r = cost of capital
If discounting individual cash flows, then directly adjust the number of years being discounted by the
fraction of the first year that has already elapsed. Again, on the basis of the previous example:
CF1 CF2
PV = + + etc.
7 7
( ) ( )
1 + r 1 − 12 1 + r 2 − 12
where r = cost of capital
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Note that when combining the concepts of partial-year cash flows and mid-year cash flows, the
combination of the formulas above will lead to a slight imprecision as the partial-year cash flow in year 1
will be discounted for the wrong period.
Example
7 13
PV of Year 1 cash flows at 01.08.06 = NPV(r, CF1 ) * (1+ r) 0.5
* (1+ r) 12 = NPV(r, CF1 ) * (1+ r) 12
a b
Given the valuation date of 1 August 2006, the partial-year cash flow in year 1 on average accrues in mid-
October. Hence, as the NPV formula has discounted the cash flow back to 1 January 2006, discounting
(of CF1 only!) would need to be reversed by 9.5 months (rather than 13 months) to bring it to the valuation
date.
In most instances, the impact of this on the derived Enterprise Value will however be marginal and can be
ignored. In cases where this has a material impact (i.e. the first year cash flow is extraordinarily high, you
will need to discount each year’s cash flow separately rather than using the NPV formula.
„ Multiple method
In addition, fade models are becoming increasingly common as an alternative Terminal Value approach.
Fade models determine terminal value based on an assumed development of value creation over time,
i.e. the assumption (supported by Credit Suisse HOLT research) that a company typically does not
produce excess returns in the long term but rather that its return on capital approaches its cost of capital
in the long term.
Multiple Method
This method implicitly assumes that the business is sold at the end of the final forecast year either in the
private or the public market. The choice of multiples will depend on which exit scenario is considered
most appropriate for valuation purposes:
„ Compacq: assumes sale in the private market (i.e. through an M&A transaction)
„ Multiples applied need to be consistent with the steady state assumption underlying the terminal value
concept
§ The Terminal Value calculation should be based on the most appropriate multiple (or multiple range)
for the company’s sector (i.e. the multiple on which the sector mainly trades today)
§ In cyclical industries, it is important to select a terminal multiple which can be considered
representative for the business at the mid-point of the cycle
§ In less mature / high growth industries, consideration needs to be given to the impact of slowing
growth rates and possibly stabilising margins on multiples, e.g. multiples observed at present for
high-growth sectors will be potentially significantly higher than multiples to be expected once the
sector growth has slowed towards the end of the projection period. Bear in mind that the terminal
multiple represents eternity, i.e. ask whether the implicit growth rate is sustainable on a permanent
basis
§ Theoretically, depending on the tax regime governing the enterprise, a disposal may trigger tax
liability on the capital gain. Such capital gains tax would reduce the terminal value of the enterprise
if an exit were to take place. However, in the majority of cases, also apply the multiple method as a
proxy for the terminal value in cases where it is not actually expected that the business be sold after
140
the projection period. In such cases, it is clearly inappropriate to reduce the terminal value for a
theoretical tax liability. Judgement is required to determine the appropriate treatment in each specific
situation – discuss this with team members if in doubt
„ Financial metric (e.g. EBITDA) and multiple applied must be consistent: trailing vs. forward multiple
§ Correct: Terminal Value = EBITDAn ∗ LTM multiple , or
§ Correct: Terminal Value = EBITDAn ∗ (1+ g) ∗ FY1multiple , where g = long-term nominal growth
rate
§ Wrong: EBITDAn ∗ (1+ g) ∗ LTM multiple produces Terminal Value at the end of year n+1
„ When valuing the enterprise, the Terminal Value calculation must be based on the Enterprise Value
concept (e.g. Sales, EBITDA, EBIT, Asset Value Multiple). When valuing equity cash flows, Terminal
Value must be based on Equity Value Concept (e.g. P/E, Equity Book Value Multiple)
„ The multiple method values the Terminal Value as per 31 December of year n / 1 January of the
perpetuity period. Ensure the correct discounting factor is applied (i.e. when using mid-year cash flow
convention, the discounting factor used for final year cash flow is different from the discounting factor to
be used for discounting Terminal Value)
When applying the multiple method, the implied perpetual growth rate should be calculated as a sanity
check:
WACC ∗ TV − UFCFn
Implied Perpetual Growth Rate =
TV + UFCFn
or
This method assumes that the business continues to generate FCFs that grow at a constant rate into
perpetuity. The implicit assumption of applying the perpetual growth method is that rather than selling the
business at the end of the explicit forecast period, the business is held into perpetuity.
UFCFn+1
Terminal Value =
(r − g)
where: UFCFn+1 = Unlevered FCF in period n+1
g = perpetual growth rate
r = Weighted Average Cost Of Capital (WACC)
The unlevered FCF in period n+1 can either be calculated as UFCFn * (1+g) or, if the model contains a
normalisation of the final year (where the normalised year includes a revenue growth factor relative to the
year n of the model) the normalised UFCF can be taken straight from the normalisation schedule.
Note that the perpetual growth formula is implicitly based on the end-year convention, i.e. it assumes that
cash flows accrue at the end of a given financial year. Further, the formula computes the Terminal Value
as per the end of year n. When calculating the DCF value and applying the mid-year convention, it is,
therefore, necessary to adjust the Terminal Value to also reflect the mid-year convention:
UFCFn+1
Terminal Value = ∗ (1+ r )
0.5
(r − g)
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Further, note that such Terminal Value continues to represent value at the end of year n and needs to be
discounted to the present time by applying the appropriate number of years.
When applying the perpetual growth method, the implied Terminal Multiple should be calculated as a
sanity check:
TV
Implied Terminal Multiple =
Relevant Metric (e.g. EBITDA)n
Note that all formulas provided here need to be adjusted when basing the calculation on the normalised
final year where the normalisation includes revenue growth at the perpetuity growth rate, i.e. turning the
final year EBITDA / UFCF into a EBITDA/ UFCF in year n+1.
Apply a terminal growth rate which is close to the expected long-term growth of the economy, if
appropriate for the specific business (and its sector) being valued. Note that the typical measure of
underlying economic growth, i.e. GDP growth, is often – but not always – projected on a real basis by
economic research. For the purposes of setting the perpetuity growth rate, ensure that the impact of
expected long-term inflation is considered, as the model is typically based on nominal cash flows.
Fading Cash Flow Analysis (In Lieu of a Traditional Terminal Value Analysis)
Over the long term, firms’ cash flows tend to be subject to a competitive life cycle. Empirical studies
indicate that competition tends to compress returns toward a long-term average. The company generates
value as long as its average returns on capital are higher than the average cost of capital.
Returns On Capital and Steady State As Part of a Company Life Cycle (Illustrative)
Competitive pressures
Cost of capital
(investor’s required
rate of return)
In principle, the Terminal Value should be applied after the valued company has reached a steady state.
A steady state is reached when incremental returns on capital are equal to the cost of capital – meaning,
the original capital will continue earning fading returns, but no value will be created on incremental
investments.
Traditionally however, an explicit forecast horizon – after which a Terminal Value is calculated – is chosen
somewhat arbitrarily (e.g. five or ten years) and the majority of a company’s value is embedded in the
Terminal Value. A problem is that this arbitrary explicit forecast horizon may miss (be significantly short
of) a point in the forecast when a steady state has been reached. Missing this point may mean either a
systemic overvaluation (when incremental returns on capital embedded in Terminal Value are perpetually
above the cost of capital) or a systemic undervaluation (when the incremental returns on capital are below
the cost of capital). The shorter the explicit forecast horizon, the bigger the problem.
142
A solution may be to apply the concept of a fading cash flow, which simply means gradually fading the
5
company’s returns on capital (ROIC or CFROI ) over a relatively long period of time (e.g. over 20 or 40
years) – until the point when average returns on capital are close to the cost of capital. As a result, the
Terminal Value is calculated in the steady state period (or close enough to such state). Consequently, the
value embedded in the Terminal Value is relatively low and – by the virtue of the time value of money –
any potential mistakes associated with the Terminal Value assumptions are less meaningful for the
valuation.
In terms of mechanics of the fade, research by Credit Suisse HOLT shows that in the long-term horizon
the delta between the returns on capital and the cost of capital tends to decrease by 10% exponentially
every year over a 100 year period. This is an assumption which can be employed in the model after the
explicit forecast horizon. Consequently, if one assumed no Terminal Value (returns fading long-term to the
cost of capital and growth fading to a long-term economy growth), the company’s cash flow and growth
evolution would follow a pattern similar to that depicted in the following chart.
Fading DCF: Company’s Capital Growth, Return on Capital and Cost of Capital (Example)
Explicit / CAP
Forecast Fade
60% Period Period
40%
30%
10%
5
ROIC (return on invested capital) = NOPLAT / Invested Capital, where NOPLAT is a net operating profit less adjusted taxes
(appropriately accounting for the tax shield), and invested capital is:
Operating net working capital (operating current assets – non-interest-bearing current liabilities)
+ Net PP&E
+ Other operating assets net of other liabilities
Operating invested capital (ex goodwill)
+ Goodwill
Operating invested capital (incl. goodwill)
+ Excess cash and securities
+ Non-operating investments
= Invested Capital
CFROI (cash flow return on investment) is the cash flow a business generates in a given year as a % of the cash invested to fund
assets used in the business. CFROI = (Gross Cash Flow – Economic Depreciation) / Gross Investment.
143
Terminal Year Normalisation
The Terminal Value calculation should be based on financials reflective of a long-term steady-state which
the enterprise can be expected to achieve. While it is reasonable to expect that financial forecasts over
the explicit forecast horizon will often trend towards such a steady state, it is typically an advisable and
common practice to normalise the EBITDA (or other metric) needed for the multiple method and the
UFCF needed for the perpetual growth method.
Typical normalisation adjustments which may be considered and discussed with the team include:
„ EBITDA margin
§ Consider whether EBITDA margins in the explicit forecasts are sustainable in the very long run vis-
à-vis the competitive environment, market dynamics, peer performance and so on
„ Tax rate
§ Normalisation will be appropriate to the extent tax loss carry-forwards or other non-permanent
effects lead to a deviation of the actual tax rate from the statutory tax rate during the explicit
projection period
Please note that appropriate normalisation adjustments depend on the individual case and require
judgement calls which should be discussed with the team.
Also note that adjustments to the Terminal Value formulas outlined above may be required if
normalisation includes a growth element, making the final EBITDA / UFCF effectively an EBITDA / UFCF
in year n+1.
Refer to section 4, step 3, of this chapter for an example of a normalisation for the terminal year.
144
2.4.3. WACC
To value a company using enterprise DCF, one discounts FCF by the weighted average cost of capital
(WACC). WACC represents the investors’ opportunity cost for investing in a particular business instead of
others with a similar risk.
WACC is the market-based weighted average of the after-tax cost of debt and cost of equity:
D E
WACC = kd (1-Tm )+ ke
V V
where:
D
= target level of debt to Enterprise Value
V
E
= target level of equity to Enterprise Value, using market-based values
V
kd = pre-tax cost of debt
ke = cost of equity
Tm = company’s marginal income tax rate
For companies with other securities, such as preferred stock, additional terms must be added to the cost
of capital, representing each security’s expected rate of return and percentage of total Enterprise Value.
P
= target level of preferred stock to Enterprise Value, using market-based values
V
kp = cost of preferred stock
Example:
D E P
WACC = kd (1-Tm )+ ke + kp
V V V
The cost of capital does not include expected returns on operating liabilities, such as accounts payable.
Required compensation for such funds is included in operating expenses, such as cost of goods sold (and
is already incorporated in FCF).
145
Components of WACC
kd kp ke
„ WACC must include the opportunity cost from all sources of capital, since FCF is available to all
investors
„ The target capital structure, and not the current capital structure, is the most relevant in determining the
WACC
§ Company capital structure at any point may not reflect the capital structure expected to prevail over
the life of the business
„ Market value, not book value, is most relevant to weigh each component of capital
§ Market values reflect more accurately the true economic claim of each type of financing outstanding
§ Exception: Use of book value of debt for market value is acceptable
– Large portion of debt may not be publicly traded
– Generally, there is little difference between book value and market value, except in extreme
cases
„ WACC must be computed after corporate taxes (since FCF is calculated in after-tax terms). Any
financing-related tax shields not included in FCF must be incorporated into the cost of capital or valued
separately, i.e. if interest is tax deductible, it needs to be tax-adjusted in the WACC formula
„ WACC must be stated in nominal terms when cash flow is stated in nominal terms
146
Cost of Equity
To estimate the cost of equity, determine the expected rate of return of the company’s stock. Capital
Asset Pricing Model (“CAPM”), the most common method for estimating expected returns, is a Credit
Suisse preferred methodology to calculate the cost of equity. CAPM defines a stock’s risk as its
contribution to the overall market risk.
CAPM stipulates that the expected rate of return on a security equals the risk-free rate plus the security’s
beta times the market risk premium:
ke = rf + βL (rm –rf)
where:
The risk-free rate and equity risk premium are common to all companies in a given market; only beta
varies across companies. Beta represents a stock’s incremental risk to a diversified investor, where risk is
defined by how much the stock co-varies with the aggregate stock market.
CAPM breaks up total risk (variability of returns) into two parts – systematic and non-systematic risk:
„ Systematic Risk
§ Unavoidable – external, macroeconomic factors that affect all companies
§ CAPM only rewards systematic risk
§ Size of risk premium proportionate to the relative movement against the market (measured by beta)
„ Non-Systematic Risk
§ Can be diversified away
§ CAPM does not reward non-systematic risk
Risk-Free Rate
„ The bond horizon should relatively closely match the cash flow horizon. In practice, use a single yield
to maturity from a government bond that best matches the entire cash flow stream being valued (e.g.
the 10-year German Eurobond). Note that the longer-dated bonds (e.g. 30-year bonds) might match
the cash flow stream better, but their potential illiquidity can cause out-of-date prices and risk premiums
„ The currency denomination of the bond should match that of the cash flows
„ The correct rate to use is the Yield to Maturity (“YTM”) of the bonds, not the coupon rate or historical
average of yields
Different methods that can be used to estimate the equity risk premium are shown in the following table.
The Credit Suisse preferred methodology to calculate the equity risk premium is the methodology used by
the CS Global Equity Strategy Group. When working on situations with a US angle, be sure to check with
colleagues in the US as to any particular considerations to be kept in mind when setting the Equity risk
premium.
147
Methodology Explanation
Credit Suisse Global The forward-looking equity risk premium is derived from a Dividend Discount Model
Equity Strategy (“DDM”), based on:
„ I/B/E/S forecasts
„ Long-term government bond yields
The data is available from the Global Equity Strategy Group, email Marina Pronina to be
included in distribution)
Ibbotson Associates „ Utilises historically observed data
„ ERP defined as arithmetic average of the stock market total return less income return
on a risk-free asset
– Stock market total return is based on each countries’ sub-set in MSCI Index
assuming dividend re-investment
– Risk-free asset defined as government bonds for the individual countries
„ Also estimates a global long-term horizon ERP using large company stock total
returns minus LT government bond income returns (20-year US T-bond)
„ Identify separate small company premium; appropriateness of applying such small
company premium should be discussed with team members
Bloomberg „ The computation of the equity risk premium (EQRP) consists of two parts:
– First, the expected market return (EMR) is calculated using forecasted data
(forecasted growth rates, earnings, dividends, payout ratio) and current equity
values. The EMR calculated by taking a capital weighted average of the IRR
over all the members of the country's major index. This reflects the risk
premium in terms of forward-looking market conditions rather than historical
valuations. The risk-free rate is then subtracted from this return to obtain the
country risk premium (CRP)
– Secondly, an equity risk premium for a specific issue based on the country
premium is derived; this is simply a product of the equity’s beta and the country
premium (EQRP = CRP * Applied Beta)
Aswath Damodaran „ To estimate the long term country risk premium, Damodaran starts with the country
rating (from Moody's) and estimates the default spread for that rating (based upon
traded country bonds) over a default free government bond rate. This becomes a
measure of the added country risk premium for that country
„ He adds this default spread to the historical risk premium for a mature equity market
(estimated from US historical data) to estimate the total risk premium. In the short term
especially, the equity country risk premium is likely to be greater than the country's
default spread
„ One can estimate an adjusted country risk premium by multiplying the default spread
by the relative equity market volatility for that market (Std dev in country equity
market/Std dev in country bond)
„ Damodaran uses the emerging market average of 1.5 (equity markets are about 1.5
times more volatile than bond markets) to estimate country risk premium. He adds this
to the historical premium for the US of about 4.8% to get the total risk premium
Beta
Beta is the measure of a company’s relative market risk. The beta of a stock with respect to the market is
defined as the covariance of the stock’s return with the market return divided by the variance of the
market:
Cov(rs , rm )
βs =
Varm
where:
„ Asset beta, also called unlevered beta, takes into account only the relative risk of the company’s assets,
regardless of how they are financed
148
„ Equity beta, also called levered beta, also refers to the relative risk of the company’s assets, but takes
into account how the assets are financed. So equity betas for two separate companies (even in the
same industry) likely reflect different capital structures and are thus not comparable
Equity (levered) betas are published for listed companies and are available, inter alia, from Bloomberg or
from Barra:
Bloomberg Barra
„ Historic single factor model „ Barra provides 9 different Beta values per company,
„ Calculation based on a simple linear regression
with the key differences in calculation being:
based on: – Historic versus Predicted
– 60 months historical period – Global versus Local
– Correlation with the main index of the country – Reference market portfolio
in question „ Historic Betas are based on a simple linear
„ Bloomberg provides both raw Betas and adjusted regression using:
Betas (recommended Credit Suisse approach): – The local market subset of the reference
– Raw Beta: Linear regression index as the market portfolio
– Adjusted Beta: 2/3*Raw Beta + 1/3*1 – 60 months historical period
– Adjusted Beta is based on an arbitrary „ Predicted Betas (global and local) are based on a
adjustment to try and correct statistical multi-factor model
error/noise – Total of 152 factors considered:
– 4 risk factors: Size, Success, Value,
Variability in Markets
– 36 industry factors
– 56 country factors and 56 currency factors
„ Global Betas are calculated against the FT World
Index (38,000 securities), local Betas will use a
subset of the asset within the FT World Index (by
country)
Use of Barra projected betas in valuation analyses is preferred by Credit Suisse, unless there are
substantial reasons which warrant a different beta type or source. Discuss with the team when in doubt.
Generally it is better to use an average or median of betas for companies in the industry rather than the
beta for a single company. This prevents estimation errors. However, when averaging betas, it is not
sufficient to simply compare equity betas. It is necessary to unlever betas before taking their average and
then use the calculated average to re-lever the beta for the analysed company.
Rationale Issues
• Measure of observed volatility relative to the ‚ Does not recognize fundamental changes in
Historic
Historic vs. Predicted
market index and based on actual data the Company’s operations (e.g. spinoffs etc.)
• Simple regression analysis i.e. transparent ‚ Influenced by Company specific events that
calculation and easy to crosscheck are unlikely to occur in the future (e.g. local
natural disasters)
• De facto estimation for the Company in ‚ Does not exist for private companies
question ‚ Standard error of the regression can be high
Company vs. Peer Group
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Unlevering Beta
„ Although the beta for a listed company can be readily calculated or publicly available, the beta for an
unlisted company or an asset / project cannot be readily observed
„ In this case, the beta of an unlisted company or asset / project can be approximated using comparable
listed company betas
„ The beta of the comparable companies needs to be unlevered to remove the effect of the financing
decision:
§ Unlevered beta reflects the risk related to the business of the company excluding the risk related to
the financial structure of the company
In its simplest form (excluding preferred stock), the formula for unlevered beta is:
βL
βU =
D
1 + (1 − T )
E
where:
βU = unlevered beta
βL = levered beta
D
= debt to equity ratio
E
T = marginal tax rate
After unlevering beta, it is necessary to re-lever it, using the analysed company’s debt-to-equity ratio and
the (possibly new) country-specific marginal tax rate. The formula for re-levered beta is:
Dnew
βL = βU [1+ (1 − Tnew )]
E new
Cost of Debt
„ Debt is the least risky type of investment, providing investors with a fixed cash flow from interest
payment and principal repayment
„ Debt is also the cheapest cost of capital for companies – debt capital providers require a lower return
commensurate with the risk level
„ Cost of debt in the form of interest expense is tax deductible in most jurisdictions
„ Cost of debt of a company is calculated as the weighted average of current yields of all issues in the
company’s target debt structure. When calculating the cost of debt, it is recommended to:
§ Use the current yield to maturity, not face coupon rate or historical yield
§ Use the target debt structure, not current debt structure
§ Use the marginal statutory tax rate to compute the post-tax cost of debt:
– An accurate measure of the company’s expected tax rate is difficult to obtain, especially when
considering short-term and longer-term perspectives as well as the variable assumptions of the
DCF (e.g. target capital structure, impact of past and future potential operating losses)
– It is usually cleaner to look at the tax shields and the ability of the company to utilise them in a
separate valuation, thereby distinguishing the economic value of the asset from the particularities
of its tax situation
150
Example of WACC Calculation and Sensitivity
(2)
Levered Gross Debt / Statutory Unlevered
(1) (3)
Beta Mk Cap. (%) Tax Rate (%) (Asset) Beta
Selected Comparables
CoA 0.600 5.0% 35.0% 0.581
CoB 0.500 10.0% 35.0% 0.469
CoC 0.700 12.5% 35.0% 0.647
CoD 0.800 15.0% 35.0% 0.729
CoE 0.700 10.0% 35.0% 0.657
CoF 0.400 12.5% 35.0% 0.370
Average 0.617 10.8% 35.0% 0.576
Median 0.650 11.3% 35.0% 0.614
Selected Unlevered Beta 0.614
Gross Debt / Gross Debt / Relevered Corporate Cost of Debt Cost of Implied
(2) (6)
Agg Value Market Value Beta Risk Spread (Pre-tax) (After-tax) Equity WACC
– – 0.614 1.0% 6.5% 3.9% 8.0% 8.0%
10.0% 11.1% 0.655 1.2% 6.7% 4.0% 8.1% 7.7%
20.0% 25.0% 0.706 1.8% 7.3% 4.4% 8.3% 7.5%
30.0% 42.9% 0.772 2.1% 7.6% 4.6% 8.6% 7.4%
40.0% 66.7% 0.860 2.5% 8.0% 4.8% 8.9% 7.3%
50.0% 100.0% 0.983 2.8% 8.3% 5.0% 9.4% 7.2%
60.0% 150.0% 1.167 3.1% 8.6% 5.2% 10.2% 7.2%
70.0% 233.3% 1.474 3.3% 8.8% 5.3% 11.4% 7.1%
80.0% 400.0% 2.088 3.8% 9.3% 5.6% 13.9% 7.2%
90.0% 900.0% 3.931 4.3% 9.8% 5.9% 21.2% 7.4%
Assumptions
(4)
Risk Free Rate : 5.5%
(5)
Equity Risk Premium (ERP) : 4.0%
Corporate Tax Rate: 40.0%
There are two alternative ways to adjust the DCF valuation for political risk in a market:
„ “Hair cut” the cash flows of the target firm, reflecting added risk; or
„ Bump up the market risk premium by the difference between the two analysed markets’ yields in
government or corporate bonds of similar maturity and denominated in the same currency (in Euros)
It is important to do either one or the other – not both – to avoid over-conservatism / double counting.
„ Non-consolidated subsidiaries
If no market value is available, try to perform a separate DCF valuation of the equity stake
„ Tax-loss carry-forwards
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Create a separate account for the accumulated tax-loss carry-forwards and forecast the developments
of this account by adding any future losses and subtracting any future taxable profits on a year-by-year
basis. For each year in which the account is used to offset taxable profits, discount the tax savings at
the cost of debt. Also, set the carry-forward’s value at the tax rate times the accumulated losses. The
operating DCF itself should be based on a normalised effective tax rate, i.e. a tax rate which the
company would incur if it did not have tax-loss carry-forwards (this will typically be the Company’s
marginal tax rate, unless special factors such as, for example, progressive tax rates apply).
In valuing an enterprise on the basis of its fully consolidated unlevered FCFs, the fact that a third party
owns a stake in a subsidiary is not captured. Hence, the resulting Enterprise Value needs to be adjusted
for the portion in effect not owned by the parent company’s shareholders as follows:
„ Treat the minority interest similar to a financial claim and subtract it from the Enterprise Value when
calculating the equity value. After the Enterprise Value has been reduced by the claims of debt and
preferred stock holders (see below), the residual is split between minority interest and common equity
in proportion to their book values
„ Treat earnings attributable to minority interest similar to a financing cost (e.g. an interest expense), i.e.
do not reduce UFCF by the minority interest
„ Treat any associated cash flow to the minority investors similar to a financing flow. The cash flow can
be estimated as the earnings attributable to minority interest less the increase in the minority interest
account in the balance sheet; this essentially equals the dividends paid to the minority investors less
any contributions from them
In many jurisdictions preferred equity closely resembles unsecured debt: preferred stock dividends are
similar to interest payments as they are often predetermined, can be withheld only under special
circumstances and often are cumulative, i.e. any failure to pay preferred dividends needs to be made up
before dividends can be paid to common equity holders. In the event of liquidation, such preferred equity
often does not grant a share of the residual value but rather is redeemed at a fixed value. In such cases,
preferred stock should be treated as a debt equivalent – its market value should be deducted from the
Enterprise Value. In many cases the preferred equity will be traded, i.e. you can establish its market
value. Contact a GMSG DCM officer for assistance in obtaining a reliable market quote.
In other jurisdictions, e.g. Germany, preferred equity has a more equity-like nature, in that preferred equity
has a preferred dividend entitlement in exchange for a lack of voting rights. In the event of liquidation,
preferred equity ranks pari passu with common equity and receives a pro rata share of the residual value.
In such cases, preferred equity should not be treated as a debt-like security but rather as equity. The
resulting equity value needs to be allocated to common and preferred equity holders. While the starting
assumption may be an allocation pro rata to the respective equity class’s share of the total book value of
the equity, take into consideration the precise nature of the shares and the practice and precedents in the
relevant jurisdiction.
In either case, the preferred dividend should not be included in the derivation of the UFCF.
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These schemes define the fixed benefits to be paid by employers to employees on retirement. Normally
the benefit is expressed as a fraction of final salary, which changes as years of employment are added.
Complexity arises because there are many uncertainties associated with such schemes: How long will
the employment last? What will the final salary be? What investment returns are achieved on assets
held against such future benefit obligation?
In the case of defined benefit schemes, companies typically hold long-term investments against such
benefit obligations - either on their own balance sheets or in a separate pension fund. To the extent the
benefit obligation (i.e. the present value of expected future benefit payments) exceeds the market value of
the assets held against such benefit obligation, the company is said to have an un- or under-funded
pension obligation and records a pension liability in its balance sheet. This pension liability arguably
constitutes a loan provided by the company’s employees to the company and as such needs to be treated
similarly to a financial debt item in the DCF valuation.
The amount of the gap is deducted from Enterprise Value to arrive at Equity Value. Note that payments
made by the company to cover the gap may be tax-deductible (check with local tax counsel), i.e. the value
impact of the gap may be reduced by the tax shield, if any.
Where a company shows a pension surplus, i.e. assets held against the pension benefit obligation exceed
the obligation itself, this represents the equivalent of a long-term financial asset which in principle should
be added to the Enterprise Value. Consult with more senior team members as to whether it is appropriate
in the given context to ascribe value to such pension surplus.
When treating the pension deficit as a debt-equivalent, it is important to ensure that pension expenses are
treated in a consistent fashion. In general, pension expenses consist of a service cost component (i.e.
the expense incurred due to the service of an employee during the accounting period as a consequence
of having made a pension promise to such employee) plus an interest cost component (i.e. the expense
incurred as progression in time leads to a shorter time to pension age and hence to an increasing present
value of a set pension promise) reduced by the expected return on pension assets held against the
pension obligation. The service cost component represents a genuine operating expense and as such
needs to be reflected in the derivation of unlevered FCF. The interest cost component as well as the
expected return on plan assets – while often recorded by companies among the operating expenses – in
contrast do not represent a genuine operating expense but rather a financing cost (benefit) and as such
need to be excluded from the derivation of unlevered FCFs. Hence, if a company reports such interest
cost as part of the operating expenses (i.e. above EBITDA), add back such interest cost to EBITDA (and
therefore UFCF) to ensure consistent treatment with other financing items.
Further, it is important to ensure that subsequent cash flows, i.e. payments of pension liabilities, are not
included in the derivation of unlevered FCFs to avoid double counting (i.e. double penalisation by
deducting the gap as liability and deducting the retirement of the liability).
2.5.5. Provisions
Provisions are non-cash expenses reflecting future costs or expected losses. When setting up provisions,
companies reduce profit and add a respective position to the liability side of the balance sheet. Although
in principle provisions per se should not have any valuation impact – the valuation depends on cash flow
and not on accrual-based accounting – a standardised and rigorous treatment of provisions adds
transparency and insights to valuation and performance evaluation exercises.
153
The following table summarises the treatment of provisions for the purposes of the cash flow and
valuation computations:
Treatment of Provisions for Purposes of Cash Flow, Invested Capital and Valuation
„ The value of options that will be granted in the future needs to be accounted for in the FCF projections
– and thus in the value of operations
„ The value of options currently outstanding must be subtracted from Enterprise Value as a non-equity
claim. The value of options will depend on an estimation of Enterprise Value. The option value can be
estimated using option valuation models, such as the Black-Scholes model or binomial models
Stock options expensing creates tax assets because reported taxes are lower than cash taxes (financial
reports treat options as tax deductible even though they are not tax deductible at the moment of grant
only at the moment of exercise).
„ Estimate the principal amount of operating leases: capitalise this year’s lease expense as perpetuity
using the cost of debt
„ To estimate the implied interest expense, multiply the implied principal amount by the marginal
borrowing rate
„ Reclassify the implied interest portion of the lease expense from COGS or SG&A to interest (this
increases EBITA)
154
„ Add the non-interest portion to NOPLAT when calculating gross Cash Flow
„ Subtract debt associated with operating leases from EV when calculating value of equity
In principle, a deferred tax liability represents a future cash outflow in the form of higher tax payments.
However, as long as there is no reason to expect a change in tax and accounting rules and there are no
fundamental changes to the company’s operations, it may be reasonable to expect that the company will
also in future benefit from similar effects which gave rise to the deferred tax liability in the first place.
Thus, while the cash outflow will occur in the future, this could be expected to be counterbalanced by
equivalent tax savings in the future. As such, it would be appropriate to treat deferred tax assets and
liabilities similar to a working capital item. Note also that a deferred tax liability represents the nominal
value of such cash outflows, whereas for valuation purposes only consider the present value of such cash
outflows if there was reason to believe that in future the company would not benefit from similar effects,
requiring assumptions as to the timeframe over which such cash outflows would then occur.
Alternatively, equity cash flow is a sum of all cash paid to (minus that which is received from)
shareholders:
In a simplified world, one could equate discounting the equity cash flow to discounting dividends. Although
dividends are often the largest part of the equity cash flow, other components (mentioned above) should
be also considered because they can have a very material impact.
6
Other Comprehensive Income includes net unrealised gains and losses on certain equity and debt investments, net unrealised gains
and losses on hedging activities, adjustments to the minimum pension liability, and foreign currency translation items
155
7
Simplified Example of Bank Valuation
(€ in millions, unless otherwise indicated)
2005A 2006F 2007F 2008F 2009F 2010F 2011F 2012F 2013F 2014F 2015F TV
Long term growth rate 2.5%
Long term ROE 14.0%
Opening shareholder funds 3,800 4,100 4,500 5,000 5,700 6,500 7,400 8,100 8,800 9,300 9,550 12,921
ROE 17.7% 18.6% 18.9% 20.6% 21.3% 20.1% 18.1% 16.6% 15.5% 14.9%
Profit after tax 700 800 900 1,100 1,300 1,400 1,400 1,400 1,400 1,400 1,400
Retained earnings = increase in equity 300 400 500 700 800 900 700 700 500 250 250
Other comprehensive income 0 0 0 0 0 0 0 0 0 0 0
Cash flow to equity 400 400 400 400 500 500 700 700 900 1,150 1,150
Dividends paid 0 390 400 430 430 430 430 430 430 430 460
Equity issued 0 0 0 30 0 30 0 0 0 0 0
Equity bought back 400 10 0 0 70 0 270 270 470 720 690
Cash flow to equity 400 400 400 400 500 400 700 700 900 1,150 1,150
Discounted cash to equity value:
NPV five year free cash flow 3,560
NPV terminal value 4,550
Value of shareholders' funds 8,111
Cost of Equity 11.0%
In principle, there are two ways to value a company across currency borders:
„ Value cash flows in home terms (e.g. Euros) according to this approach:
§ Convert the Serbian dinar (CSD) flows to €, using the forecast of forward CSD/€ x-rate
§ Then discount the € cash flows using the €-based WACC that reflects not only the systematic risk of
the industry and local equity market, but also the political risk of the country (further discussed later
in the chapter)
8
This approach assumes that purchasing power parity (PPP) and interest rate parity (IRP) hold
„ Value cash flows in foreign terms (e.g. CSD) according to this approach:
§ Discount the dinar flows using the Serbian cost of capital. Importantly, if discounting dinar flows, it is
necessary to base the WACC’s risk-free rate on the dinar-denominated bonds
§ Then translate the dinar DCF into € using the spot rate
This approach assumes that the availability, and quality, of foreign capital market data is good (which is
not always the case).
Tax Rates
When applying tax rates to the cash flow, take into consideration the local tax regime:
„ Use the marginal tax rate of the foreign country if the buyer resides in a country that is part of a
territorial tax system in which the buyer’s country exempts foreign income from further taxation (about
half of the OECD countries use a territorial tax system)
7
Terminal value in the example is calculated using a Gordon Growth Formula: dividends = earnings – retention = (ROE – growth rate) *
net asset value. Thus, a terminal value = net asset value * (ROE – growth rate) / (Cost of Equity – growth rate).
8
PPP asserts that €/CSD exchange rate will be based on the purchasing power of the two currencies: x-rate will tend toward 85 if 85
CSD buys in Serbia the same bundle of goods as 1€ in the Euro-area). IRP asserts that the difference between the spot and forward
x-rates is equal to the difference between interest rates prevailing in the money markets for lending/borrowing in the respective
currencies: SPOTCSD/€ / FWDCSD/€ = (1+Return€) / (1+ReturnCSD).
156
„ Use the higher of the buyer’s or target’s country tax rate if the buyer resides in a country that is part of
a worldwide tax credit system (e.g. the US) in which the buyer’s country recognises taxes paid in a
foreign country as a credit against tax liability at home
Consistency
In the complex maze of multi-currency valuation in emerging markets a couple of important consistency
rules should be observed:
„ The same tax rate should be assumed in estimating the after-tax cash flows, the levered beta, the
WACC and the debt tax shields
„ Assuming that both revenue and costs are derived from the same currency base, the same inflation
rate should be used for revenues, costs, working capital, Capex, risk-free rate, interest rates and Forex
rates
„ Does the valuation, based on the terminal multiple method and the terminal growth method, provide
broadly consistent valuation results? If the values derived by applying both methods are vastly
different, question whether:
§ The chosen range of multiples and growth rates is consistent; in particular, double check the
reasoning behind the chosen terminal multiples to ensure they are appropriate for the business in a
steady state
§ The terminal year EBITDA margin and unlevered FCF are truly normalised
„ Are the implied entry multiples consistent with the assumed / implied exit multiples? If there is a
material difference, an explanation should be provided. In particular, beware of situations where the
exit multiple is significantly above the implied entry multiple. Provide reasons why the business will
trade at a higher multiple in the future than the multiple implied by the DCF analysis
Further, to ensure that the range selected is meaningful, try not to exceed a range of 15 – 20% unless
justified by significant uncertainty.
DCF analyses implicitly assume access to cash flows and management decisions and as such implicitly
include a control premium. As a consequence, DCF analysis is considered to be at a premium to market
value which a rational investor would ascribe to individual shares in the company.
It is, therefore, not only vital to understand the DCF analysis itself but also how it fits into the overall
valuation exercise. To avoid inappropriate conclusions, which could arise from simply using the DCF
analysis for valuation, it is important to apply other valuation techniques in conjunction with DCF analysis,
for example Compco and Compacq analysis. Note that DCF valuation results typically range closer to
valuation results obtained through Compacq analyses and above values suggested by Compco analysis.
3. Helpful Hints
157
Key checks to keep in mind include:
„ Unlevered FCF
§ Make sure the numbers add up, i.e. all line items are included in the total and are added or
subtracted in line with their impact on cash flow (e.g. D&A is added, not subtracted, change in net
working capital is cash flow positive when net working capital decreases)
§ Reconcile the unlevered FCF with the change in cash. Any line item not included in the unlevered
FCF calculation which is included in the change in cash calculation needs to be explainable, i.e.
needs to be captured in the EV adjustments (e.g. interest and debt repayments are excluded from
unlevered FCF since DCF is an Enterprise Value concept and Net Debt is treated as an EV
adjustment)
„ Use a calculator to cross check the discounting of FCFs and Terminal Value
„ Ensure all appropriate adjustments have been made to derive Equity Value from Enterprise Value,
paying special attention to minorities, pensions, etc.
„ Terminal Value
§ Terminal Value must be consistent with the strategy assumed during the explicit forecasting period.
For example, if the asset base was run down during forecast period, Terminal Value should reflect
state of facilities
§ Use normalised results as the basis for the Terminal Value calculation. Ratios should be evaluated
and adjusted, if necessary (e.g. depreciation relative to capex, required capex level, EBITDA margin,
change in net working capital, tax rate)
§ Avoid using multiples implying high growth for which the market might be prepared to pay today. At
the end of the explicit forecast period assume normalized growth of the business
§ Always check how much the Terminal Value contributes to total Enterprise Value. The higher the
proportion, typically the less meaningful the valuation (obviously depends on planning horizon)
„ Value drivers
§ Focus on what is driving value. Five key value drivers are typically more important than 15 low-
impact variables
„ Structure the model in a clean, clear fashion which provides for a clear separation of inputs and outputs
so that causes and effects are easily separable and understandable
§ Keep in mind, MDRs dislike models which are not easily printable in their entirety
„ Never mix assumptions and formulas, i.e. do not hardcode within formula cells
„ Prepare an assumptions summary and a structured collection of back-ups to the assumptions while
building the model
158
„ Test how it reacts to changes in key drivers and be ready to explain why it reacts in such fashion
4. Example
The following example demonstrates the mechanics and key steps of a DCF. The task is to perform a
DCF valuation on ChocoFriends, a Swiss-based niche premium chocolate manufacturer.
The historical financials for the last 3 years are provided below.
159
ChocoFriends Historical Balance Sheet
(€ in millions, FYE December 31)
Liabilities
Shareholders' Equity 543.6 601.1 668.0
Minority Interest 21.6 23.2 25.0
Shareholders' Equity 565.2 624.3 693.0
Long Term Debt 344.0 342.0 347.0
Other Long Term Liabilities 17.0 15.0 21.0
Net Pension Liability 41.0 37.0 35.0
Long term Liabilities 402.0 394.0 403.0
Short Term Borrowings 236.0 162.0 64.0
Trade Receivables 141.0 95.0 119.0
Other Current Liabilities 183.0 231.0 277.0
Current Liabilities 560.0 488.0 460.0
Total Liabilities & Shareholders' Equity 1,527.2 1,506.3 1,556.0
Given management’s good track record, broker research indicates that sales growth will reach 8% in 2006
and 7.5% in 2007, owing to the launch of new products and rapid growth in North America. The consumer
chocolate market is growing by an average of 1-2% p.a., while the premium segment is growing at 5%
p.a. In the long term, analysts estimate that, thanks to its presence in the most attractive upscale
segment, ChocoFriends will be able grow 100 basis points p.a. above the industry growth level. Analysts
project a gradual deceleration of the sales growth down to the industry average of 5% p.a. from 2013.
As a result of productivity gains and higher profitability in underdeveloped segments in the European and
North American markets, the management estimates a continuing gross margin improvement of 100 basis
points over the period 2005–2008, with stable SG&A costs (as % of sales).
160
Management estimates that Capex will grow to €90m in 2006 due to investments in the capacity
expansion, technology and retail outlets. Afterwards, Capex will grow in line with sales.
The table below summarises the key drivers for the base, downside and upside cases. For the purposes
of this case study, the base case assumptions will be used.
COGS Margin
COGS (854) (872) (939)
Margin 53.7% 51.9% 52.1%
Base Case 51.7% 51.4% 51.0% 51.0% 51.0% 51.0% 51.0% 51.0% 51.0% 51.0%
Downside Case 53.0% 53.0% 53.0% 53.0% 53.0% 53.0% 53.0% 53.0% 53.0% 53.0%
Upside Case 51.0% 50.0% 49.0% 49.0% 49.0% 49.0% 49.0% 49.0% 49.0% 49.0%
Base Case 51.7% 51.4% 51.0% 51.0% 51.0% 51.0% 51.0% 51.0% 51.0% 51.0%
Capex (% sales)
Capex (67) (39) (75)
% of sales 4.2% 2.3% 4.2%
Base Case 4.6% 4.5% 4.5% 4.5% 4.5% 4.5% 4.5% 4.5% 4.5% 4.5%
Downside Case 5.0% 5.0% 5.0% 5.0% 5.0% 5.0% 5.0% 5.0% 5.0% 5.0%
Upside Case 4.0% 4.0% 4.0% 4.0% 4.0% 4.0% 4.0% 4.0% 4.0% 4.0%
Base Case 4.6% 4.5% 4.5% 4.5% 4.5% 4.5% 4.5% 4.5% 4.5% 4.5%
The broker research forecasts no significant changes in the net working capital turns, as ChocoFriends
management has already implemented most of the immediately available optimisation measures.
Current Liabilities
Accounts Payable 119.0 127.5 136.3 144.7 154.3 164.0 173.9 183.4 192.6 202.2 212.4 6.2%
Other Current Liabilities 277.0 299.2 321.6 344.1 366.8 390.1 413.5 436.2 458.1 481.0 505.0 6.2%
Total Current Liabilities 396.0 426.7 457.9 488.8 521.1 554.1 587.4 619.7 650.7 683.2 717.4 6.2%
Total Net Working Capital 433.0 469.2 505.2 541.7 577.4 614.1 650.9 686.7 721.0 757.1 795.0 6.2%
Decrease / (Increase) in NWC (49.0) (36.2) (36.0) (36.5) (35.8) (36.6) (36.8) (35.8) (34.3) (36.1) (37.9) 6.2%
Change in NWC as % of Change in Sales (40.8%) (25.1%) (24.7%) (24.9%) (24.2%) (24.2%) (24.2%) (24.2%) (24.2%) (24.2%) (24.2%)
Assumptions
Inventories as Days of Sales 50.9 50.9 50.9 50.9 50.9 50.9 50.9 50.9 50.9 50.9 50.9
Trade Receivables as Days of Sales 104.2 104.2 104.2 104.2 104.2 104.2 104.2 104.2 104.2 104.2 104.2
Other Receivables and other Assets as % of Sales 3.6% 3.6% 3.6% 3.6% 3.6% 3.6% 3.6% 3.6% 3.6% 3.6% 3.6%
Accounts Payable as Days of COGS 46.3 46.3 46.3 46.3 46.3 46.3 46.3 46.3 46.3 46.3 46.3
Other Current Liabilities as % of Sales 15.4% 15.4% 15.4% 15.4% 15.4% 15.4% 15.4% 15.4% 15.4% 15.4% 15.4%
In order to prepare the above financials for valuation purposes, make all appropriate EBITDA
adjustments. For the purposes of this case study, a pension adjustment is illustrated.
The accounts show that ChocoFriends has a net pension liability of €40.7m, €36.7m and €34.7m in 2003,
2004 and 2005, respectively. For valuation purposes, treat the net pension liability as an interest bearing
debt.
161
For operating cash flow purposes, the pension expense equals: service cost + interest expense –
expected return on the pension fund. ChocoFriends reports the aggregate pension expense as part of
operating expenses. The logic followed to estimate the operating cash flow adjustment is:
„ Leave service cost (the cost of the promised pension benefit incurred due to the service of employees
during a given accounting period) as a cost that is part of P&L leading to EBITA
„ Add back the interest portion to EBITA (as with other interest expenses) – this is the pension cash flow
adjustment. Make sure to account appropriately for the respective tax shield adjustment – tax shield
effect should be accounted for in WACC, not in cash flow
To estimate the yearly pension interest portion (to be added back to EBITA), multiply the total net pension
liability by ChocoFriends’ average cost of debt.
The table below shows the unlevered FCF calculations for ChocoFriends for the year 2006-2015.
The Terminal Value calculation should be based on financials reflective of a long-term steady state, which
ChocoFriends can be expected to achieve.
A growth-to-perpetuity rate of 2% has been used, which broker research considers a standard level for
the consumer sector.
Based on ChocoFriends past performance and broker research, it is expected that ChocoFriends will
achieve a sustainable EBITDA margin of 15% in a steady state.
Depreciation is a function of Capex. Estimate Capex requirements in line with historical levels (as a
percentage of sales). Depreciation as a % of Capex is estimated at 95% (replacement Capex of
ChocoFriends’ assets is higher than historical depreciation).
The change in net working capital is based on absolute change of net sales.
162
ChocoFriends – Terminal Year Normalisation
(€ in millions, FYE December 31)
Normalised
2015E 2016E Comment on Normalisation
Net Sales 3,283.4 3,349.1 Net sales grow in perpetuity by 2.0%
Growth 5.0%
EBITDA 492.5
Adjustments 2.1
EBITDA (adjusted) 494.6 502.4 % of sales 15.0%
% of sales 15.1% 15.0%
EBITA 367.5
% of sales 11.2%
Adjusted EBITA (tax base) 367.5 359.2 EBITDA minus Depreciation
% of sales 11.2% 10.7%
Tax on Adjusted EBITA (110.3) (107.8) % taxes on EBITA 30.0%
Marginal tax rate 30.0% 30.0%
NOPAT 257.3 251.4
Calculate WACC based on the methodology described in the WACC section. For this purpose, request
the Barra betas for the set of comparable companies from the library and calculate the unlevered beta of
each company using the respective Gross Debt, Market Cap and statutory tax rate figures. Cost of equity
for ChocoFriends is calculated using the average unlevered beta of the comparable companies, the target
capital structure, the Swiss risk free rate and the equity risk premium from Credit Suisse Global Equity
Strategy. Then calculate an after-tax cost of debt using the company’s current yield to maturity on its
outstanding bonds, the target capital structure and the marginal Swiss tax rate. Results yield a WACC
range of 8.0-9.0%, a figure which needs to be crosschecked with broker research.
Now calculate the Terminal Value using the multiple method and the perpetual growth method.
To calculate the Terminal Value with the perpetual growth method apply the following formula (incl.
adjustment for the assumption of mid-year cash flows):
UFCFn+1
Terminal Value = * (1+ r)0.5
(r − g)
where: UFCFn+1 = unlevered FCF in period n+1
g = perpetual growth rate
r = weighted average cost of capital (WACC)
Use the normalised unlevered FCF and apply the growth-to-perpetuity rate of 2%.
163
Companies in the relevant consumer goods sector are usually valued on an EV/EBITDA multiple. Below
are the current trading multiples for traded companies comparable to ChocoFriends.
EV / EBITDA 2006E
Competitor A 7.2x
Competitor B 7.6x
Competitor C 6.3x
Competitor D 7.0x
Average 7.0x
To calculate the terminal value with the EBITDA multiple method multiply the normalised EBITDA by an
average trading multiple of ChocoFriends’ comps.
EBITDA 502.4
EBITDA Exit Multiple 7.0x
Terminal Value 3,516.6
In order to arrive at the Enterprise Value of ChocoFriends, both the cash flow projections and the terminal
value need to be discounted back to the valuation date. In order to value ChocoFriends as of 30 June
2006, all cash flows occurring before the valuation date must be excluded. Include only 50% of the 2006
cash flow for valuation purposes. The table below summarizes the calculation, based on the assumption
of mid-year cash flows.
Calculation of Enterprise Value (EBITDA Exit Multiple) Calculation of Enterprise Value (Perpetuity Growth Rate)
Sum of PV of Free Cash Flows 958.4 Sum of PV of Free Cash Flows 958.4
Enterprise Value 2,578.0 Enterprise Value 2,641.0
Note that the Discount factor for the final year’s cash flow is different from the discount factor for the
Terminal Value. This is due to the fact that we are assuming mid-year cash flows, whereas the Terminal
Value only accrues at the end of the final year.
164
Step 7: Calculation of Equity Value
In order to arrive at the Equity Value, deduct all value components not attributable to equity holders. As
ChocoFriends is being valued as of the 30 June 2006, take the latest available financials. The Q2 report
of ChocoFriends reveals the following:
Based on these numbers, the table below demonstrates the Equity Value calculation for both Terminal
Value methodologies. The net pension liability has been deducted at full value. Depending on the
jurisdiction one needs to check whether tax shields can be realised on un- or under-funded pension
liabilities.
Calculation of Equity Value (EBITDA Exit Multiple) Calculation of Equity Value (Perpetuity Growth Rate)
The DCF matrix below shows the result of the valuation exercise for a range of WACC rates as well as a
range of terminal value multiples / growth rates.
9.00% 938 39.4% 938 37.7% 938 36.1% PV of Unlevered FCF (2006E - 2015E) 938 39.3% 938 38.5% 938 37.6% 9.00%
1,440 60.6% 1,550 62.3% 1,661 63.9% PV of Terminal Value 2015E 1,447 60.7% 1,499 61.5% 1,555 62.4%
2,377 2,488 2,599 Enterprise Value 2,385 2,437 2,492
(272) (272) (272) EV Adjustments (current) (272) (272) (272)
2,105 2,216 2,326 Equity Value (m) 2,113 2,165 2,220
27.0 28.4 29.8 Value per Share 27.1 27.8 28.5
6.9x 7.2x 7.6x Implied EV / 2007E EBITDA Multiple 7.8x 7.9x 8.1x
1.7% 2.2% 2.6% Implied FCF perpetuity growth rate / 6.5x 6.8x 7.0x
Implied 2015E EV / EBITDA multiple
8.50% 958 38.9% 958 37.2% 958 35.6% PV of Unlevered FCF (2006E - 2015E) 958 37.2% 958 36.3% 958 35.4% 8.50%
1,504 61.1% 1,620 62.8% 1,735 64.4% PV of Terminal Value 2015E 1,620 62.8% 1,683 63.7% 1,750 64.6%
WACC
7.50% 980 38.4% 980 36.7% 980 35.1% PV of Unlevered FCF (2006E - 2015E) 980 34.9% 980 34.0% 980 33.1% 7.50%
1,571 61.6% 1,692 63.3% 1,813 64.9% PV of Terminal Value 2015E 1,824 65.1% 1,900 66.0% 1,983 66.9%
2,551 2,672 2,793 Enterprise Value 2,804 2,880 2,963
(272) (272) (272) EV Adjustments (current) (272) (272) (272)
2,279 2,399 2,520 Equity Value (m) 2,531 2,607 2,690
29.2 30.8 32.3 Value per Share 32.5 33.4 34.5
7.4x 7.8x 8.2x Implied EV / 2007E EBITDA Multiple 9.1x 9.4x 9.7x
0.8% 1.3% 1.7% Implied FCF perpetuity growth rate / 7.5x 7.9x 8.2x
Implied 2015E EV / EBITDA multiple
165
Leveraged Buy-Out Analysis
167
Leveraged Buy-Out Analysis
1. Overview
A LBO could be a key strategic alternative for a Company considering how to maximise shareholder
value. Therefore, it is a key valuation metric to use in the context of a buy-side or sell-side mandate with a
corporate (or a Financial Sponsor).
Strategic Alternatives
Strategic Alternatives
Continue to
operate Major Selected asset
Recapitalisation Merger of equals Sale of company IPO
company in purchases divestures
current form
Financial
Strategic
Buyer
Buyer
(LBO)
„ The equity portion typically represents 25%-30% of the target’s Enterprise Value
§ Part of the equity can often be invested in the form of shareholder loans with capitalised annual
interest (not paid in cash), which is often tax deductible
„ Typically, debt would represent 70%-75% of the Enterprise Value, and would be serviced from the
target’s cashflows
§ Debt usually includes a combination of senior bank debt, second lien and subordinated debt
(Mezzanine or High Yield)
„ In Europe today, Financial Sponsors manage a total fund pool in excess of €40 billion. The main type
of fund managed by Financial Sponsors are pension funds, which have been consistently allocating a
reduced percentage of their resources to Private Equity funds in the past years (such investments
being considered by Pensions Funds as part of the most risky class of assets held in their portfolio)
169
A Decade of European Fund Raising
50,000 2,500
Funds raised for buyouts (€ in millions)
68 41,233
40,000 2,000
62
„ Large Financial Sponsors manage funds in excess of US$5 billion each, and are able to invest up to
US$1 billion in equity on a single transaction:
§ Acting in consortium, Financial Sponsors can acquire large corporates (e.g. TDC, largest European
LBO to date had an EV of c. €12.7bn at closing in November 2005)
170
„ Some major Financial Sponsors: The following table lists the major Financial Sponsors active in
Europe (in terms of maximum investment size)
Maximum Equity
Global Private Ticket on One
(1) (2)
Equity Funds Latest Fund Raised Single Deal Landmark Transactions Funds Managed
Carlyle Partners IV (US$10bn) US$2 billion Avio Spa c. US$ 25 bn
Carlyle European Private Equity II (€2 bn)
Qinetiq
KKR European Fund II ( €4.5bn) US$2 billion TDC A/S c. US$ 21bn
KKR 2006 (US$ 6bn)
SunGard Data Systems
Legrand
Blackstone Capital Partners IV (US$ 6.5bn) US$1.3 billion Allied Waste c. US$14 bn
Cine UK/UGC
Bain Capital Fund IX (US$6 bn) US$1.2 billion Warner Music c. US$27 bn
Seat
TPG Partners V (US$ 5.8bn) US$1.2 billion Grohe c. US$20 bn
Debenhams
CVC European Equity Partners IV (€6 bn) €1.2 billion Automobile Association c. €14.5 bn
Seat
BC European Capital VIII (€5.5 bn) €1.1 billion Amadeus c. €11 bn
Picard
Seat
Apax Europe VI (€4.6 bn) €1 billion TDC A/S c. US$20 bn
VNU World Directories
Permira Europe III ( €5 bn) €1 billion Inmarsat c. €11 bn
Gala
Seat
Cinven Fund IV (€5 bn) €1 billion Amadeus c. €13 bn
Frans Bonhomme
NM (not pure private equity) approx. €1bn Europcar c. €4 bn
Rexel
171
1.3. Value Creation in LBOs
Financial Sponsors have several ways of making an investment a success
„ Growth
§ Accelerate organic growth opportunities
§ Consolidation platform
§ Bolt-on acquisition(s)
„ Margin Enhancement
§ Operational improvements
§ Product mix enhancement
§ Add-on acquisitions to expand product range and/or geographical reach and/or provide synergies
„ Restructuring
§ Accelerated cost-cutting
§ Divestiture of non-performing / non-core assets
§ Capital structure optimisation
„ Deleveraging
§ Using target‘s cashflows, thereby increasing the equity component of target’s Enterprise Value, to
repay debt
The graph below illustrates the cumulative effect of these measures over the life cycle of a typical
investment
Equity 60%
E=£300m
20%
Equity 30% E=£150m
0%
EBITDA = £100m EBITDA = £100m EBITDA = £150m
EBITDA Mult. = 5x EBITDA Mult. = 5x EBITDA Mult. = 5.5x
172
2. How to Complete a LBO Analysis
„ Industry
§ Barriers to entry
§ Reduced price competition
§ Potentially fragmented market, suitable for consolidation
„ Products
§ Value-added products or services
§ Low risk of technological obsolescence
§ Attractive and growing niche markets
„ Business
§ Strong market positions
§ Sustainable competitive advantages
§ Low customer concentration
§ Low fixed costs / capital requirements
§ Divestible non-core assets
„ Situation
§ Opportunity for operating efficiencies / growth through consolidation
§ Strong management team
§ Sensible valuation (not overvalued)
§ Exiting founding family
„ Exit
§ Attractive exit options
The characteristics above are obviously not all always met in any given situation, but nevertheless give a
good sense of the attributes of a suitable LBO Target.
173
2.2. Simplified Acquisition Structure Overview
Acquisition would typically be structured through the setting-up of a Special Purpose Vehicle (“NewCo”) to
purchase the shares of the target, with equity proceeds contributed by Financial Sponsors and
management and debt proceeds from senior and junior lenders.
Financial
Management
Sponsor
Equity
Target Cash
Shareholders
Subordinated
Debt
High Yield Mezzanine
Investors
NewCo
100% of Shares
Senior Banks
Senior
Debt
Senior Debt
Target
Potential Merger
Sources Uses
„ Equity „ Purchase of Target Equity
– New equity from LBO Sponsor – Pay existing equity owners
– Potential equity contribution from existing – If public, current share price plus tender
Management premium
– Potential investment rolled-over from existing – Cost of options, convertibles redemption, etc
shareholder
– Strategic equity
„ Debt „ Retire existing debt
– Senior Debt (banks) – Refinancing of existing debt (covenants on
– Subordinated Debt (High Yield or Mezzanine) existing indebtedness typically prohibits post-
– Highly Subordinated Debt (PIK notes, etc) LBO leverage)
– Potential prepayment penalties (for existing
bonds, etc)
„ Pay transaction costs
174
Overview of a Typical Capital Structure in a LBO
BANK DEBT A, B, C
(Senior First Lien Debt / EBITDA) up to 4.25x to 4.75x
Senior Debt
SECOND LIEN DEBT
(Senior Debt (incl. 2nd Lien) / EBITDA) up to 5.25x to 5.75x
COMMON EQUITY
Equity SHAREHOLDER LOANS 25% - 30%
Equity >25% of the capital structure
Secured
Revolver 7.0 Floating; Cash +225bps No „ Typically put in as a facility to be
drawn down for W/C needs
Term Loan A 7.0 Floating; Cash +225bps No „ Cheapest cost of capital but has
maintenance covenants and
restricts flexibility
Term Loan B 8.0 Floating; Cash +250-275bps No „ Cheapest cost of capital but has
maintenance covenants and
restricts flexibility
Term Loan C 9.0 Floating; Cash +300-325bps No „ Cheapest cost of capital but has
maintenance covenants and
restricts flexibility
Second Lien Debt 9.5 Floating; Cash +475-550bps No „ Enables to future maximise bullet
/ back-ended debt
Mezzanine 10.0 Floating; Cash + PIK 950-1100bps Possibly „ Flexible but potentially expensive
and/or dilutive
Unsecured
High Yield Bond(1) 10.0 Fixed; Cash 850-1050bps Possibly „ More expensive than bank debt
but much greater flexibility;
dependant on ratings
PIK Note 10.5–11.0 Fixed; Cash 1500-2000bps Possibly „ Quasi-equity - Used to decerase
the equity component of the deal
Shareholder Loans 11.0–11.5 Fixed; Cash 500-1000bps Possibly „ Quasi-equity - Used to decerase
the equity component of the deal
- Provided by Equity investors
(1) High Yield Bonds tend to sometimes benefit from second ranking security
175
2.4. How To Assess Maximum Leverage
Maximising debt is crucial to optimising Financial Sponsor returns. In situations other than preliminary
“back-of-the-envelope” analysis, it is therefore crucial to have colleagues from the Financial Sponsors
Group involved.
The two key drivers of maximum leverage are cashflow and minimum equity requirement.
„ Cashflow: Maximum leverage is significantly influenced by the cashflow generation of the target
§ Key determinants of a company’s cashflow generation include sustainable sales growth, EBITDA
margin evolution, future Capex requirements and working capital needs
§ Leverage levels will often depend on the characteristics and precedents in the target’s industry
– For example yellow pages companies could be potentially levered up to 7.5x – 8.0x EBITDA
(strong and recurrent cashflow), whilst a capital goods company would typically sustain a
maximum leverage of 5.0x – 6.0x EBITDA (cyclical and Capex intensive)
„ Minimum equity requirement: Maximum leverage is sometimes capped by valuation considerations and
minimum equity requirements
§ For example, if the target’s cashflows could sustain 6.0x leverage but the contemplated acquisition
price is only 7.0x EBITDA, leverage would, in general, have to be reduced such that equity invested
remains above 25%-30% of capital structure
§ The minimum equity constraint is mostly driven by lenders requiring (i) Financial Sponsors to invest
a minimum amount of equity to demonstrate their commitments in the transaction and (ii) a “safety
cushion” in case the target becomes bankrupt and needs to be sold by the lenders to recover their
debt (more of the asset value will belong to the lenders in the event of a liquidation)
„ Leverage ratios are used to measure the debt quantum relative to the target’s operating performance
and cashflows
If at all in doubt, even in the context of a preliminary analysis, please seek input from the Financial
Sponsors Group.
176
2.5. Exit Strategy
Understanding the exit strategy / exit value is an essential component of a LBO. In particular, determining
an appropriate exit multiple range will help to calibrate the right acquisition price range and assess the
feasibility / attractiveness of a LBO at a given price.
In the case of an early stage LBO analysis, where the exit strategy has not yet been defined, a broader
range of exit multiples could be used on a preliminary basis to compute IRRs and perform the analysis.
„ The Operating Model, needs to be detailed enough to assess future cashflows, debt amortisation
profile and, consequently, maximum debt capacity. Flexibility for scenario analysis is also important in
order to stress test the capital structure under various operating projections scenarios
„ Proposed capital structure, including maturities, and pricing (i.e. interest rate) of various debt
components
„ Range of exit multiples (typically of EBITDA or EBIT) to assess implied Enterprise Value range at exit
for IRRs and Money Multiples computation
„ Projected income statement, cashflow statement and balance sheet to show operating profile of the
target and the amortisation profile of the various debt components
„ IRRs and money multiples for the equity invested by the Financial Sponsors
1
§ IRR = Y − 1 (assuming no dividend payment is made between entry and exit), where:
n
X
X = the initial cash equity invested by the Financial Sponsors
Y= equity value of the Financial Sponsor’s investment at exit calculated as Enterprise Value less Net
Debt at time of exit
n= exit year of investment
177
3. How To Use and Interpret a LBO Analysis
„ Use of returns tables (IRRs and Money Multiples) showing a range of reasonable entry multiples and
exit multiples (at contemplated exit horizons) is therefore recommended to help LBO value assessment
„ As it is not necessarily easy to predict what the exit horizon would be, it may be useful to show return
tables for various exit horizons (e.g. 3, 4 and 5 years)
„ The reasonableness / achievability of operating projections is key in determining an Equity Base Case.
This case would be the basis starting from which a Sponsor will assess both upside and downside
(through sensitivities on the projections)
„ Sensitivities on the operating model, based on forecasts of industry trends and cyclicality of the
business, as well as other identified potential risks / opportunities specific to the target, are therefore
essential to fully assess a LBO value
178
§ If, on the other hand, IRRs stand well below 20%-25%, this may indicate that the purchase price is
too high to be achieved in the context of a LBO
„ As the analysis gets more detailed, the industry and environment in which the Target operates must be
taken into account. For example:
§ For low-beta targets, investors may potentially accept lower equity returns, typically in the 18-22%
range (on the basis of their Equity Base Case), sometimes less
§ For high-beta targets (e.g. involved in relatively new and fast-growing markets, such as IT or biotech,
or those having demonstrated high historical operating performance volatility), investors would be
more likely to expect equity returns in the 25%-30% range (or above) under the Equity Base Case
„ External factors can also be considered when assessing the equity returns acceptable for a specific
LBO
§ Due to the increased size of many Financial Sponsor funds, many sponsors may accept equity
returns lower than the historically traditional 25% if they are able to put a very large equity cheque
into a single investment
§ Individual Financial Sponsors also have varying IRR objectives and investment philosophy
„ Overall, the 20%-25% IRR range should be considered as an initial rule of thumb but must be used
with care and caution when assessing the LBO valuation
Please be sure to seek input / involvement from the Financial Sponsors Group when performing a LBO
analysis.
4. Common Pitfalls
„ Inappropriate leverage levels
§ The existing capital market conditions at the time of the transaction should be closely looked at
when assessing the maximum leverage, and precedent transactions should be benchmarked for
both structure and quantum of leverage (e.g. if the contemplated leverage is above the leveraged
comps, there would need to be strong arguments as to how this could be justified)
§ Check leverage multiples vs. valuation multiples from Compcos / Compacqs and proposed
acquisition multiples. If the leverage multiple which is derived is close to applicable valuation
multiples, double check the projections to verify that the operating profile of the business vs. the
comps warrants the additional leverage and that the valuation also includes a sufficient premium
over the comps to justify the better operating profile. The debt leverage multiple should not, in any
case, exceed the valuation multiple range which is believed to be applicable to the target considered
„ Miscomputation or misinterpreting of equity returns for the investors. The previous section “How to
Interpret a LBO Analysis” details the main considerations in this regard
179
Make sure colleagues from the Financial Sponsors Group are involved, particularly if the analysis needed
is not “back-of-the-envelope”. They will provide input on capital structure optimisation and IRR
requirements for a given situation (each Financial Sponsor has specific IRR requirements, driven by its
funds but also by the nature of the Target). In particular, if showing the analysis to a client, it is strongly
recommend that a Financial Sponsors Group review the LBO valuation approach and capital structure
beforehand.
5. Example
„ The bid valued Amadeus at €7.35 per share, which equates to an Enterprise Value of c. €4.4 billion
(7.7x Adjusted FY04A EBITDA of €604 million)
„ Prior to the tender offer, 50.1% of Amadeus’ Class A shares were free floating, with Air France, Iberia
and Lufthansa holding 23.4%, 18.3% and 5.1%, respectively
„ Industry Leader
§ Amadeus is the leading worldwide GDS provider with global 2004 market share of c. 29%
§ Market shares historically growing consistently
180
§ Significant capital and time investments required to build-up technology and relationships with travel
providers / travel agents
§ High switching costs for GDS users
Consortium Airlines
Equity i njecti on
Bondholders
Sharehol der Sharehol der
loans WAM Acquisition loans
(BidCo)
Investors
Acqua Finance
funds SA
Bond pr oceeds
Minorities MergCo
Bank Loans
proceeds
Holding Gmbh Senior Lenders
Amadeus
Gmbh
Total equity included in the transaction will amount to €989 million, or 21.5% of total sources of funds.
This amount includes investments by the airlines of €448 million, the Sponsors of €526 million, and
Amadeus management of €15 million.
The following table summarises the sources and uses of this transaction:
181
Amadeus LBO – Capital Structure
(1) (1)
Sources €m % x EBITDA Uses €m % x EBITDA
Senior A 800 17.4% 1.32x Purchase Price (at €7.35 per share) 4,262 92.9% 7.06x
Senior B 950 20.7% 1.57x Debt Repaid 127 2.8% 0.21x
Senior C 950 20.7% 1.57x Enterprise Value 4,389 95.6% 7.27x
Total Senior Debt 2,700 58.8% 4.47x
High Yield Bond 900 19.6% 1.49x Fees 200 4.4% 0.33x
Total Cash Debt 3,600 78.5% 5.96x
Shareholder Loans 565 12.3% 0.94x
"Hard" Equity 424 9.2% 0.70x
Total Equity 989 21.5% 1.64x
o/w rolled over by
existing shareholders 448
Total Funded Sources 4,589 100.0% 7.60x Total Funded Uses 4,589 100.0% 7.60x
Proposed capital structure, and the actual leverage based on 2004 adjusted EBITDA of €604 million as
per table below.
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5.1.3. Financial Projections
The projections summarised below, which will serve as an illustrative Equity Base Case, have been
designed for training purposes only and differ, for reasons of confidentiality, from the Equity Case
developed at the time of the transaction. The projections are based on views of forecasted industry
volumes from external sources such as IATA and other industry surveys at the time of the transaction and
assume market share growth in various geographic regions as well as growth rates in various channels.
LTM 05-14
2004 2005P 2006P 2007P 2008P 2009P 2010P 2011P 2012P 2013P 2014P Cum
Sales 2,032 2,100 2,200 2,300 2,400 2,500 2,700 2,804 2,940 3,088 3,243 26,275
EBITDA 604 602 650 675 390 750 800 850 900 950 975 7,842
Capex 0 (87) (156) (150) (150) (155) (160) (160) (170) (170) (180) (1,538)
Change in NWC 35 (9) (6) (5) (10) (15) (10) (10) (15) (15) (60)
Free Cash Flows 604 550 485 519 535 585 625 680 720 765 780 6,244
Sales Growth 5.3% 3.3% 4.8% 4.5% 4.3% 4.2% 8.0% 3.8% 4.9% 5.0% 5.0%
EBITDA Margin 29.7% 28.7% 29.5% 29.3% 28.8% 30.0% 29.6% 30.3% 30.6% 30.8% 30.1%
Capex as % of Sales 0.0% 4.1% 7.1% 6.5% 6.3% 6.2% 5.9% 5.7% 5.8% 5.5% 5.5%
NWC as % of Sales
Less: Total Cash Taxes (53) (61) (71) (79) (103) (126) (150) (170) (204) (223) (1,239)
Less: Cash Interest Expenses (233) (222) (214) (205) (195) (184) (173) (163) (127) (84) (1,801)
Cash Flow available for Debt Repayment 265 202 233 251 286 316 357 387 435 473 3,204
LTM
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Year from closing 1.0y 2.0y 3.0y 4.0y 5.0y 6.0y 7.0y 8.0y 9.0y 10.0y
Cash Balance 0 115 213 316 421 532 752 1,109 546 31 504
Debt Outstanding
Revolver 0 0 0 0 0 0 0 0 0 0 0
Term Loan A 800 650 546 417 271 96 0 0 0 0 0
Cum % paid down 19% 32% 48% 66% 88% 100% 100% 100% 100% 100%
Term Loan B 950 950 950 950 950 950 950 950 0 0 0
Term Loan C 950 950 950 950 950 950 950 950 950 0 0
Total Senior Debt (excl. Cap lease) 2,700 2,550 2,446 2,317 2,171 1,996 1,900 1,900 950 0 0
(1)
Capital Leases 105 105 105 105 105 105 105 105 105 105 105
Total Senior Debt (incl. Cap lease) 2,805 2,655 2,552 2,422 2,276 2,101 2,005 2,005 1,055 105 105
Subordinated Debt 900 900 900 900 900 900 900 900 900 900 900
Total Cash Debt 3,705 3,555 3,452 3,322 3,176 3,001 2,905 2,905 1,955 1,005 1,005
Total Net Debt 3,441 3,239 3,006 2,755 2,469 2,153 1,796 1,409 974 501
EBITDA / Cash Interest 2.58x 2.92x 3.15x 3.36x 3.84x 4.36x 4.92x 5.51x 7.50x 11.60x
(EBITDA-Capex) / Cash Interest 2.21x 2.22x 2.45x 2.63x 3.05x 3.49x 3.99x 4.47x 6.16x 9.46x
Fixed Charge Cover 1.30x 1.30x 1.30x 1.30x 1.30x 1.79x 3.07x 0.49x 0.52x NA
2007 17.9% 20.3% 24.3% 27.7% 31.1% 2007 1.6x 1.7x 1.9x 2.1x 2.3x
Exit in year
Exit in year
2008 18.8% 20.4% 22.9% 25.1% 27.3% 2008 2.0x 2.1x 2.3x 2.4x 2.6x
2009 22.0% 23.0% 24.7% 26.1% 27.6% 2009 2.7x 2.8x 3.0x 3.2x 3.4x
Note: IRRs and money multiples are pre management dilution and exit costs
183
6. Case Study
Solutions can be found in the separate Investment Banking Department Analysis Handbook – Solution
Set.
Company A is a public company involved in manufacturing and selling building materials in Europe.
Shares currently trade at €97.0. Total diluted number of shares stands at 12.5 million and the existing Net
Debt at €600 million.
Research analysts’ consensus projections are available for the next 3 years, and have been extrapolated
by CS thereafter to cover a 10-year timeframe as follows:
(€ in millions)
Preliminary input from the Leveraged Finance team seems to indicate that a 5.0x total leverage (4.0x
2006E EBITDA of Senior Debt and 1.0x 2006E EBITDA of High Yield) could be contemplated for
transactions of this nature
Assuming:
„ 4.0x senior leverage (split 30%/35%/35% of A/B/C tranches paying respectively 3 years swap Euribor
of 3.5% + 2.25%/2.75%/3.25%). Full cash-sweep repayment (i.e. all FCFs after interest are used to
repay the senior debt every year)
„ 1.0x subordinated debt (High Yield paying a fixed coupon of 9.0% p.a.)
„ Sponsors investment made 100% through hard equity injection (i.e. no equity contributed in
shareholder loans form)
„ Is the debt paydown profile over the coming 10 years acceptable? Is there any refinancing risk on the
Senior Debt at maturity (i.e. in Year 9)?
„ What would the expected equity returns of the investors, assuming an ISO-multiple exit (i.e. Exit
EBITDA multiple = Entry EBITDA multiple) be in Year 4? What could a preliminary LBO valuation range
be?
184
Credit and Debt Capacity Analysis
185
Credit and Debt Capacity Analysis
1. Overview of Credit Analysis
This section provides an overview of the key aspects of credit analysis including:
„ The basis for the debt capacity and optimal capital structure work undertaken
„ A day-to-day guide to the methodology and practical steps in completing these analyses
„ Operating metrics
§ Such as growth, margins and future investment needs
„ Financial flexibility
§ Including access to the debt financing markets and new equity
„ Ratings
„ External factors
„ Debt structure
In addition to the financial modeling exercise of assessing the future cash flows of a company and its
consequent ability to service and pay down debt within an appropriate timeframe, these factors should
also be considered when looking at the various credit statistics which are used to compare companies
and assess their relative standing (see Section 1.5 of this chapter).
Whilst these analyses are critical to understanding the credit picture and confirming the robustness of a
company’s financial plan, the following sections concentrate on debt structure.
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1.3. Structuring Considerations, Security, Covenants and Tenor
1.3.1. Overview
There are a number of credit products available to suit the varying needs of clients. The key
distinguishing factors between these products are based on their relative ranking, security packages,
terms (such as maturity and amortisation requirements) and covenants. These products are structured to
balance the needs of issuers (maximum borrowing and operational flexibility at lowest costs) and
investors (highest return with lowest risk).
There are two basic forms of debt products available to corporate clients:
„ Loans
Commonly known as bank debt or syndicated loans, these products are not listed on public exchanges
§ Historically, these products have been lent by the banking community and as such have tended to
be less tradable and in a private-form, with lenders having access to confidential information on the
company, including company projections
§ However, recently a large institutional investor base for loans has developed and, as such, the
product has taken on a more tradable and public form, whereby investors are seeking both ongoing
interest and capital appreciation as the loans trade up in the aftermarket
„ Bonds
Bonds are forms of debt which have market exchange listings and are fully public in nature. They are
tradable and as such, do not benefit from the dissemination of confidential information on the company,
but rather have consistent, typically historical, information which is provided to investors at regular
intervals. The ability to trade in and out of the security is key for these investors
As noted above, the boundary between loans and bonds has blurred in recent years. The investor base
for bonds (institutional investors including hedge funds) has increasingly been participating in the loan
market. This trend has become more common in the US, where a number of loan transactions,
particularly in the non-investment grade arena, are institutional only. In the European market, banks still
frequently participate in loan transactions alongside institutions.
The range of alternatives for the security a loan or bond takes is as follows:
„ Asset security
§ This can either take the form of a fixed charge, where the lender has a fixed pledge over specified
assets of a company or a floating charge, whereby the lender has general pledge, where possible,
9
over the company’s asset base . The benefit of asset security is that in a default scenario, the
lender is able to enforce its pledge on these assets and receive the proceeds from this sale of
assets to satisfy its debt obligation, coming ahead of other creditors
„ Share security
§ Similarly to asset security, this is a scenario where lenders have a pledge over the shares of a
particular company or operating entity. This enables the lender, in a default scenario, to sell the
shares of the company to repay debt. While this is a valuable option, it is arguably less attractive
than asset security which enables a lender to sell off assets piecemeal as well as in their entirety as
would be the case in a share sale. In addition, a sale of shares would mean that the entity sold
would have to be sold with its various obligations and encumbrances intact so that, for instance, the
trade payables at the company would effectively rank ahead of the lender enforcing on the share
security
„ Guarantees
§ This is an obligation which an entity provides to another entity to support an obligation. The
guarantee can take a secured (i.e. benefiting from asset security) or unsecured form
9
The concept of fixed and floating charges is an English law distinction which in other jurisdictions varies in terminology and nature.
188
„ First vs second ranking security
§ The above forms of security can be taken in first ranking form or second ranking form, whereby the
lenders enjoying the second lien would receive enforcement proceeds only after the first lien debt
has been repaid
In addition to security, debt can have differing forms of seniority or subordination in the capital structure.
„ Senior debt typically takes loan form and is the first recovery component of the capital structure
§ For non-investment grade transactions, the senior debt typically enjoys security over the company’s
assets and/or shares as a means of ensuring this first priority ranking in the capital structure
§ Forms of senior debt include term loan facilities, revolving credit facilities and securitisation
transactions
§ Typically in investment grade loans or bonds, the lenders do not benefit from any security at all or at
most, an unsecured guarantee from the company’s operating subsidiaries. However, this debt
would still often rank senior in the capital structure by virtue of there being no priority debt ahead of it
„ Subordinated debt has a ranking below that of senior debt in a company’s capital structure
§ Forms of subordinated debt include high yield bonds, mezzanine loans and PIK debt. These forms
of debt have various levels of subordination in a company’s capital structure
§ Debt can be subordinated either by legal contract (contractual subordination) or by way of structure
(structural subordination) whereby the debt could be raised at a holding company one step removed
from the company’s operating entity and as such is subordinated to the debt residing at the
operating entity itself
§ This subordinated debt is cushioned against a first loss on insolvency by a company’s invested
equity, but takes losses afterwards
The chart below sets out the various securities available to a company, differentiated by the seniority of
such instruments:
Expected and
Required (%)
After-Tax Common
Rate of Return Stock
PIK Preferred Stock
Holding Company Cash Pay Preferred Stock
Subordinated Note
Risk Premium Senior Debenture (Unsecured)
Common Stock
189
1.3.3. Covenants
In order to protect the interests of lenders, debt is usually structured with various covenants to govern the
behaviour of a company or act as an early warning system in the event of underperformance by the
company. Covenants can take various forms, a summary of which is set out below:
190
§ Change of control – if the ownership of the company changes hands (or ownership changes beyond
a certain defined threshold), the bondholders can require, at their option, that the company
repurchase the notes at 101% of the aggregate principal amount of the bonds
§ Reporting – the company must furnish the bondholders with (i) all quarterly and annual financial
information that would be required in a 10-Q or 10-K and (ii) all reports that would be required to be
filed under form 8-K
„ Maturity
§ Bank debt typically has a shorter maturity (5-9 years for non-investment grade) than bonds (7-10
years)
„ Amortisation profile
§ Bank debt can have an amortising profile (typically, term A loans have a 5-7 year maturity and have
annual scheduled repayments) or a bullet repayment profile (typically, term B and C loans have an 8
or 9 year maturity and are repayable in whole at maturity)
§ Bonds are typically bullet repayment instruments (although very rarely, they can have sinking fund
requirements whereby some payments are required in advance of maturity)
„ Pricing
§ Given the differing repayment profile, ranking and security that bonds and bank debt typically enjoy,
as a general matter bank debt is cheaper than bonds. However, as noted above, bonds can be
structured to rank senior in a company’s capital structure and as such can be similarly priced to bank
debt
§ Interest on bank debt is typically floating rate in nature (paying a percentage margin of EURIBOR or
LIBOR) whereas bonds can either be floating rate or fixed rate
„ Covenants
§ Bank debt typically has maintenance covenants whereas bonds typically have incurrence based
covenants
„ Ratings
§ Bonds tend to be rated by the rating agencies whereas this is less common for bank debt
„ Mezzanine is often structured to have some bond-like and some bank-like properties. The chart below
sets out a standard profile for this form of debt, although mezzanine transaction and indeed all forms of
non-investment grade debt, are tailored to specific borrower’s needs and investor perception
191
The following chart sets out the major forms of non-investment grade debt available to a company.
„ Maturity
§ The maturity of investment grade loans can vary from 1 to 7 years. Bonds can have even longer
maturities, with 30 year tenors not being uncommon and some bonds having perpetual maturities
„ Amortisation profile
§ As with non-investment grade loans, investment grade loans can be amortising or bullet in nature
§ Similarly, investment grade bonds are typically bullet repayment instruments
192
„ Pricing
§ Interest on bank debt is typically floating rate in nature (paying a percentage margin of EURIBOR or
LIBOR) whereas bonds can either be floating rate or fixed rate
„ Covenants
§ For very highly rated investment grade corporates, the debt tends to have very limited covenant
protection. To the extent that there is covenant protection, this tends to be limited to major issues
such as a change of control provision (requiring a prepayment of the debt in a change of control
scenario) and a negative pledge (preventing the company from pledging its assets to another party)
„ Hybrid bonds
§ These are bonds which are structured to receive partial equity treatment from the rating agencies
and are in many ways similar to preferred equity. As such, they have been devised to bolster a
company’s credit rating, while continuing to enjoy the benefits of being debt (tax deductibility and
fixed coupon)
§ Hybrids can vary in nature depending on the amount of equity treatment received, but typically have
long tenors (e.g. 60 years), limited or no covenants and the ability to defer cash interest
„ Show how a company’s bonds are trading and how the public markets are valuing these bonds relative
to peer group
„ Form the basis for pricing benchmarks for a client considering a bond offering
„ Analyses the potential ratings impact of a capital structure contemplated in the context of a debt capital
raising (see section 2 in this chapter)
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1.5.2. Key Credit Ratios and Metrics
The credit ratios which are considered in evaluating an entity’s credit quality essentially compare various
operating and financial metrics for a company with their levels of debt. Although valuations are important
in this analysis, the metrics used tend to focus on cash flows given the importance of cash flows for the
servicing of debt.
Whilst there are certain industry specific metrics which can be used to compare the credit profiles of
certain companies, the credit statistics most commonly used in undertaking capital structure related credit
analyses are as follows:
„ Leverage ratios – the amount of debt a company has as a multiple of its cash flow or overall capital
structure:
§ Senior Debt / EBITDA
§ Total Debt / EBITDA
10
§ Total Debt (including the value of operating leases) / EBITDAR
§ Total Net Debt / EBITDA
§ Total Debt / Capitalisation
– Capitalisation is defined as the balance sheet values of a company’s debt plus preferred plus
book equity
§ Total Debt / Enterprise Value
„ Coverage ratios – the amount of cushion between a company’s cash flow and required debt service
payments:
§ EBITDA / Interest
§ EBITDA / Net Interest
§ (EBITDA-Capex) / Interest
§ Fixed charge cover
– Defined as a company’s FCF divided by its debt service (interest plus scheduled debt
amortisation payments)
§ Other
– EV / EBITDA
These metrics are typically considered on an historical (e.g. LTM or in high growth sectors, Latest Quarter
Annualised – “LQA”) basis, although when analysing projections, these same metrics are also considered
on a look forward basis.
Examples of the metrics used for specific industry based analyses include debt per subscriber, which is
sometimes used in the cable sector and debt / appraised land value which is used in the real estate
market. As noted, however, the credit ratios identified above represent the most important and commonly
used statistics in the credit comparisons which are undertaken.
10
Particularly used for lease heavy businesses such as retailers
194
The following table is an example of the sources and uses for a transaction:
195
1.6. Issues to Consider
„ Projections
§ Company information, where available
§ Published research should also be used whether or not company information is available, to
benchmark the projections provided by the company
„ Ratings
§ Moody’s, Standard & Poor’s, Bloomberg (CPRAT function)
„ Bond yields
§ High Yield / Debt Capital Markets
„ Debt
§ Remember to include Finance Lease Obligations and Short Term Debt in the calculation of debt
„ Non-recurring items
§ Make sure adjustments are made for items such as restructuring charges, gains (losses) on sales of
assets or write offs
196
„ Make sure consistent adjustments are made
§ For instance, if an adjustment for a company’s pension shortfall is included in the leverage multiple,
make sure that EBITDA is adjusted to take out pension contributions (so the numerator and
denominator are consistent) and make similar adjustments for the comparable universe
§ Seek guidance from High Yield / Debt Capital markets on which metrics are most relevant. For
instance, in certain sectors such as retail, it is relevant to consider (Debt + Operating Leases) /
EBITDAR (i.e. EBITDA plus rental payments) as well as Debt / EBITDA
Advanced
Micro Amkor Hynix Freescale MagnaChip STATS
Devices Technology Semi Semiconductor Semiconductor Spansion ChipPAC
Issue Sr Nts Sr Nts Sr Nts Sr Nts Sr Sub Nts Sr Nts Sr Sec Nts
(1)
Principal Amount $600.0 $425.0 $300.0 $500.0 $250.0 $250.0 $215.0
Coupon 7.750% 7.750% 9.875% 7.125% 8.000% 11.250% 6.750%
First Call Date 01/11/2008 5/15/2008 01/07/2009 7/15/2009 12/15/2009 1/15/2011 11/15/2008
Maturity 01/11/2012 5/15/2013 01/07/2012 7/15/2014 12/15/2014 1/15/2016 11/15/2011
Rating (Moody's / S&P) B1 / B Caa1 / CCC+ B1 / B+ Ba1 / BBB- B2 / B- Caa1 / B Ba2 / BB
Price (2-May-06) 104.000 95.250 109.875 103.250 93.000 103.250 97.250
YTW 6.70% 8.66% 7.53% 6.48% 9.19% 10.61% 7.36%
STW (bps) +176 +367 +258 +150 +416 +560 +240
Cash $1,794.8 $206.6 $1,267.3 $3,025.0 $71.0 $725.8 $290.1
Bank Debt $270.3 $417.1 $1,170.0 $1,237.0 $511.1 $378.7 $475.2
Convertible and Other Subordinated Debt 1,100.0 1,723.6 710.0 0.0 250.0 380.9 346.5
Total Debt $1,370.3 $2,140.6 $1,880.0 $1,237.0 $761.1 $759.6 $821.7
Net Debt (424.5) 1,934.1 612.7 (1,788.0) 690.1 33.8 531.7
Market Value of Equity $16,441.6 $1,547.3 $12,712.1 $11,173.9 N/A $1,938.9 $1,507.8
Enterprise Value 16,017.1 3,481.4 13,324.8 9,385.9 N/A 1,972.6 2,039.4
Enterprise Value / Revenue 2.7x 1.7x 2.4x 1.6x N/A 1.0x 1.8x
Enterprise Value / EBITDA 10.8x 10.8x 5.3x 7.1x N/A 7.4x 7.3x
LTM Revenue $5,847.6 $2,099.9 $5,620.0 $5,843.0 $858.4 $2,002.8 $1,157.3
LTM EBITDA 1,487.8 323.8 2,520.0 1,317.0 177.6 267.1 279.0
Margin % 25.4% 15.4% 44.8% 22.5% 20.7% 13.3% 24.1%
Capital Expenditures $1,513.0 $295.9 $2,440.0 $491.0 $53.1 $431.8 $209.3
Bank Debt / EBITDA 0.2x 1.3x 0.5x 0.9x 2.9x 1.4x 1.7x
Convertible and Other Subordinated Debt / EBITDA 0.7x 5.3x 0.3x 0.0x 1.4x 1.4x 1.2x
Total Debt / LTM EBITDA 0.9x 6.6x 0.7x 0.9x 4.3x 2.8x 2.9x
Net Debt / LTM EBITDA (0.3x) 6.0x 0.2x (1.4x) 3.9x 0.1x 1.9x
Cash / Capex 1.2x 0.7x 0.5x 6.2x 1.3x 1.7x 1.4x
Total Debt / Enterprise Value 8.6% 61.5% 14.1% 13.2% N/A 38.5% 40.3%
197
1.8.2. Summary Term Sheet Examples
Borrower TBA
Lead Arranger, Credit Suisse
Bookrunner and Agent
Principal Amount €709 million, split as follows:
Term Loan A: €178 million
Term Loan B: €178 million
Term Loan C: €178 million
Term Loans A, B, C to be available in EUR, USD, GBP in splits to be agreed
Revolving Facility: €50 million (drawn in EUR and other currencies to be agreed)
Acquisition Facility: €125 million (drawn in EUR and other currencies to be agreed)
Tenor Senior Term Loan A amortising, final repayment 7 years from completion with
average loan life of no more than 4.5 years
Term Loan B: 8 year bullet maturity
Term Loan C: 9 year bullet maturity
Revolving Facility: 7 year maturity
Acquisition Facility: 7 year maturity; 3 years availability, amortising in equal semi-
annual instruments over remaining 4 years
Purpose Term loans A, B, C: to (i) refinance existing indebtedness; (ii) pay portion of the
acquisition price; and (iii) pay related fees and expenses
Revolving Facility: To fund working capital and for general corporate purposes
Acquisition Facility: To fund Permitted Acquisitions together with associated costs
and expenses
Ranking Senior secured (to the extent permitted by law)
Interest Rate The aggregate of: (i) the Margin; (ii) EURIBOR; and (iii) reserve asset costs (if
applicable)
Margin Term Loan A: 225 bps
Term Loan B: 275 bps
Term Loan C: 325 bps
Revolving Facility: 225 bps
Acquisition Facility: 225 bps
Term Loans A and B together with Revolving and Acquisition Facilities will be
subject to an interest margin ratchet based upon Total Net Debt to EBITDA.
Financial Covenants To include Leverage, Interest Coverage, Cashflow and Capex Tests - headroom
20% - 25% above the agreed base case
Security Full security package to the extent legally and practically possible
Conditions Precedents Usual for transactions of this nature, to include due diligence reports
Mandatory Prepayment Typical for these transactions, to include change of control, listing and sale,
disposals, surplus cash, vendor payments, insurance proceeds
Governing Law and Forum English Law
Counsel to Credit Suisse Clifford Chance and Cravath, Swaine & Moore
Fees 2.25%
Commitment Fee on Revolving and Acquisition Facilities: 0.75% per annum
Note: Integration costs to be covered by the Revolving Credit Facility or the Acquisition Facility
198
European Second Lien Facility
Borrower TBA
Lead Arranger, Credit Suisse
Bookrunner and Agent
Amount €120 million
Tenor Six months after the final maturity of the Senior Credit Facilities
Purpose To: (i) refinance existing indebtedness; (ii) pay portion of the acquisition price; and
(iii) pay related fees and expenses
Ranking Second secured plus benefits from sub guarantees (intercreditor agreement)
Interest Rate EURIBOR; and Cash Margin
Margin 4.50 - 4.75% per annum cash pay or a 2% spread differential to the Floating Rate
Notes
Financial Covenants Same as for the Senior Credit Facilities
Borrower TBA
Lead Arranger, Credit Suisse
Bookrunner and Agent
Amount €275 million
Tenor One year after the final maturity of the Senior Credit Facilities, but at least upon tenth
anniversary from closing
Purpose To: (i) refinance existing indebtedness; (ii) pay portion of the acquisition price; and
(iii) pay related fees and expenses
Ranking Second secured plus benefits from sub guarantees (intercreditor agreement)
Interest Rate The aggregate of: (i) EURIBOR; and (ii) the Cash Margin, (iii) an accruing semi-
annually compounding PIK margin
Margin 4.0% per annum cash pay (with semi-annual interest payments); 6.5% per annum
PIK
Financial Covenants Standard for financings of this nature, set at a 10% cushion to the covenants under
the Senior Credit Facilities, and including financial undertakings substantially similar
to the Senior Credit Facilities
Events of Default Usual for transactions of this nature
Conditions Precedents Usual for transactions of this nature, to include due diligence reports
Fees 2.75%
199
High Yield Senior Notes
Issuer TBA
Lead Arranger and Credit Suisse
Bookrunner
Issue: Senior Notes (the “Notes”)
Distribution: Private Placement via Rule 144A (without registration rights)
Principal Amount: €275 million
Indicative Rate: 8.5%
Maturity: 10 years
Interest: Semi-annual cash coupon
Ranking: The Notes will rank pari passu to all existing and future Senior Indebtedness,
including any Senior Credit Facilities, and rank senior to all subordinated debt of the
Company.
Call Protection: 5 year non-call (10 year maturity); best efforts at NC4
Optional Redemption: Redeemable at the option of the Company at any time after the after the 5th
anniversary at a premium equal to one half the coupon declining ratably to Par at the
end of the 8th anniversary
Equity Clawback: Up to 35% of the Notes may be redeemed at any time prior to the 3rd anniversary of
the Issue Date at a premium with the proceeds of one or more public equity offerings
of the Company’s Common Stock
Change of Control Put: In the event of a Change of Control, the Company will be obligated to make an offer
to redeem a holder’s Notes at a redemption price of 101% of the principal amount of
the Notes plus accrued and unpaid interest to the Redemption Date
Guarantees: All domestic subsidiaries
Certain Covenants: Incurrence Covenants Only (No Maintenance Covenants):
Limitation on Indebtedness
Limitation on Restricted Payments
Limitation on Mergers and Consolidations
Limitation on Asset Sales
Limitation on Payments Restrictions Affecting Subsidiaries
Limitation on Transactions with Affiliates
Limitation on Liens
200
PIK Notes
2.1. Overview
These can either be assigned to a legal entity (Issuer Rating) or to a specific debt instrument (Short or
Long Term Debt Rating).
There is a separation of investment grade (AAA to BBB-) and non-investment grade ratings (BB+ and
below). An investment grade rating views the obligor’s capacity to meet its financial commitment to the
obligation from extremely strong (AAA) to adequate (BBB). Non-investment grade ratings are regarded as
having significant speculative characteristics. While such obligations likely will have some quality and
protective characteristics, these may be outweighed by large uncertainties or major exposure to adverse
conditions.
As a practical matter, issuers can only access the capital markets with ratings of Caa2 / CCC or better
since low CCC and below means default.
201
The Rating Scale
A+ A1 A+
A A2 A
A- A3 A-
BBB+ Baa1 BBB+
BBB Baa2 BBB
BBB- Baa3 BBB-
Debt Ratings (Short- and/or Long-Term) „ A rating assigned to a public or private issue of debt and
monitored throughout the debt’s life
Indicative Ratings „ A non public, informal rating, at a single point in time, assigned
to an issuer contemplating a debt issue
Issuer Ratings „ A public rating assigned at the senior unsecured level albeit
that there may be no debt outstanding at that level
Syndicated Loan Ratings „ A rating assigned to a syndicated bank loan and monitored
throughout the life of the loan (may also be private and not
monitored)
Indicative ratings are often used by bankers or issuers in trying to assess cost of capital or optimal
structures.
„ Take a bondholder perspective (i.e. focus on cash flows and cash adequacy)
„ Evaluate the ability of the borrower’s capacity and willingness to meet financial obligations to lenders /
investors as they come due
„ Look for evidence of contingency planning and financially responsible growth plans
„ Assess the severity of loss and recovery for different classes of creditors in a bankruptcy (structural
assessment)
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The ratings analysis takes into account the industry fundamentals as well as the specific business and
financial profile of a company:
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2.2.2. Financial Analysis: Key Credit Ratios
EBIT interest coverage = Earnings from continuing operations before interest and taxes
Gross interest incurred before subtracting capitalized interest and interest income
EBITDA interest coverage = Adjusted earnings from continuing operations before interest, taxes and D&A
Gross interest incurred before subtracting capitalized interest and interest income
FFO*/Total debt = Net income from continuing operations + D&A, deferred income taxes
and other non-cash items
Long-term debt** + current maturities, commercial paper
and other short-term borrowings
FOCF/Total debt = FFO* - CAPEX - (+) the increase (decrease) in working capital
(excluding changes in cash, marketable securities, and short-term debt)
Long-term debt** + current maturities, commercial paper
and other short-term borrowings
Operating income/Sales = Sales - cost of goods manufactured (before D&A), SG&A costs and R&D costs
Sales
Discretionary cash flow/ = FFO* - CAPEX - (+) increase (decrease) in working capital
Total debt (excluding changes in cash, marketable securities, and short-term debt)
- common and preferred dividends
Long-term debt** + current maturities, commercial paper
and other short-term borrowings
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Moody’s formulas for key ratios:
EBIT interest coverage = EBIT plus other income minus other expense plus foreign
currency translation minus other expense
Interest expense
Retained cash flow / = Gross cash flow minus total dividends (common and preferred)
Total adjusted debt Long term debt plus short term debt plus current maturities, adjusted for
operating leases, pension liabilities, hybrids, accounts receivable securitizations
and other off-balance sheet obligations
Operating margin = EBIT plus other income mi nus other expense plus foreign
currency translation minus other expense
Net sales
Total coverage = EBIT plus other income mi nus other expense plus foreign
currency translation plus interest component of rent expense mi nus other expense
Interest expense plus interest component of rent expense
plus (tax effected preferred dividends)
Total adjusted debt / = Long term debt plus short term debt plus current maturities, adjusted for
Total adjusted capitalization operating leases, pension liabilities, hybrids, accounts receivable securitizations
and other off-balance sheet obligations
Total adjusted debt plus common shareholder’s equity, minority
interest, preferred stock (at liquidation value) and deferred taxes
minus cumulative other comprehensive income adjustment
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2.2.3. Interpretation of Key Ratios
The table below presents the medians per rating category for industrials. The ratios do not constitute a
requirement for any given rating. The Rating Agencies assign ratings through the cycle so in a cyclical
industry ratios of a particular company at any point in the cycle may not appear to be in line with its
assigned ratings. The business profile of a company, the quality of its management, its track record with
the Rating Agencies and the industry fundamentals are the key differentiating factors. Therefore, it is
common to have two companies with exactly the same ratios but completely different ratings.
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2.2.5. Suggested Outline of a Ratings Presentation
To the extent that certain obligations have a priority claim on the company’s assets, lower-ranking
obligations are at a disadvantage because a smaller pool of assets will be available to satisfy the
remaining claims. Three forms of disadvantage can arise:
„ When the instrument is contractually subordinated the terms of the issue specifically provide that debt
holders will receive recovery in a reorganisation or liquidation only after the claims of other creditors
have been satisfied
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„ When the instrument is unsecured while assets representing a significant portion of the company’s
value collateralise secured borrowings
„ When there is an operating subsidiary / holding-company structure, in which case, if the whole group
declares bankruptcy, creditors of the subsidiaries, including holders of even contractually subordinated
debt, would have the first claim to subsidiaries’ assets, while creditors of the parent would have only a
junior claim, limited to the residual value of the subsidiaries’ assets remaining after the subsidiaries’
direct liabilities have been satisfied. The disadvantage of parent-company creditors owing to the parent
/ subsidiary legal structure is known as structural subordination
Notching practices at S&P and Moody’s differ and can result in different bond and bank loan ratings:
Where syndicated loans or bonds are secured, Standard & Poor’s assigns a recovery rating (and Moody’s
is going to introduce the practice as well). The recovery rating scale estimates the likely recovery of
principal in the event of default and is de-linked from the corporate credit rating. The recovery rating uses
a numerical scale with 1+ and 1 being the two highest rankings, denoting different levels of likelihood that
an issue will fully recover principal in the event of default. Recovery ratings below that, from 2 to 5, denote
progressively lower levels of expected principal recovery.
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2.4. Equity Credit: What It is and How an Issuer Gains It
„ No creditor rights
From the Rating Agencies’ perspective, the equity-like instrument’s economic impact is relevant and not
the accounting, tax or regulatory treatment. The Rating Agencies evaluate the flexibility that the
instrument provides to the issuer compared with pure equity. They assess the instrument’s component
features and then allocate a portion to debt and equity. Equity credit and the resultant impact on financial
ratios varies by rating agency.
Maturity „ Similar to common equity that has no defined term: perpetual or very long-dated,
long non-call period and/or call with substitution or refinancing
„ Expected to remain a permanent feature of the capital structure
Loss Absorption „ Limited or no ability to enforce default or acceleration (no negative pledge or
similar covenants)
Management Intent „ Regarding use of proceeds, capital mix, call and replacement
Moody’s analytical goal is to simulate a company’s financial statements assuming it had bought and
depreciated the leased assets, and financed the purchase with a like amount of debt. Moody’s approach
entails adjustments to the balance sheet, income and cash flow statements. Moody’s applies a multiple to
current rent expense to calculate the amount of the adjustment to debt. The number of rent multiples
expands from 5x to 10x depending on the sector of activity.
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2.5.2. PIK Instruments
Rating Agencies view secondary PIK notes typically being sold to third-party investors as a means for
shareholders to effectively receive an early cash return from their investment often signalling a change in
financial policy from that incorporated in the initial ratings.
The calculation of total leverage needs to be adjusted to include any PIK instruments.
Shareholder
PIK proceeds
Holdco
Restricted Group
(Sr. Unsec. Issuer)
Opco
(bank borrower)
However, LBO shareholder loans which serve to provide initial acquisition funding to purchase the LBO
asset normally are excluded from the debt calculation, provided that:
„ There is no cross-acceleration of debt obligations to the bond and bank debt group
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2.5.3. Post-Retirement Obligations
S&P treats all pension obligations the same way whilst Moody’s differentiates between funded and
unfunded plans:
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