A NOTE ON THE ACQUISITION VALUATION PROCESS
In theory, valuation of a company can be based on a wide variety of models
ranging from highly analytical to highly intuitive.
In practice, valuation of acquisition and divestiture targets results from one
or a combination of three methods:
1. Comparable companies
2. Comparable transactions
3. DCF spreadsheet methodology
Comparable Companies And Transactions
The comparable methods have a significant limitation in that finding a broad
sample of fully comparable situations is difficult and often impossible. Also,
they can produce a high dispersion of results as several financial
relationships are frequently compared in the comparable companies
approach.
In class the comparable companies and comparable transactions approaches
were illustrated by Charts 1 – 8 in the attachments to this Note as presented
in Chapter 8 of Takeovers, Restructuring, and Governance by J. Fred
Weston et al., Pearson Prentice Hall, 2004, 2001.
DCF Spreadsheet Methodology
Although based on historical financials, the DCF spreadsheet methodology
essentially looks forward in projecting cash flows for a defined period
(usually 3 to 5 years) post acquisition. Unfortunately, any confidence
generated by “tons” of Excel spreadsheet data can be highly misleading as
results are materially influenced by human variables such as forecasting and
residual value assumptions. DCF results are typically tested against
minimum IRR hurdles. Not infrequently, hurdle requirements lead to
excessively unrealistic projections.
Approaching valuation with a DCF spreadsheet methodology (net present
value(NPV) analysis or internal rate of return(IRR) analysis) has three
critical elements:
1. Building a forecast model
2. Determining residual value
3. Calculate the WACC
Attachment Chart 10 provides an overview of the DCF approach and Chart
10 offers a practical “snapshot” of a representative analysis.
Building A Forecast Model
The process begins with a highly detailed examination of several years of
prior and current financials to understand factors useful for forecasting
including (but not limited to):
Balance Sheets
Excess cash and investments
Receivables: aging, write-off experience and reserves
Inventory: valuation methods, write-off experience,
levels, turns and reserves
Other assets: securities, notes and intangibles
Liabilities: stated, understated, unstated and contingent
Income Statements
Revenues: recognition policies and trends
Gross and operating margins and trends
Impact of inventory and depreciation methods
Incidence of “owner’s perks” i.e. non-essential
Salaries, pensions, travel, automobiles,
airplanes, insurance, payments et al.
The process continues with a review of macro-economic and applicable
industry conditions, forecasts and studies along with an understanding of
competitor’s financial results and strategies.
The objective is to determine the target’s quality of earnings as a
fundamental basis of developing the profit plan forecast model.
Building a realistic earnings model:
Incorporates anticipated economic and industry events
Builds upon prior results carefully adjusted to reflect the
new realities post acquisition
Adds back the net costs of owner’s perks reflecting any
new costs needed to replace prior management
Includes supportable positive and negative synergies
Schedules anticipated capital expenditures
Reflects “newco” after planned adjustments such as:
excess cash/investment distributions
divestments
discontinuations
terminations
pension elimination
other benefits
facility closings
When completed, it makes sense to “gut check” the model versus the target’s
past results and its competitors. Also, reasonableness of growth rates and
margins should be considered.
Determining Residual Value
For valuations using a DCF approach, the determination of residual value is
a critical element – often the most critical – of the calculation. Frequently,
the residual component of the valuation outweighs the scheduled cash flows
component and hence significantly impacts total valuation.
The two primary approaches to residual value are:
1. Multiple of Earnings Method
2. Growing Perpetuity Method
The Multiple of Earning Method typically involves some level of earnings
(i.e. net, operating, EBITDA, EBITA et al.) or occasionally factors such as
sales or book value expressed as a multiple for valuation purposes. LBO
firms typically use an EBITDA or EBITA approach while public companies
may use a multiple of net or operating income. The characteristics of the
business and its industry may influence the choice of earnings or other factor
to be multiplied. The selection of the multiple may reflect current or
anticipated conditions at the end of specifically forecasted cash flows. In
some cases it may simply be the multiple paid for the assets or business.
The Growing Perpetuity approach assumes that cash flow is expected to
grow after the end of the period of specifically forecast cash flows. The cash
flow for the year following the forecast period is estimated and then
capitalized by a rate equal to the target’s Weighted Average Cost of Capital
(WACC) less the assumed perpetuity growth rate.
Calculate the WACC
The specifics for calculating the WACC can be found in financial analysis
textbooks and likely have been studied in other courses. Note that in
acquisition analysis, the proper WACC is that of the target – not the
acquirer. The objective is to discount at a rate that appropriately reflects the
risk profile of the investment not the investor; hence the need to use the
target’s WACC.
Drawing Conclusions On Valuation
Final decisions on valuation often are based on an examination (and perhaps
averaging) of several approaches. Obviously, this confirms that valuation is
more an art than a science!
Chart 9 in the Attachment shows how a broad application of valuation
techniques might be used to ensure that the approaches discussed above
eliminate alternatives that might create value especially when considering
divestments. This entity wants to maximize value in total by evaluating each
of its 5 business groups. Note that this thorough approach includes creating a
DCF to capture specific synergies estimated for a specific buyer as well as a
liquidation analysis, among others.
Before locking-in a valuation, an acquirer will need to understand the impact
of an offer on the accretion or dilution of earnings per share (EPS).
For most corporate senior managements and boards, projections of post
acquisition EPS dilution and accretion are of critical concern and affect their
price negotiating parameters when issuing stock. Many will tolerate limited
dilution of perhaps a few years if there is a clear long-term payout.
EPS dilution occurs whenever the P/E ratio paid for the target exceeds the
acquirer’s P/E ratio. Significantly, the magnitude and extent of continued
dilution/accretion are determined by the relative size of the earnings of the
acquirer and the target and by their relative growth rates.
A proposed acquisition valuation that meets or exceeds IRR hurdles may
well be reduced if dilution is indicated. Conversely, an expected accretive
transaction can result in raising an offer to a point where the IRR hurdle is
not met.
The simplified presentation “Stock Or Cash -- A Financial Perspective”
discussed in class and found in the attachments demonstrates how the
expectation of dilution or accretion can be a critical factor in deal structuring
as well.