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Chapter 5bGlobal mergers and acquisitions

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Valuation methods

Adjusted net assets

Comparables

Value based on the net realizable value of the assets and liabilities on a going concern basis.

The net present value of the projected free cash flows discounted at an appropriate discount rate (risk adjustedcost of capital).

Valuation benchmarks based on the targetindustry/country’s previous recent deals or market valuation of comparable business. Use of earnings multiples or sales multiples.

Valuationmethodologies

Discountedcash flow

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TangibleLand and propertyEquipmentInventoriesReceivablesSecuritiesCashIntangiblePatentsBrandsCustomer base

Market valueReplacement valueMarket value minus obsolete itemsFace value minus unrecoverableMarket valueFace value

???

Industry norms?

Minus Long term Short termSuppliersHidden liabilities

ASSETS

LIABILITIES

Adjusted net assetsViews the value of the business as the excess of assets over liabilities in adjusted book value terms.

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Commonly used when:• the company being valued is predominantly an investment-holding entity

which does not carry on any business operations of a commercial nature;

• or the company businesses is tangible asset intensive;

• or the company carries on a business which incurs losses or generates insufficient return on the assets employed;

• or the future prospects of a company are extremely doubtful and/or liquidation is being contemplated;

• or the sale of a company is required.

• Replacement value• “Fire sale” or its assets• Orderly realization of its assets

Adjusted net assets cont.

Three potential assumptions:

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Standalone: Business as a going concern

Synergies: Value added resulting from the combination of operations

Discounted cash flow (“DCF”)Two kinds

of cash flow

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DCF approach requires:

- Estimation of forecast net “free cash flows” for the company for its outlook period (approx. 5 years), based on revenues and costs projection

- Estimation of key industry risks, growth prospects and the general economic outlook, etc.

- Estimation of a terminal value for the company at the end of its outlook period

- Determination of discount rates, given the optimum mix of financing between equity and debt given the company rating and the estimated costs of these forms of financing (weighted average cost of capital)

- Calculation of the value of the company based on the sum of the net present values of the forecast net cash flows and the terminal value

DCF cont.

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Earnings before interest, depreciation, amortization & tax (EBITDA)- Tax on EBITDA1

= Net operating profit before depreciation, amortization and after tax

+ Depreciation tax shield2

- Increase in working capital requirement (Δ inventories+ Δ receivables -Δ payables)

- Net capital expenditures

= Cash flow from assets (free cash flow)

Estimating standalone free cash flows from accounting data

1 Tax rate × EBITDA2 Depreciation expenses × tax rate

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Forecasting the standalone cash flow

1. Forecast sales: market share * size of the target market

2. Examine the historical relationship between sales and the components of cash flow (EBITDA/sales, working capital/sales, fixed assets/sales)

3. Check how reasonable the forecast is: compare growth, profit, economic value added with past performances and competitors’ performance

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The relevant cash flows

Ignore all financing cash flows. All these cash flows are takeninto account by the cost of capital. Estimate only pre-financing cash flows.

Only CASH matters!

For valuation purposes we need to discount cash expenditures as they occur - NOT the accounting measures of earnings.

The relevant cash flow includes the sales of non productives assets.

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Forecasting the standalone cash flow terminal value

The business is considered as continuing after the end of the cash flow calculation period (except in special cases, e.g. mining, oil)

The business usual methods are:• to calculate the terminal value as a perpetual value equal to last cash

flow/WACC (weighted average cost of capital)

• or if on considering that the business is still growing equal to last cash flow * 1+ growth rate)/ WACC – growth rate

• another method is to calculate the liquidation value at the end (net assets)

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Standalone valueEquals:

- NPV of free cash flows- Plus disposals- Minus debts

Adjusted with:

- Cash flows resulting from post mergers- Operational improvements (without synergies)

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Revenuesenhancement

Cost reduction

Processimprovement

Financial

Synergies

Transfer of best practices

Information sharing

= higher cash flow stream

Synergies cash flow

1=either cash flow or WACC

Extension of distribution

Product complementarity

System integration

Geographical extension

Market power

Economies of scale poolingResources e.g. procurement

Economies of scope

Consolidation

Risk reduction1

Cost of debts reduction1

Tax shield

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R&D Procurement Manufacturing Marketing General

COMPETENCES

ASSETS

R&D Procurement Manufacturing Marketing General

Synergies

RESOURCES How much can we gain from common sourcing, access to contacts, financial clout, etc.?Do we have access to better people thanks to the combination of industry?

How much can we gain from grouping factories, sharing distribution and sales forces,computer systems, etc.?

What know-how can we transfer? Can we learn from the other industry? How much isthe technology of this diversification worth?

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Innovation Technology transfer - License - Know-howleading to: Process improvement Product improvement New products Rationalization of R&D

Estimate of additional cash flow coming from:

Cost reductions; speed Increase in sales New sales Overheads; headcount

Procurement Purchasing power Time delivery Rationalization ofprocurement process and supply chain, and sources of supplies

Lower supplies cost Increase in sales and lower inventories Overheads, headcount Higher quality, lower costs

Valuation of synergies

Value chain element Source of synergies How is it measured?

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Manufacturing/operations

Economies of scale Time delivery Rationalization of operations(plant closure, reorganization)

Lower unit costs Increase in sales and lower inventories Overheads; headcount

Marketing Economies of scale in distribution logistics Extended distribution Rationalizationof sales force Joint advertising Joint market research Joint product management Solution selling

Lower unit costs and lower inventories Increased salesOverheads; headcount Lower costs Lower costs Lower costs Higher revenues

Value chain element Source of synergies How is it measured?

Valuation of synergies cont.

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Administration Rationalization of IT and other infrastructures Legal, accounting and consulting fees Rationalization of offices

Net saving (total potential saving minus migration costs) Overheads; headcount

Financial Debts capacities Tax shield

Lower cost of debts Tax savings

Value chain element Source of synergies How is it measured?

Valuation of synergies cont.

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Valuation of synergies: summary

Revenues increase

Cost decreaseSource of synergies

Effect of cash flow

Innovation Procurement Manufacturing/Operations Marketing Administration Financial Others

+++++++

-------

NET EFFECT over cash flow periodExceptional items:

Sales of duplicated assets (indicate year)Cost of integration (indicate year)

+ -

Cash flow effects over the years 1, 2, 3, 4, ….

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Selecting a discount rate

WACC (Weighted average cost of capital) =

(Cost of debts *% of debts financing)+ (Cost of equity * % of equity financing)

Cost of debt= interest rateCost of equity = risk free rate + (market risk premium * company risk premium)

• Premium? Which risk premium ? Acquirer or Acquiree?• Adjusted cash flows

How do we assess RISK?

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How to incorporate country risk in cash flow

valuation?

Adjust cost of capital(equity and debts)

Adjust cash flow

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1. Calculate the risk premium due to market risk (off-shore project beta) to be included in the cost of equity

1. Off-shore project beta = beta of comparable project in home country * country beta2. Where country beta = volatility of the host country stock market (correlation of changes

with home country) (or GDP)/ to the home country

2. Add a political risk premium1. Bond risk premium

3. Adjust WACC accordingly

4. Cost of equity in a foreign investment:

1. = risk-free home country + country risk (bond risk premium) + market risk premium*2. (company beta * country market beta)

Adjusting the cost of equity (Donald Lessard - MIT)

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1. Identify the elements of cash flow subject to country risk variation (revenues, costs)

2. Assign a probability of occurrence to those elements

3. Take the expected value [likely cashflow * (1-probability of adverse event)]

4. Possibility to run a Monte Carlo simulation if various probabilities affect various elements

5. Calculate NPV with global cost of capital

Adjusting the cash flows (Hawawini & Viallet - INSEAD)

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Has a strong theoretical basis and is most commonly used for:

• businesses with reasonable predictable revenue and cash flows

• start up projects

• businesses with diverse capital expenditure requirements over time

• businesses that are subject to cyclical factors

• limited life projects

Source: Ernst & Young

Discounted cash flow (“DCF”)

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Comparison of similar transactions in similar industries:• Price/earnings ratio • or price/ EBITDA• or in some cases price/ sales

Appropriate valuation when comparable transactions are available

This method involves:

• Selection of the earnings, EBITDA, sales level based on historical and forecasted operating results, non-recurring items of income and expenditure and known factors likely to impact on operating performance; and

• Determination of an appropriate capitalization multiple taking into consideration the market rating of comparable companies, the extent and nature of competition, quality of earnings, growth prospects and relative business risks.

Source: Ernst & Young

Comparable values

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The appropriate multiple is usually assessed:• Comparing the multiples of companies that are in the same

or similar industries• And where possible, purchase and sale transactions

involving comparable companies

Some of the issues to be considered:• Individual characteristics (growth, size, gearing, etc.)• Time period consistency (e.g. Historical earnings with

historical multiples) • Obtaining market evidence of comparable company multiple

(from Bloomberg…)

Source: Ernst & Young

Comparable values cont.

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The value capture decomposition

Stand-alonevalue

Implement-tationcosts

EmployeesSuppliersCustomersCompensations

Competitors’gains

Valuecaptured

Total valuepotential

Synergies

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