1

Book Summary – Investment Banking

Chapter 7 Buy-Side M&A (pp. 355-361; 372-375; 376-396)

Mergers and acquisitions (M&A) is a catch-all phrase for the purchase, sale, and
combination of companies, their subsidiaries and assets. M&A facilitates a company’s ability
to continuously grow, evolve, and re-focus in accordance with ever-changing market
conditions, industry trends, and shareholder demands.
M&A advisory assignments are core to investment banking, traditionally
representing a substantial portion of the firm’s annual corporate finance revenues.
On buy-side advisory engagements, the core analytical work centers on the
construction of a detailed financial model that is used to assess valuation, financing
structure, and financial impact to the acquirer (“merger consequences analysis”).

Buyer Motivation
In many instances, growth through an acquisition represents a cheaper, faster, and less risky
option than building a business from scratch (Greenfielding). Acquisitions typically build
upon a company’s core business strengths with the goal of delivering growth and enhanced
profitability to provide higher returns to shareholders.

Synergies
Synergies refer to expected cost savings, growth opportunities, and other financial benefits
that occur as a result of the combination of two companies.
Due to their critical role in valuation and potential to make or break a deal, bankers
on buy-side assignments need to understand the nature and magnitude of the expected
synergies. Upon announcement of a material acquisition, public acquirers typically provide
the investor community with guidance on expected synergies.

Cost synergies
On the cost side, traditional synergies include headcount reduction, consolidation of
overlapping facilities, and the ability to buy key inputs at lower prices due to increased
purchasing power. Increased size provides for economies of scale and economies of scope.

Revenue synergies
A typical revenue synergy is the acquirer’s ability to sell the target’s products through its
own distribution channels without cannibalizing existing acquirer or target sales. An
additional revenue synergy occurs when the acquirer leverages the target’s technology,
geographic presence, or know-how. Revenue synergies tend to be more speculative than
cost synergies.
2

Acquisition Strategies
Horizontal Integration
Horizontal integration involves the purchase of a business (at the same level of the value
chain) that expands the acquirer’s geographic reach, product lines, services, or distribution
channels. In this type of transaction, the acquirer seeks to realize both economies of scale
and scope.

Vertical Integration
Vertical integration seeks to provide a company with cost efficiencies and potential growth
opportunities by affording control over key components of the supply chain. There are two
ways of vertical integration:
- Backward integration: when companies move upstream to purchase their suppliers.
- Forward integration: when companies move downstream to purchase their
customers.

Conglomeration
Conglomeration refers to a strategy that brings together companies that are generally
unrelated in terms of products and services provided under one corporate umbrella. This
strategy seeks to benefit from portfolio diversification benefits.

Buy-Side Valuation
The primary methodologies used to value a company – namely, comparable companies,
precedent transactions, DCF, and LBO analysis – form the basis for this exercise. The results
of these analyses are typically displayed on a graphic known as a “football field” for easy
comparison and analysis.

Football Field
This graphic is a commonly used visual aid for displaying the valuation ranges derived from
the various methodologies. Once completed, the football field is used to help fine-tune the
final valuation range, typically by analyzing the overlap of the multiple valuation
methodologies.

The DCF typically provides the highest valuation, primarily due to the fact that it is based on
management projections, which tend to be optimistic, especially in M&A sell-side situations.
Traditionally, LBO analysis, which serves as a proxy for what a financial sponsor might be
willing to pay for the target, has been used to establish a minimum price that a strategic
buyer must bid to be competitive.
3

Analysis at Various Prices

AVP displays the implied multiples paid at a range of offer prices (for public targets) and
transaction values at set intervals.

Contribution Analysis
Contribution analysis depicts the financial “contributions” that each party makes to the pro
forma entity in terms of sales, EBITDA, EBIT, net income, and equity value, typically
expressed as a percentage.

Merger Consequences Analysis

Merger consequences analysis involves examining the pro forma impact of a given
transaction on the acquirer. It measures the impact on EPS in the form of
accretion/(dilution) analysis, as well as credit statistics through balance sheet effects.

Key merger consequences analysis outputs:

- Purchase price assumptions
- Sources and uses of funds
- Premium paid and exchange ratio
- Summary financial data (balance sheet effects)
o Factoring into both purchase price and financing structure considerations.
o Driven primarily by purchase price and the sources of financing.
- Pro forma capitalization and credit statistics
o Most widely used credit statistics are grouped into leverage ratios and
coverage ratios.
- Accretion/(dilution) analysis
o Measures the effects of a transaction on a potential acquirer’s earnings,
assuming a given financing structure.
o If pro forma combined EPS < acquirer’s standalone EPS  transaction is
dilutive.
o If pro forma combined EPS > acquirer’s standalone EPS  transaction is
accretive.
o Key drivers for accretion/(dilution) are purchase price, acquirer and target
projected earnings, synergies, and form of financing.
 Accretion decreases as purchase price is increased.
 Accretion increases in accordance with a higher proportion of debt
financing and a lower offer price.
 Maximum accretive results are achieved by increasing synergies and
decreasing offer price.
- Implied acquisition multiples
4

Chapter 6 Sell-Side M&A

If the seller is largely indifferent toward confidentiality, timing, and potential business
disruption, the advisor may consider running a broad auction. This type of auction is
designed to maximize competitive dynamics and heighten the probability of finding the one
buyer willing to offer the best value.
If speed, confidentiality, a particular transaction structure, and/or cultural fit are a
priority for the seller, then a targeted auction, where only a select group of potential buyers
are approached, or even a negotiated sale with a single party, may be more appropriate.

In a sale process, theoretical valuation methodologies are ultimately tested in the market
based on what a buyer will actually pay for the target. An effective sell-side advisor seeks to
push the buyer(s) toward, or through, the upper endpoint of the implied valuation range for
the target.

Auctions
An auction is a staged process whereby a target is marketed to multiple prospective buyers.
A successful auction requires significant dedicated resources, experience, and expertise. To
ensure a successful outcome, investment banks commit a team of bankers that is
responsible for the day-to-day execution of the transaction. In the later stages of an auction,
a senior member of the sell-side advisory team typically negotiates directly with prospective
buyers with the goal of encouraging them to put forth their best offer.

Valuation Paradigm
Implied valuation range
- Comparable companies analysis
- Precedent transactions analysis
- Discounted cash flow analysis
- Leveraged buyout analysis

Common value drivers

- Sector performance and outlook
- Company performance
- Company positioning
- General economic and financing market conditions

Broad Auction
- Maximizes the universe of prospective buyers approached
- Designed to maximize competitive dynamics, thereby increasing the likelihood of
finding the best possible offer.
5

(Dis)advantages Exhibit 6.2 on page 318.

Targeted Auction
Focuses on a few clearly defined buyers that have been identified as having a strong
strategic fit and/or desire, as well as the financial capacity, to purchase the target.
(Dis)advantages Exhibit 6.2 on page 318.

Stages of an Auction Process

- Organization and preparation (2-4 weeks)
- First round (4-6 weeks)
- Second round (6-8 weeks)
- Negotiations (2-4 weeks)
- Closing (4-8 weeks +)

Auction Structure
Organization and Preparation
- Identify seller objectives and determine appropriate sale process
o Whether to run a broad or targeted auction.
- Perform sell-side advisor due diligence and preliminary valuation analysis
o Understanding of the target’s business and the management team’s vision.
o Understand and provide perspective on the assumptions that drive
management’s financial model.
- Select buyer universe
o When evaluating strategic buyers, the banker looks first and foremost at
strategic fit, including potential synergies, and financial capacity or “ability to
pay”.
o When evaluating potential financial sponsor buyers, key criteria include
investment strategy/focus, sector expertise, fund size, track record, etc.
- Prepare marketing materials
o Teaser: first marketing document presented to prospective buyers.
o Confidential information memorandum (CIM): detailed written description of
the target that serves as the primary marketing document for the target in an
auction.
- Prepare confidentiality agreement
o Legally binding contract between the target and prospective buyers that
governs the sharing of confidential company information.

First Round
- Contact prospective buyers
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o Scripted phone call, followed by the delivery of the teaser and CA.
- Negotiate and execute confidentiality agreement with interested parties
- Distribute Confidential Information Memorandum and initial bid procedures letter
- Prepare management presentation
- Set up data room
o Serves as the hub for the buyer due diligence that takes place in the second
round of the process.
- Prepare stapled financing package (if applicable)
o “pre-packaged” financing structure in support of the target being sold. The
staple is targeted toward financial sponsor buyers and is typically only
provided for private companies.
- Receive initial bids and select buyers to proceed to second round
o Advisor’s past deal experience, specific sector expertise, and knowledge of
the given buyer universe is key in this respect.

Second Round
The second round of the auction centers on facilitating the prospective buyers’ ability to
conduct detailed due diligence and analysis so they can submit strong, final binding bids by
the set due date.
- Conduct management presentations
- Facilitate site visits
- Provide data room access
- Distribute final bid procedures letter and draft definitive agreement
o The definitive agreement is a legally binding contract between a buyer and
seller detailing the terms and conditions of the sale transaction.
- Receive final bids

Negotiations
- Evaluate final bids
- Negotiate with preferred buyer(s)
- Select winning bidder
- Render fairness opinion
o A fairness opinion is a letter opining on the “fairness” (from a financial point
of view) of the consideration offered in a transaction.
- Receive board approval and execute definitive agreement

Closing
- Obtain necessary approvals
o Regulatory approval
o Shareholder approval
- Financing and closing
7

Negotiated Sale
In contrast to an auction, a negotiated sale centers on a direct dialogue with a single
prospective buyer. Negotiated sales are particularly compelling in situations involving a
natural strategic buyer with clear synergies and strategic fit. In many negotiated sales, the
banker plays a critical role as the idea generator and/or intermediary before a formal
process begins.

(Dis)advantages Exhibit 6.10 on page 346.

8

Chapter 3 Discounted Cash Flow Analysis (pp. 135-166)

The DCF analysis is premised on the principle that the value of a company, division,
business, or collection of assets (“target”) can be derived from the present value of its
projected free cash flow (FCF).

The valuation implied for a target by a DCF is also known as its intrinsic value, as opposed to
its market value, which is the value ascribed by the market at a given point in time.

Given the inherent difficulties in accurately projecting a company’s financial performance

over an extended period of time, a terminal value is used to capture the remaining value of
the target beyond the projection period. The projected FCF and terminal value are
discounted to the present at the target’s weighted average cost of capital (WACC).

A DCF output is viewed in terms of a valuation range based on a range of key input
assumptions, rather than a single value. The impact of these assumptions on valuation is
tested using sensitivity analysis.

Discounted Cash Flow Analysis Steps

I. Study the target and determine key performance drivers
II. Project free cash flow
III. Calculate weighted average cost of capital
IV. Determine terminal value
V. Calculate present value and determine valuation

Step I. Study The Target and Determine Key Performance Drivers

Study the Target
For a public company, a careful reading of its recent SEC filings (e.g. 10-Ks, 10-Qs, and 8-Ks),
earnings call transcripts, and investor presentations provides a solid introduction to its
business and financial characteristics.

For private, non-filing companies or smaller divisions of public companies (for which
segmented information is not provided), company management is often relied upon to
provide materials containing basic business and financial information. In the absence of this
information, other sources such as company websites, trade journals, and news articles are
used, as well as SEC filings and research reports for public competitors, customers and
suppliers.
9

Determine Key Performance Drivers

Particularly sales growth, profitability, and FCF generation with the goal of crafting (or
supporting) a defensible set of FCF projections.

Step II. Project Free Cash Flow

FCF is the cash generated by a company after paying all cash operating expenses and
associated taxes, as well as the funding of capex and working capital, but prior to the
payment of any interest expense.
Free Cash Flow Calculation
Earnings Before Interest and Taxes (EBIT)
Less: Taxes (at the marginal tax rate)
= Earnings before interest after taxes (EBIAT/NOPLAT)
Plus: Depreciation and amortization
Less: Capital expenditures
Less: Increase/(Decrease) in net working capital
= Free Cash Flow

Considerations for Projecting Free Cash Flow

Historical performance
Past growth rates, profit margins, and other ratios are usually a reliable indicator of future
performance, especially for mature companies in non-cyclical sectors. Typically, a time
horizon of the prior three-year period is used.

Projection period length

Typically, the banker projects the target’s FCF for a period of five years depending on its
sector, stage of development, and the predictability of its financial performance.

Projection of Free Cash Flow

Tax projections
A marginal tax rate of 35% to 40% is generally assumed for modeling purposes, but the
company’s actual tax rate (effective tax rate) in previous years can also serve as a reference
point.

Depreciation & amortization projections

While D&A decreases a company’s reported earnings, it does not decrease its FCF.

Depreciation
The straight-line depreciation method assumes a uniform depreciation expense over the
estimated useful life of an asset. Another depreciation method is accelerated depreciation,
which assumes that an asset loses most of its value in the early years of its life.
10

Amortization
Amortization differs from depreciation in that it reduces the value of definite life intangible
assets as opposed to tangible assets.

Capital expenditures projections

Capital expenditures are the funds that a company uses to purchase, improve, expand, or
replace physical assets such as buildings, equipment, facilities, machinery, and other assets.

Change in Net Working Capital projections

Net working capital is typically defined as non-cash current assets (“current assets”) less
non-interest-bearing current liabilities (“current liabilities”).

Current assets
- Accounts receivable (A/R)
- Inventory
- Prepaid expenses and other current assets

Current liabilities
- Accounts payable (A/P)
- Accrued liabilities
- Other current liabilities

Step III. Calculate Weighted Average Cost of Capital

The WACC represents the weighted average of the required return on the invested capital
(customarily debt and equity).
D E
WACC =( r d × (1−t )) × +r ×
D+ E e D+ E

Steps for calculating WACC:

1. Determine target capital structure
2. Estimate cost of debt (r d ¿
3. Estimate cost of equity (r e ¿
4. Calculate WACC

Determine Target Capital Structure

For public companies, existing capital structure is generally used as the target capital
structure. For private companies, the mean or median for the comparables is typically used.
11

Estimate Cost of Debt

For publicly traded bonds, cost of debt is determined on the basis of the current yield on all
outstanding issues. For private debt, the banker typically consults with an in-house debt
capital markets (DCM) specialist to ascertain the current yield.

Estimate Cost of Equity

Capital Asset Pricing Model (CAPM)
Cost of Equity ( r e ) =r f + β L ×(r m−r f )

Calculate WACC
D E
WACC =( r d × (1−t )) × +r e ×
D+ E D+ E

Step IV. Determine Terminal Value

As it is infeasible to project a company’s FCF indefinitely, the banker uses a terminal value to
capture the value of the company beyond the projection period. There are two widely
accepted methods used to calculate a company’s terminal value.

Exit Multiple Method

The EMM calculates the remaining value of a company’s FCF produced after the projection
period on the basis of a multiple of its terminal year EBITDA (or EBIT).
Terminal Value=EBITDA n × Exit Multiple , where n = terminal year of the projection period.
Perpetuity Growth Method
The PGM calculates terminal value by treating a company’s terminal year FCF as a
perpetuity growing at an assumed rate.
FCF n ×(1+ g)
Terminal Value= , where r = WACC
(r −g)

Step V. Calculate Present Value and Determine Valuation

The present value calculation is performed by multiplying the FCF for each year in the
projection period and the terminal value by its respective discount factor.
1
Discount Factor= n
(1+WACC )

PV of FCF n =FCF n × Discount Factor n

Mid-year convention
Mid-year convention assumes that a company’s FCF is received evenly throughout the year,
thereby approximating a steady (and more realistic) FCF generation.
1
Discount Factor=
(1+WACC )(n−0.5)
12

Terminal value considerations

When employing a mid-year convention for the projection period, mid-year discounting is
also applied for the terminal value under the PGM. The EMM, however, uses year-end
discounting.

Determine Valuation
Calculate Enterprise Value
A company’s projected FCF and terminal value are each discounted to the present and
summed to provide an enterprise value.

Derive implied Equity value

Implied Equity value=Enterprise Value −( Net debt + Preferred stock+ Noncontrolling interest )

Derive implied Share price

Implied Equity value
Implied Share price=
Fully diluted shares outstanding

Perform Sensitivity Analysis

Key valuation drivers such as WACC, exit multiple, and perpetuity growth rate are the most
commonly sensitized inputs in a DCF.

Key Pros and Cons of DCF Analysis

Pros
- Cash-flow-based
- Market independent
- Self-sufficient
- Flexibility

Cons
- Dependence on financial projections
- Sensitivity to assumptions
- Terminal value
- Assumes constant capital structure
13

Chapter 1 Comparable Companies Analysis (pp. 13-54)

This analysis provides a market benchmark against which a banker can establish valuation
for a private company or analyze the value of a public company at a given point in time.
Comparable companies analysis is designed to reflect “current” valuation based on
prevailing market conditions and sentiment.

Comparable Companies Analysis steps

Step I. Select the universe of comparable companies
Step II. Locate the necessary financial information
Step III. Spread key statistics, ratios, and trading multiples
Step IV. Benchmark the comparable companies
Step V. determine valuation

Step I. Select the Universe of Comparable Companies

In order to identify companies with similar business and financial characteristics, it is first
necessary to gain a sound understanding of the target.

Study the Target

The process of learning the in-depth “story” of the target should be exhaustive as this
information is essential for making decisions regarding the selection of appropriate
comparable companies. The actual selection of comparable companies should only begin
once this research is completed.

Identify Key Characteristics of the Target for Comparison Purposes

Business Profile Financial Profile
 Sector  Size
 Products and Services  Profitability
 Customers and End Markets  Growth Profile
 Distribution Channels  Return on Investment
 Geography  Credit Profile

Screen for Comparable Companies

Once the target’s basic business and financial characteristics are researched and
understood, the banker uses various resources to screen for potential comparable
companies.

Investment banks generally have established lists of comparable companies. Often however,
the banker needs to start from scratch. In these cases, the following resources are used:
- Examination of the target’s public competitors
- Proxy statements for relatively recent M&A transactions in the sector
- SIC, NAICS, or other industry codes
- Senior bankers
14

Step II. Locate the Necessary Financial Information

This section provides an overview of the relevant sources for locating the necessary financial
information to calculate key financial statistics, ratios, and multiples for the selected
comparable companies.

SEC Filings: 10-K, 10-Q, 8-K, and Proxy Statement

As a general rule, the banker uses SEC filings to source historical financial information for
comparable companies.

10-K (Annual Report)

The 10-K is an annual report filed with the SEC by a public registrant that provides a
comprehensive overview of the company and its prior year performance.

10-Q (Quarterly Report)

The 10-Q is a quarterly report filed with the SEC by a public registrant that provides an
overview of the most recent quarter and year-to-date (YTD) period.

8-K (Current Report)

The 8-K, or current report, is filed by a public registrant to report the occurrence of material
corporate events or changes (“triggering event”) that are of importance to shareholders or
security holders.

Proxy Statement
A proxy statement is a document that a public company sends to its shareholders prior to a
shareholder meeting containing material information regarding matters on which the
shareholders are expected to vote.

Equity Research
Research Reports
Equity research reports provide individual analyst estimates of future company
performance, which may be used to calculate forward-looking multiples.

Consensus Estimates
Consensus research estimates for selected financial statistics are widely used by bankers as
the basis for calculating forward-looking trading multiples in trading comps.

Press Releases and News Runs

Earnings announcements, declaration of dividends, and management changes, as well as
M&A and capital markets transactions.

Financial Information Services

For example, Bloomberg.

Step III. Spread Key Statistics, Ratios, and Trading Multiples

Size: Market Valuation

Equity Value
15

Equity Value=Share Price× Fully Diluted Shares Outstanding

Basic Shares Outstanding+In-the-Money Options∧Warrants+ In-the-Money Convertible Securitie

Enterprise Value
EnterpriseValue=Equity Value+ Total Debt + Preferred Stock+ Noncontrolling Interest −Cash∧Cash Equivale

Size: Key Financial Data

- Sales
- Gross Profit
- EBITDA
- EBIT
- Net Income

Profitability
- Gross profit margin
Gross profit ( Sales−COGS)
o
Sales
- EBITDA and EBIT margin
EBITDA∨EBIT
o
Sales
- Net income margin
Net income
o
Sales

Growth Profile
In assessing a company’s growth profile, the banker typically looks at historical and
estimated future growth rates as well as compound annual growth rates (CAGRs) for
selected financial statistics.

Return on Investment
- Return on invested capital (ROIC)
EBIT
o
Average Net Debt + Equity
- Return on equity (ROE)
Net income
o
Average Shareholder s' Equity
- Return on assets (ROA)
Net income
o
Average Total Assets
- Dividend yield
Most recent quarterly dividend per share × 4
o
Current share price
16

Credit Profile
Leverage
- Debt-to-EBITDA
Debt
o
EBITDA
- Debt-to-total capitalization
Debt
o
Debt + Preferred stock + Noncontrolling interest + Equity

Coverage
- Interest coverage ratio
EBITDA , ( EBITDA−Capex ) ,∨EBIT
o
Interest Expense

Credit ratings
The three primary credit rating agencies are Moody’s, S&P, and Fitch.

Calculation of Key Trading Multiples

Equity Value Multiples
- Price-to-Earnings Ratio
- Equity Value-to-Net Income Multiple

Enterprise Value Multiples

- Enterprise Value-to-EBITDA (or EBIT) Multiple
- Enterprise Value-to-Sales Multiple

Step IV. Benchmark the Comparable Companies

Benchmarking centers on analyzing and comparing each of the comparable companies with
one another and the target. The ultimate objective is to determine the target’s relative
ranking so as to frame valuation accordingly. The benchmarking exercise is broken down
into a two-stage process:
1. Benchmark the financial statistics and ratios
2. Benchmark the trading multiples

Step V. Determine Valuation

The trading multiples for the comparable companies serve as the basis for deriving an
appropriate valuation range for the target. Consequently, as few as two or three carefully
selected comparables often serve as the ultimate basis for valuation, with the broader group
providing reference points.

Valuation Implied by EV/EBITDA

EBITDA × Multiple Range=Implied Enterprise Value
Implied Enterprise Value −Net debt=Implied Equity Value
Implied Equity Value ÷ Fully Diluted Shares=Implied Share Price

Valuation Implied by P/E

P/E – Share Price
17

Net Income × Multiple Range=Implied Equity Value

Implied Equity Value ÷ Fully Diluted Shares=Implied Share Price

P/E – Enterprise Value

Net Income × Multiple Range=Implied Equity Value
Implied Equity Value+ Net Debt=Implied Enterprise Value

Key Pros and Cons

Pros
- Market based
o Reflecting market growth, risk expectations and overall sentiment
- Relativity
- Quick and convenient
- Current

Cons
- Market based
o Can be skewed during periods of irrational exuberance or bearishness
- Absence of relevant comparables
- Potential disconnect from cash flow
- Company-specific issues
18

Chapter 2 Precedent Transactions Analysis (pp. 87-111)

This analysis is premised on multiples paid for comparable companies in prior M&A
transactions.

Precedent Transactions Analysis steps

Step I. Select the universe of comparable acquisitions
Step II. Locate the necessary deal-related and financial information
Step III. Spread key statistics, ratios, and transaction multiples
Step IV. Benchmark the comparable acquisitions
Step V. Determine valuation

Step I. Select the Universe of Comparable Acquisitions

Screen for Comparable Acquisitions
- Search M&A databases using a financial information service
- Examine the target’s M&A history
- Revisit the target’s universe of comparable companies
- Search merger proxies for comparable acquisitions
- Review equity and fixed income research reports

Examine Other Considerations

This next level of analysis involves examining factors such as market conditions and deal
dynamics.

Market Conditions
Market conditions refer to the business and economic environment, as well as the prevailing
state of the capital markets, at the time of a given transaction.

Deal Dynamics
Deal dynamics refer to the specific circumstances surrounding a given transaction.
- Was the acquirer a strategic buyer or a financial sponsor?
- What were the buyer’s and seller’s motivations for the transaction?
- Was the target sold through an auction process or negotiated sale? Was the nature
of the deal friendly or hostile?
- What was the purchase consideration (i.e. mix of cash and stock)?

Step II. Locate the Necessary Deal-Related and Financial Information

Locating information on comparable acquisitions is invariably easier for transactions
involving public targets (including private companies with publicly registered debt securities)
due to SEC disclosure requirements.
19

Public Targets
SEC Filings in M&A transactions
Proxy Statements and Other Disclosure Documents
PREM14A/DEFM14A Preliminary/definitive proxy statement
relating to an M&A transaction
PREM14C/DEFM14C Preliminary/definitive information
statement relating to an M&A transaction
Schedule 13E-3 Filed to report going private transactions
initiated by certain issuers or their affiliates
Tender Offer Documents
Schedule TO Filed by an acquirer upon commencement
of a tender offer
Schedule 14D-9 Recommendation from the target’s board
of directors on how shareholders should
respond to a tender offer
Registration Statement / Prospects
S-4 Registration statement for securities issued
in connection with a business combination
or exchange offer. May include proxy
statement of acquirer and/or public target
424B Prospectus
Current and Periodic Reports
8-K When filed in the context of an M&A
transaction, used to disclose a material
acquisition or sale of the company or a
division/subsidiary
10-K and 10-Q Target company’s applicable annual and
quarterly reports

Equity and Fixed Income Research

These research reports often provide helpful deal insight, including information on pro
forma adjustments and expected synergies.

Private Targets
When a public acquirer buys a private target, it may be required to file certain disclosure
documents, such as a registration statement/prospectus and a proxy statement.

For LBOs of private targets, the availability of necessary information depends on whether
public debt securities (typically high yield bonds) are issued as part of the financing. In this
case, the S-4 is useful.
20

Private acquirer/private target transactions (including LBOs) involving nonpublic financing

are the most difficult transactions for which to obtain information because there are no SEC
disclosure requirements. In these situations, press releases and news articles are useful.

Step III. Spread Key Statistics, Ratios, and Transaction Multiples

Calculation of Key Financial Statistics and Ratios
Equity Value
To calculate equity value for public M&A targets, the offer price per share is multiplied by
the target’s fully diluted shares outstanding at the given offer price.

For M&A transactions in which the target is private, equity value is simply enterprise value
less any assumed/refinanced net debt.

Purchase Consideration
The three primary types of consideration for a target’s equity are all-cash, stock-for-stock,
and cash/stock mix.

1. All-Cash Transaction
2. Stock-for-Stock Transaction
a. Fixed Exchange Ratio: defines the number of shares of the acquirer’s stock to be
exchanged for each share of the target’s stock.
i. Offer price per share=exchange ratio × acquire r ' s share price
ii.
Equity value=( exchange ratio × acquire r s share price ) × Targe t s fully diluted shares outst
' '

b. Floating Exchange Ratio: represents the set dollar amount per share that the acquirer
has agreed to pay for each share of the target’s stock in the form of shares of the
acquirer’s stock.
3. Cash and Stock Transaction
-
Offer price per share=Cashoffer per share+(Exchange ratio × Acquire r ' s share price)
-
Equity value=( Cash offer per share+ ( Exchange ratio × Acquire r s share price ) ) × Targe t s fully diluted sha
' '

Enterprise Value
Enterprise value=Equity value+Total debt+ Preferred stock+ Noncontrollinginterest −Cash∧cash equivalent

Where
Equity value=( Unaffected share price+ Premium paid)× Fully diluted shares outstanding
Calculation of Key Transaction Multiples Offer price per share
Equity Value Multiples
21

- Offer Price per Share-to-LTM EPS

- Equity Value-to-LTM Net Income

Enterprise Value Multiples

- Enterprise Value-to-LTM EBITDA, EBIT, or Sales

Premiums Paid (in %)

Offer price per share
−1
Unaffected share price

Synergies
- Synergies-Adjusted Multiple
Enterprise Value
o
LTM EBITDA + Synergies

Step IV. Benchmark the Comparable Acquisitions

As would be expected, a recently consummated deal involving a direct competitor with a
similar financial profile is typically more relevant. A thoughtful analysis weighs other
considerations such as market conditions and deal dynamics in conjunction with the target’s
business and financial profile.

Step V. Determine Valuation

The key multiples driving valuation in precedent transactions tend to be enterprise value-to-
LTM EBITDA and equity value-to-net income (or offer price per share-to-LTM diluted EPS, if
public).

Often, the banker focuses on as few as two or three of the best transactions to establish
valuation.

Key Pros and Cons

Pros
- Market based
o Based on actual acquisition multiples and premiums paid for comparable
companies
- Current
- Relativity
- Simplicity
- Objectivity

Cons
- Market based
22

o Multiples may be skewed depending on capital markets and/or economic

environment at the time of the transaction
- Time lag
- Existence of comparable acquisitions
- Availability of information
- Acquirer’s basis for valuation
23

Chapter 4 Leveraged Buyouts (pp. 199-222; 231-233; 241-248)

A leveraged buyout (LBO) is the acquisition of a company, division, business, or collection of

assets (“target”) using debt to finance a large portion of the purchase price. Companies with
stable and predictable cash flow, as well as substantial assets, generally represent attractive
LBO candidates due to their ability to support larger quantities of debt.

Key Participants
- Financial sponsors
o Traditional private equity (PE) firms, merchant banking divisions of
investment banks, hedge funds, venture capital funds, and special purpose
acquisition companies (SPACs).
- Investment banks
o Play a key role in LBOs, both as a provider of financing and as a strategic M&A
advisor.
- Bank and institutional lenders
o The capital providers for the bank debt in an LBO financing structure.
- Bond investors
o The purchasers of the high yield bonds issued as part of the LBO financing
structure.
- Target management
o Plays a crucial role in the marketing of the target to potential buyers and
lenders alike, working closely with the bankers on the preparation of
marketing materials and financial information.

Characteristics of a Strong LBO Candidate

- Strong cash flow generation
o Critical for LBO candidates given the highly leveraged capital structure.
- Leading and defensible market positions
o These qualities create barriers to entry and increase the stability and
predictability of a company’s cash flow.
- Growth opportunities
o Helps drive outsized returns, generating greater cash available for debt
repayment while also increasing EBITDA and enterprise value.
- Efficiency enhancement opportunities
o Their successful implementation often represents substantial value creation
that accrues to equity value at a multiple of each dollar saved (given an
eventual exit).
- Low capex requirements
o Enhance a company’s cash flow generation capabilities.
24

- Strong asset base

o A strong asset base pledged as collateral against a loan benefits lenders by
increasing the likelihood of principal recovery in the event of bankruptcy (and
liquidation).
- Proven management team
o Serves to increase the attractiveness (and value) of an LBO candidate.

Economics of LBOs
Returns Analysis – Internal Rate of Return
IRR measures the total return on a sponsor’s equity investment, including any additional
equity contributions made, or dividends received, during the investment horizon. IRR is
defined as the discount rate that must be applied to the sponsor’s cash outflows and inflows
during the investment horizon in order to produce a net present value (NPV) of zero.

How LBOs Generate Returns

LBOs generate returns through a combination of debt repayment and growth in enterprise
value.

How Leverage is Used to Enhance Returns

A higher level of debt provides the additional benefit of greater tax savings realized due to
the tax deductibility of a higher amount of interest expense.

Primary Exit/Monetization Strategies

- Sale of business
o Sell portfolio companies to strategic buyers, which typically represent the
most attractive potential bidders due to their ability to realize synergies from
the target and, therefore, pay a higher price.
- Initial public offering (IPO)
o In an IPO exit, the sponsor sells a portion of its shares in the target to the
public.
- Dividend recapitalization
o In a dividend recap, the target raised proceeds through the issuance of
additional debt to pay shareholders a dividend.
- Below par debt repurchase
o This strategy is particularly attractive when the debt can be bought at
distressed levels.
25

LBO Financing: Structure

In a traditional LBO, debt has typically comprised 60% to 70% of the financing structure,
with the remainder of the purchase price funded by an equity contribution. Below, the
primary types of LBO financing sources are grouped.

LBO Financing: Primary Sources

Bank Debt
- Higher ranking
- Lower flexibility
- Lower cost of capital

Bank debt is typically comprised of a revolving credit facility. A traditional cash flow
revolving credit facility (“revolver”) is a line of credit extended by a bank or group of banks
that permits the borrower to draw varying amounts up to a specified aggregate limit for a
specified period of time.
26

LBO Financing: Selected Key Terms

- Security: refers to the pledge of, or lien on, collateral that is granted by the borrower
to the holders of a given debt instrument.
- Seniority: refers to the priority status of a creditor’s claims against the
borrower/issuer relative to those of other creditors.
o Contractual subordination: refers to the priority status of debt instruments at
the same legal entity.
o Structural subordination: refers to the priority status of debt instruments at
different legal entities within a company.
- Maturity: refers to the length of time the instrument remains outstanding until the
full principal amount must be repaid.
- Coupon: refers to the annual interest rate (“pricing”) paid on a debt obligation’s
principal amount outstanding.

LBO Financing: Determining Financing Structure

The ultimate LBO financing structure must balance the needs of the financial sponsor, debt
investors, the company, and management, which are not necessarily aligned. Structuring an
LBO is predicated on analyzing the target’s cash flows and credit statistics. The target’s
sector plays a key role in determining the appropriate LBO structure. Prevailing market
conditions and precedent LBO deals play a critical role in determining leverage multiples and
key financing terms.
27

Chapter 5 LBO Analysis (pp. 251-253; 265-266; 294-295)

LBO analysis is the core analytical tool used to assess financing structure, investment
returns, and valuation in leverage buyout scenarios.

- Financing structure: to help craft a viable financing structure for the target, which
encompasses the amount and type of debt as well as an equity contribution from a
financial sponsor.
- Valuation: to determine an implied valuation range for a given target in a potential
LBO sale based on achieving acceptable returns.

Step I: Locate and analyze the necessary information

Collect information on target, sector and specifics of the transaction. Information typically
contained in a CIM, with additional information via management presentation and data
room. Also, via SEC filings, research reports and other public sources. If absent: use public
filings.

Step II: Build the pre-LBO model

Build historical and projected income statement through EBIT
Historical income statement from prior three-year period, generally only built through EBIT,
shown on pro forma basis for non-recurring items and recent events. Annual interest
expense and net income not relevant as target recapitalized through LBO. Management
projections feed projected income statement. Information from CIM. Projection period
often 7-10 years, to match maturities in capital structure. This is called the management
case.
Base case: more conservative, adjustments from due diligence. Downside case: under stress
circumstances. Sponsor case: to set covenants and market the transaction to investors.

Input opening balance sheet and project balance sheet items

Typically provided in the CIM and entered into the pre-LBO model. Financing fees and
detailed line items for the new financing structure are added.

Build cash flow statement through investing activities

Operating activities
Income statement links: link income statement items to operating activities. Balance sheet
links: YoY changes to the balance sheet account much be accounted for by a corresponding
addition or subtraction to the appropriate link item on the cash flow statement. YoY
changes in the target’s projected working capital items are calculated in corresponding line
items in the operating activities section of the cash flows statements.
28

Investing activities
Capex is a key line item, but also planned acquisitions or divestitures. They are sourced from
the CIM and inputted into an assumptions page where they are linked to the cash flow
statement.
The sum of the annual cash flows provided by operating activities and investing activities
provides annual cash flow available for debt repayment, which is commonly referred to as
free cash flow.

Financing activities
Includes line items for the (repayment)/drawdown of each debt instrument in the LBO
financing structure, also for dividends and equity issuance/(stock repurchase). They are left
blank until the LBO financing structure is entered into the model and a detailed debt
schedule is built.
Cash flow statement links to balance sheet: the ending cash balance for each year is linked
to the cash and cash equivalents line item in the balance sheet.

Step III: Input transaction structure

Enter purchase price assumptions
A purchase price must be assumed for a given target in order to determine the supporting
financing structure.
For public company: equity purchase price (EPP) = offer price per share * target’s fully
diluted shares outstanding. EPP + net debt = implied enterprise value.

Enter financing structure into sources and uses

A sources and uses table summarizes the flow of funds required to consummate a
transaction. Sources of funds: total capital used to finance an acquisition. Uses of funds:
those items funded by the capital sources. Sum of sources must equal sum of uses.

Link sources and uses to balance sheet adjustments

Any goodwill that is created is calculated on the basis of EPP and net identifiable assets. The
equity contribution must also be adjusted to account for any transaction-related fees and
expenses as well as tender/call premium fees that are expensed upfront. Also include debt
repayment. These adjustments serve to bridge the opening balance sheet to the pro forma
closing balance sheet, which forms the basis for projecting the target’s balance sheet
throughout the projection period.

Step IV: Complete the post-LBO model

Build debt schedule
The debt schedule enables a banker to complete the pro forma income statement from EBIT
to net income, complete the pro forma long-term liabilities and shareholders’ equity
sections of the balance sheet, complete the pro forma financing activities section of the cash
flow statement.
The debt schedule applies free cash flow to make mandatory and optional debt repayments
(linked to cash flow statement), thereby calculating the annual beginning and ending
balances for each debt tranche (linked to income statement).
29

Forward LIBOR curve: interest rates are typically based on LIBOR plus a fixed spread.
The annual projected cash available for debt repayment is the sum of the cash flows
provided by operating and investing activities on the cash flow statement.
Key terms are entered for each individual debt instrument in the financing structure (size,
term, coupon, and mandatory repayments/amortization schedule, if any).

The banker typically employs an average interest expense approach in determining annual
interest expense in an LBO model, as bank debt is paid throughout the year rather than at
the beginning or end of the year. Annual average interest expense for each debt tranche is
calculated by multiplying the average of the beginning and ending debt balances in a given
year by its corresponding interest rate.

Complete pro forma income statement from EBIT to net income

The calculated average annual interest expense for each loan, bond, or other debt
instrument in the capital structure is linked from the completed debt schedule to its
corresponding line on the income statement.

Cash interest expense: actual cash interest and associated financing-related payments in a
given year. Total interest expense: sum of cash and non-cash interest expense, most notably
the amortization of deferred financing fees, which is linked from an assumptions page. Net
interest expense: subtracting interest income received on cash held on a company’s balance
sheet form its total interest expense.

Net income is EBIT minus net interest expense plus tax shield. It is linked from the income
statement to the cash flow statement as the first line item under operating activities. It also
feeds into the balance sheet as the first line item under operating activities.

Complete pro forma balance sheet

Liabilities: year-end balances for each debt instrument are linked directly from the debt
schedule.
Shareholders’ equity: pro forma net income is added to the prior year’s shareholders’ equity
as retained earnings.

Complete pro forma cash flow statement

Mandatory and optional repayments for each debt instrument (from debt schedule) are
linked to the appropriate line items in the financing activities section and summed to
produce the annual repayment amounts.

Step V: perform the LBO analysis

LBO-model can now be used to evaluate various financing structures, gauge target’s ability
to service and repay debt, and measure the sponsor’s investment returns and other
financial effects under multiple operating scenarios. This enables the banker to determine
the appropriate valuation range for the target.
Analyze financing structure
You want to craft the optimal financing structure for a given transaction. Leverage and
coverage ratios are used to analyze the target’s ability to support a given capital structure
30

(service annual interest expense and repay all of bank debt, credit statistics). Output is
shown on a transaction summary page.

Perform returns analysis

You determine if sufficient returns to the sponsor are provided given the proposed purchase
price and equity contribution. If returns too low: revise purchase price and financing
structure. IRRs are driven primarily by the target’s projected financial performance, the
assumed purchase price and financing structure, and the assumed exit multiple and year. A
traditional LBO analysis contemplates a full exit via a sale of the entire company in five
years.

It is common practice to conservatively assume an exit multiple equal to (or below) the
entry multiple.
Assuming no additional cash inflows (dividends) or outflows (additional investment) during
the investment period, IRR and cash return are calculated on the basis of the sponsor’s
initial equity contribution (outflow) and the assumed equity proceeds at exit (inflow).

As you progress through the projection period, equity value increases due to increasing
EBITDA and decreasing net debt. Therefore, cash return increases as it is a function of the
fixed initial equity investment and increasing equity value at exit. However, IRR decreases in
accordance with the declining growth and the time value of money.

Sensitivity analysis is critical for analyzing IRRs and framing LBO valuation. IRR can be
sensitized for several key value drivers, such as entry and exit multiple, exit year, leverage
level, and equity contribution percentage, as well as key operating assumptions such as
growth rates and margins.

Determine valuation
Sponsors base their valuation of an LBO target in large part on their comfort with realizing
acceptable returns at a given purchase price. LBO analysis is also informative for strategic
buyers by providing perspective on the price a competing sponsor bidder might be willing to
pay for a given target in an organized sale process. It allows strategic buyers to frame their
bids accordingly.

Traditionally, the valuation implied by LBO analysis is toward the lower end of a
comprehensive analysis when compared to other methodologies, particularly precedent
transactions and DCF analysis. This is largely due to the constraints imposed by an LBO,
including leverage capacity, credit market conditions, and the sponsor’s own IRR hurdles.
Furthermore, strategic buyers are typically able to realize synergies from the target, thereby
enhancing their ability to earn a targeted return on their invested capital at a higher
purchase price.

Create transaction summary page

Once the LBO model is fully functional, all the essential model outputs are linked to a
transaction summary page. It provides an overview of the sources and uses of fudns,
31

acquisition multiples, summary returns analysis, and summary financial data, as well as
projected capitalization and credit statistics.

Book Summary – Cornerstones

Chapter 5 The Best Owner
This cornerstone is called the best owner because value is maximized when it’s owned by
whomever can generate the highest cash flows from it.

Who’s the Best Owner?

In order to identify the best owner, the sources of how value is added by the potential new
owners have to be examined.

Unique Links with Other Businesses

The most straightforward way that owners add value is through links to other businesses
within the portfolio, especially when such links are unique to the parent company.

Distinctive Skills
Better owners may have distinctive and replicable functional or managerial skills in any
number of areas across the business system, but to make a difference the skill has to be a
key success driver in the industry.

Better Insight/Foresight
Owners who have insight into how a market and industry will evolve, and can then capitalize
on that insight, can sometimes expand existing businesses or develop new ones as
innovators.

Better Governance
Better governance refers to the way the company’s owners (or their representatives)
interact with the management team to drive maximum long-term value creation.

Distinctive Access to Talen, Capital, Government, Suppliers, and Customers

This category applies more often to companies in emerging markets where running a
business is complicated by an inherently truncated pool of managerial talent, undeveloped
capital markets, and high levels of government involvement in business as customers,
suppliers, and regulators.
32

Best-Owner Life Cycle

Here’s an example of how a company’s best owner might evolve. Naturally, a business’s
founders are typically its first best owner. Then as the company grows, it often needs more
capital, so it sells a stake to a venture capital (VC) fund that specializes in helping new
companies grow. To provide even more capital, the VC firm may take the company public.
As the industry evolves, the company might find that it can’t compete with larger
companies, so it may sell itself to a larger company. As the division’s market matures, the
larger company decides to focus on other faster growing businesses, so it sells its division to
a private equity firm, which restructures the division. Once the restructuring is done, the
private equity firm sells the division to another large company that specializes in running
slow-growth brands.

At each stage of the company’s life, the next best owner took actions to increase its cash
flows, thereby adding value.
33

Chapter 12 The Business Portfolio

Deciding what businesses to be in is clearly one of the most important decisions executives
make. In fact, to a large extent, the businesses a company is in represent its destiny.
Companies need to regularly assess whether they should continue to own each of the
businesses in their portfolios. Companies also need to be on the constant lookout for new
businesses.
Companies with a passive portfolio approach – those that didn’t sell businesses or
only sold poor businesses under pressure – underperformed companies with an active
portfolio approach.

This disciplined approach leads companies to focus strategically on three activities:

1. Defining why and how they are the best (or at least better) owners of the businesses
in their portfolio.
2. Continually pruning businesses that are losing their innate attractiveness or best-
owner status
3. Searching for new businesses with innate attractiveness or opportunities for the
company to add value.

Best Owner: Corporate Value Added

As economies, capital markets, and companies mature and become more sophisticated,
some sources of value are becoming more rare. Therefore, we’ve seen a clear trend toward
companies becoming more focused and less diversified, and we expect this trend to
continue. Thus, the trend is toward portfolio focus and vertical disintegration.

Divestitures: Regular Pruning

Regularly divesting businesses – even some good healthy ones – ensures that remaining
units reach their full potential and that the overall company grows stronger.

The Costs of Keeping Businesses

Costs to the Parent
Well-established, mature businesses provide a company with stability and cash flows, but
this stability can be a mixed blessing.
- The culture of the mature business unit may become incompatible with the culture
that the parent company wants to create.
- Mature units are often relatively large and may absorb a significant share of scarce
management time (that might be better spent on pursuing growth opportunities).
- Conflicts of interest between business units can also distort decision making.
34

Costs to the Unit

A business unit’s performance may be hampered by poor fit with the parent company, not
just in strategy but also in terms of the parent company’s core capabilities and top
management capacity.

Depressed Exit Prices

The final cost of postponing divestitures is the direct impact on the company’s value. A well-
timed divestiture can increase value and a poorly timed one can destroy it. Most
corporations fail to “buy low, sell high”. When companies do divest, they almost always do
so too late, reacting to some kind of pressure.

Adding to the Portfolio

One of the most difficult tasks for executives is identifying new businesses to add to their
portfolios, either by starting them from scratch or through acquisitions. Much of the
literature in this area argues that companies are not systematic enough in their search.

The key is to make sure that the company pays sufficient attention to activities in each of
these three horizons:
- Horizon 1 businesses are those that currently generate the bulk of a company’s
profits and cash flow.
- Horizon 2 businesses are the emerging stars of the company with modest revenues
and profits.
- Horizon 3 businesses are the research projects, test-market pilots, alliances, minority
stakes, and memoranda of understanding that are currently under way and that will
be significant future contributors.

Business Portfolio Diversification

Diversification is intrinsically neither good or bad; it depends on whether the parent
company adds more value to the businesses it owns than any other potential owner could,
making it the best owner of those businesses under the circumstances.

Size and Scale

Economies of scale: as a company gets larger it can spread its fixed costs over a larger
volume of sales, so its cost per unit will decline, leading to higher profit margins and ROIC.
Size and scale, just like diversification, don’t automatically confer benefits to a
company’s performance or value in the stock market. As with many other strategic issues,
whether size helps or hurts, whether it generates scale economies or diseconomies,
depends on the unique circumstances of each company.
35

Chapter 13 Mergers and Acquisitions

Acquisitions are both an important source of growth for companies and an important
element of a dynamic economy.

Measuring Value Creation

Acquisitions create value when the cash flows of the combined companies are greater than
they would have otherwise been. The value created for an acquirer’s shareholders equals
the difference between the value received by the acquirer and the price paid by the
acquirer.
 Value received = intrinsic value of target company (stand-alone value) + present value of
performance improvements.
 Price paid = market value of target company + acquisition premium.

It’s difficult for an acquirer to create a substantial amount of value from acquisitions.

Empirical Results
Researchers have also tried to identify specific factors that differentiate deals that are good
for acquirers from those that are not.
1. Strong operators are more successful
2. Low transaction premiums are better
3. Being the sole bidder helps

Characteristics that don’t matter:

- Size of the acquirer relative to the target
- Whether the transaction is EPS accretive or dilutive
- The P/E ratio of the acquirer relative to the target
- The relatedness of the acquirer and target

Value-Creating Acquisition Archetypes

The strategic rationale for an acquisition that creates value typically fits one of the following
five archetypes. If an acquisition doesn’t fit one or more of these archetypes, it’s unlikely to
create value.

Improve the Target Company’s Performance

One of the most common sources of value creation. Improving the target company’s
performance can be achieved by reducing costs and accelerating revenue growth.
Delivering this is what the best private equity firms do.
36

Consolidate to Remove Excess Capacity from an Industry

Companies often find it easier to close plants across the larger combined entity resulting
from an acquisition than, absent an acquisition, to close their least productive plants and
end up with a smaller company.

Accelerate Market Access for Target’s or Buyer’s Products

Often, relatively small companies with innovative products have difficulty reaching the
entire potential market for their products. Larger companies typically have the sales and
product management capacity to radically accelerate the sales growth of the smaller
companies’ products.

Acquire Skills or Technologies Faster or at a Lower Cost than They Can Be Built

Pick Winners Early and Help Them Develop Their Businesses

Involves making acquisitions early in the life cycle of a new industry or product line, long
before it’s apparent to most others that the industry will become large.

More Difficult Strategies for Creating Value from Acquisitions

Although these strategies can create value, we find that they do so rarely, in large part
because they’re difficult to successfully execute.

Rollup Strategy
Rollup strategies consolidate highly fragmented markets in which the current competitors
are too small to achieve scale economies. This strategy works when the businesses as a
group can realize substantial cost savings or achieve higher revenues than individual
businesses.

Consolidate to Improve Competitive Behavior

Many executives in highly competitive industries hope that consolidation will lead
competitors to focus less on price competition, thereby improving the industry’s ROIC.

Enter into a Transformational Merger

Acquisition or merger where one or both companies is transformed.

Buy Cheap
Buy at a price below the target’s intrinsic value.

Focus on Value Creation, Not Accounting

Markets react only to the value that the deal is estimated to create. Focusing on accounting
measures is, therefore, dangerous and can easily lead to poor decisions. The only relevant
37

measure is whether the acquisition increases the cash flow of combined entity over the
longer term.

Chapter 1 Why Value Value?

The laws of value creation and value measurement are timeless. In addition to their
timelessness, the ideas in this book about creating and measuring value are straightforward.
Corporate finance can be summarized by four principles or cornerstones.

The Four Cornerstones

1. Companies create value by investing capital from investors to generate future cash
flows at rates of return exceeding the cost of that capital. In short, the combination
of growth and return on invested capital (ROIC) drives value and value creation. This
cornerstone is also named the core of value.
2. Value is created for shareholders when companies generate higher cash flows, not by
rearranging investors’ claims on those cash flows. We call this the conservation of
value.
3. A company’s performance in the stock market is driven by changes in the stock
market’s expectations, not just the company’s actual performance (growth, ROIC,
and resulting cash flow). We call this the expectations treadmill.
4. The value of a business depends on who is managing it and what strategy they
pursue. Otherwise called the best owner.

Consequences of Not Valuing Value

- Widespread stock market bubbles (e.g. Internet bubble)
- Financial crises (e.g. that of 2007)

Advantages of Valuing Value

Pursuing the creation of long-term shareholder value doesn’t mean that other stakeholders
suffer. We would go further and argue that companies dedicated to value creation are more
robust and build stronger economies, higher living standards, and more opportunities for
individuals. Besides, value-creating companies generate more jobs. Moreover, many
corporate social responsibility initiatives help create shareholder value.

In all, managers who make the effort to create longer-term value for shareholders see that
effort rewarded in their companies’ stock market performance. In turn, companies that
create more lasting value for their shareholders have more financial and human capital to
foster behaviors that beneficially impact other stakeholders too.
38

Challenges for Executives

Applying the principles of value creation requires independence and courage, as investors
often exert pressure on short-term results. However, long-term value creation is most
important.

Chapter 2 The Core of Value

Companies create value for their owners by investing cash now to generate more cash in
the future.

Growth and ROIC drive value

Return on invested
capital
Cash flow

Revenue growth Value

Cost of capital

Relating Growth, ROIC, and Cash Flow

Growth, ROIC, and cash flow (as represented by the investment rate) are tightly linked and
tied together mathematically in the following relationship:
Growth
Investment Rate=
ROIC

From an economic perspective, describing a company in terms of growth and ROIC is most
insightful.

Payout ratio (towards investors) varies with growth and ROIC

As a percentage of profits, cash flow is highest when growth is slow and ROIC is high. For
any level of growth, value always increases with improvements in ROIC. In other words,
when all else is equal, higher ROIC is always good.

Translating growth and ROIC into value

The same can’t be said of growth. When ROIC is high, faster growth increases value, but
when ROIC is low, faster growth decreases value. The dividing line between whether growth
creates or destroys value is when the return on capital equals the cost of capital.
39

 If ROIC > cost of capital: faster growth increases value.

 If ROIC < cost of capital: faster growth destroys value.

Managerial Implications
In general, high-return companies generate more value from growth (assuming ROIC
remains constant), while low-return companies generate more value from increasing ROIC.

The general lesson is that high-return companies should focus on growth, while low-return
companies should focus on improving returns before growing.

Growth strategies
New products typically create more value for shareholders, while acquisitions typically
create the least. The key at these extremes is, you guessed it, returns on capital.
40

Chapter 10 Return on Capital

This chapter explores how competitive advantage, industry structure, and competitor
behavior drive ROIC. It is very difficult to escape poor industry structure, and the millstone
of high capital intensity can be very damaging.

What Drives Return on Capital?

We’ll use a simple formula to show the linkage between strategy and ROIC in the context of
an industry’s structure and behavior.
Operating Profit Price−Cost
Return on Capital= =
Capital Capital

A company that has a competitive advantage earns a higher ROIC because it either charges a
price premium or it produces its products more efficiently (having lower costs or capital per
unit) – or both.

Structure-Conduct-Performance (SCP) Model

The SCP model says that the structure of an industry influences the conduct of the
competitors, which in turn drives the performance of the companies in the industry.

The high-ROIC industries (household and personal products) tend to be those with attractive
industry structures. The low-ROIC industries (paper products) are those with
undifferentiated products, high capital intensity, and fewer opportunities for innovation.

Price-premium advantages can be disaggregated into five subcategories, and cost and
capital efficiency advantages can be disaggregated into four subcategories.

Price Premium Advantages

- Innovative products – difficult-to-copy or patent-protected products, services, or
technologies (e.g. Apple’s iPod).
- Quality – real or perceived difference in quality over and above competing products
or services (e.g. BMW).
- Brand – brand price premium over and above any innovation or quality differences
(e.g. Coca-Cola).
- Customer lock-in – difficult for customers to replace a product or service with a
competing product or service (e.g. Bloomberg financial terminals).
- Rational price discipline – transparent behavior by industry leaders in capacity
management and pricing policy.
41

Cost/Capital Efficiency Advantages

- Innovative business methods – difficult to copy business methods that contrast with
established industry practice (e.g. Dell).
- Unique resources – unique location (geological, transport) characteristics or unique
access to a raw material (e.g. a mine whose ore is richer than most other ore bodies).
- Economies of scale – scale in targeted activities or local markets.
- Scalability/Flexibility – adding customers and increasing or redirecting capacity at
negligible marginal cost (e.g. eBay)

Return on Capital Sustainability

Central to value creation is understanding the sustainability of ROIC. The longer a company
can sustain a high ROIC the more value it will create.

Persistently high-return industries included household and personal products, beverages,

pharmaceuticals, and software. Persistently low-return industries included paper and forest
products, railroads, utilities, and department stores.

In general, advantages that rise from brand and quality on the price side, and scalability on
the cost side, tend to have more staying power than those rising from more temporal
sources of advantage, like innovation (which tends to be surpassed by newer innovations).

A unique resource can be a durable source of advantage if it’s related to a long product life
cycle, but not as advantageous if it isn’t.

High-ROIC companies tend to maintain their high returns, and low-ROIC companies tend to
retain their low returns.

Trends in Returns on Capital

- Increase in companies with high ROIC
o Although many industries have increased their ROIC in recent years, some of
the increases are probably cyclical and not sustainable.
- Impact of acquisitions
o Although returns without goodwill (difference between price paid and value
of the underlying assets; merely reflects part of the price paid on which the
acquirer needs to earn a return) have been increasing remarkably, returns
with goodwill have been flat, suggesting that these companies haven’t been
able to extract much value from their acquisitions.
42

Chapter 11 Growth
Growth doesn’t lead to higher value creation unless return on capital are adequate. Growth
in undeniably a critical driver of value creation, but different types of growth come with
different return on capital and, therefore, create different amounts of value.

Different Growth Creates Different Value

A useful way to assess the value creation potential from a specific type of growth is to
examine who loses when a company grows revenues, and how the losers can respond or
retaliate.

Above Average Value Creation

- Create new markets through new products
o No established competitors; diverts customer spending
- Convince existing customers to buy more of a product
o All competitors benefit; low risk of retaliation
- Attract new customers to the market
o All competitors benefit; low risk of retaliation

Average Value Creation

- Gain market share in fast-growing market
o Competitors can still grow despite losing share; moderate risk of retaliation
- Make bolt-on acquisitions to accelerate product growth
o Modest acquisition premium relative to upside potential

Below Average Value Creation

- Gain share from rivals through incremental innovation
o Competitors can replicate and take back customers
- Gain share from rivals through product promotion and pricing
o Competitors can retaliate quickly
- Make large acquisitions
o High premium to pay; most value diverted to selling shareholders

Growth is Difficult to Sustain

Sustaining high growth is much more difficult than sustaining high ROIC. Besides,
maintaining high growth is uncommon.
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Growth Requires Continual Search for New Markets

Sustaining growth is difficult because most products have natural life cycles. Sustaining high
growth presents major challenges for companies of virtually any size. Given the natural life
cycle of products, the only way to achieve high growth is to continually find new products,
geographic markets, or customer segments in which to compete, entering those markets
early enough to enjoy their more profitable high-growth phase.

To sustain high growth, companies need to overcome the portfolio treadmill effect: for
each product that matures and declines in revenues, the company needs to find a similar-
sized replacement product to stay level in revenues – and even more to continue growing.
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Appendix A The Math of Value

This appendix shows the core-of-value cornerstone as a simple formula along with its
derivation. We call this the key value driver formula as it relates the value of a company to
growth and ROIC:
g
NOPLAT t =1 (1− )
ROIC , where:
Value=
WACC −g

NOPLAT
ROIC=
Invested Capital

We call the key value driver formula the Tao of corporate finance because it relates a
company’s value to the fundamental drivers of economic value: growth, ROIC, and the cost
of capital.

Appendix B The Use of Earnings Multiples

Earnings multiples, particularly the P/E ratio, are a common shorthand for summarizing a
company’s value. Many successful investors use earnings multiples to analyze potential
investments, but they emphasize the need to use multiples with caution. These days,
sophisticated investors and bankers use forward-looking enterprise value-to-EBIT(D)A
multiples.

Since earnings multiples are driven by the combination of growth and return on capital, it’s
essential to compare the multiples of companies with similar growth and ROIC expectations.