M&A: CONCEPTS AND THEORIES

NEW YORK INSTITUTE OF FINANCE

Valuation part 1

What are the four approaches? The first one is the one you learn about in business
school or in finance class. And that's where a firm equals the present value of its
cash flow or dividend. That's often referred to as fundamental value or discounted
cash flow.

The second one is publicly traded companies, where you have a subject business--
could be privately owned-- and you're comparing it to similar public companies. So a
lot of you have probably seen this if you ever bought a house. Because you're going
to look at an apartment or a condominium in a certain neighbourhood, and the
agent will show you comparable sales in that neighbourhood. So it's comparable to
public companies. It's just like real estate.

Acquisitions-- it's very similar to public companies, except there you're looking at
companies that have been taken over that are similar to the subject business. And
then the last one, which is not applicable to a lot of businesses but is often used for
those that qualify, would be the leveraged buyout, where you look at the target,
see if it qualifies for a leveraged buyout. If it did, what would a leveraged buyout
firm pay for the company?

So I'm going to spend a few minutes looking at the pluses and the minuses of each
technique. So discounted cash flow-- what's the big plus there? Well, it's
theoretically appropriate. I mean, in a perfect world, you'd use discounted cash flow
to value any business. The other thing that's good about it is corporate lenders.
Those people who are going to lend the buyer money for a transaction use
discounted cash flow a lot.

Now, the negative side is actually larger than positive. I mean, what are the
negatives of discounted cash flow? Well, a lot of practitioners don't use it--
practitioners, i.e., investment bankers, buyers, sellers-- because projections are too
subject to manipulation, too subjective. Not only are the projections subject to
manipulation and inaccurate, but the discount rates are also a subject of argument.

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So a lot of practitioners, to save time, they don't want to argue with buyers and
sellers about what that forecasts are and what the right discount rate is. It's just
running around in a circle. It's just a complete waste of time.

Finally, the terminal value, if you do one of these DCF calculations-- usually they're
like five or 10 years-- the terminal value, the price at which the target company is
sold in this imaginary world, is often half the value in the present. So here you have
most of your discounted cash flow dependent on some projection of price in five or
10 years, so you can see how crazy it gets. Finally, at least in the States, a lot of
courts are sceptical of this approach, which, again, provides more support for not
using it.

So the comparable public company approach has got some pluses, because the
values of the public companies-- you can just look them up on your computer. Just
pick out all the companies that are similar to your target business, and then you
look at what the values are. What are the PE multiples of the enterprise valued to
EBITDA multiples? And there's no dispute. There's no subjectivity. It's right there in
the newspaper or a computer.

All these calculations are also audited. All the financial statements are audited by
these big name accounting firms. Yeah, they're not right 100% of the time, but they
are usually reasonably accurate. So you have undisputed values based on
accounting data.

Now, what are the negatives? Well, the negative is a lot of times there aren't any
comparables. The subject business is such that there's just not enough companies
to compare it to.

For example, 15 years ago, when Starbucks went public, people wanted to compare
it to something, but there weren't any publicly traded coffee shop chains. So people
had to think of other, somewhat similar businesses. Anybody got an idea what a
similar one would be with a coffee chain?

Sandwiches.

Yeah. Sandwich shop or a small gift shop or an ice cream chain or something like
that. But they were hurting. The underwriters were hurting for comparables. Also,

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there's often no yardstick to determine whether the current market is a fair market
for these stocks.

So now you might say, oh, social media stocks are just way overpriced. You're
probably right. So if you're thinking of buying a social media stock, the whole
sector's inflated, so therefore your valuation for their target business will also be
inflated.

So that's a problem if you're not in the social media business. You're going to end up
paying too much. Also, when you look at the numbers for these comparable public
companies, when you look at PE ratios and other ratios, if you look at, say, General
Motors' PE ratio right now and look it up in the computer-- let's say it's 20 time--
that's based on the earnings going backwards.

So today is March, and you're looking at the year going backwards, whereas when
you buy a company you're supposed to be looking forwards, not backwards. When
you drive your car, do you look forwards or do you look backwards? 99% of the time
I'm looking forwards. So when you're buying a company, think of it just like you're
driving a car. Backwards is one reference point, but you want to look at in the
future.

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