M&a Treatise Valuation

Valuation & Pricing

M&A

Valuation - Myths

Myth 1 - A valuation is an objective search for “true” value Truth - All valuations are biased

Myth 2 - A good valuation provides a precise estimate of value Truth - The payoff to valuation is greatest when

valuation is least precise Myth 3 - More quantitative a model, the better the

valuationTruth - Simple valuation models do much better than

complex ones

Valuation is an art within a science

Building Blocks

Motive

Identification & Valuation

Structuring

Financing

Diversification

Control

Acquiring

Undervalued Firm

Operating or Financial Synergy Managerial

Pursuit

Motive

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Motive

Identification & Valuation

Status Quo ValuationAscribe MotiveAscribe

ValuationPricing

What underpins the cash flows of this business - fixed assets, people (or one person), know-how ?

Once you have worked out what drives the value make sure that it is still there after you have acquired the business!

People business

Asset business

“Where is the Value”

Intangibles - usually a part of business valuation

“Feel the Deal”

Theoretical analysis will potentially give you an indication of value, but you need to “Feel the Deal”; for a buyer, for instance: What is the competitive tension in the process? How strategically important is the acquisition to

you? How committed is the vendor? How good is the disposal story, how good are the

vendor’s advisers? What is your relationship with the target

management and key clients?

Incidental Valuation consideration

Business Rationale

Compelling strategic rationale

Create or consolidate market leadership position

Essential new technologies, markets or products

Financial Considerations

Transaction multiples compared to public comparables and precedent transactions

Impact on combined company revenue and earnings growth trajectories

Effect on margins

Revenue and cost synergies

EPS accretion / dilution

Market Reaction

Market perception of target company / merger partner

Consistent, simple to understand story

Financial parameter clarity

Price paid / consideration mix

A number of factors to consider in pursuing any M&A transaction

Valuation Mismatches

Perceived

Synergies

Mismatching Cash Flows & Discount

rates

(In) Comparable Firms & Multiples

Transaction infirmities

-False order book

-Accounting policies

-Contingent /Hidden liabilities

Winner Curse

?

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Valuation methods and principles

The Techniques

Extended valuation techniques

DCF

Trading Multiples

Comparable Transactions

Contingent upon purpose of the valuation

More than one right way to value

Approaches are not exclusive; but complement each other

Limited valuation techniques

NAV

PECV

NAV Attempts to measure the value of net assets Appropriate in the context of -

Paucity of information about future earnings Past profits do not serve as a guide to future

earrings Loss-making companies Companies in liquidation / intended to be liquidated Certain industries (e.g. shipping)

Bases of NAV Book Value / Replacement Value / Realizable Value

Continued relevance in certain circumstances/industries

PECV

Attempts to capitalise the value of future maintainable earnings from past earnings

Appropriate in the context of valuation of going concerns

Key elements in valuation Earnings

Past profits adjusted for extra-ordinary itemsTax incidence

Capitalisation rate

PECV usually preferred over NAV

Trading Multiples Estimates value by relating the same to underlying elements of

similar companies or for past years

Constituents of Trading Multiples - Profits, Sales, Assets

Generally used trading multiples EBIT/EBITDA, Market value/Book Value, Industry specific, etc.

Application of Trading Multiples Understand the company you are valuing & the industry in

which it operates Develop peer group Review several multiples

Comparables & their application

Important part of “deal-speak”

Often necessary for Board of Directors, fairness opinions, etc.

Provides insights into various factors

List of likely buyers & their valuation techniques

Bidding strategies

Application of Comparable Transactions

Identify most comparable & recent transactions

Judgement of the Valuer is important - “Feel the Deal”

Availability of transaction data - Key limitation

Comparable company analysis

Comparable company analysis values a company by reference to other publicly traded companies with similar operating and financial characteristics. The exact ratios and range analyzed will vary from project to project

Comps are good for valuing companies in virtually any given industry

Comps serve as the primary measure of value when analyzing a public offering

Trading comps (contd..)1. Determine the peer group (your comps universe)

2. Gather the appropriate financial information

3. Enter the financial information into your spreadsheet normalize for non-recurring items (why?)

4. Calculate relevant historical or forward multiples (P/E; EV/EBITDA) Medians are better than means (why?) Forward multiples are better than historical multiples (why?)

5. Forecast your company’s future financial performance (EBITDA, EPS, Cash Flow, etc.)

6. Apply appropriate multiples to your company’s financial stats and derive implied valuation range

Trading comps (contd..)

Operational Industry Product Markets Distribution channels Customers Seasonality Cyclicality

Financial Size (revenues, assets, market

cap) Leverage Margins Dividend yield Growth prospects Shareholder base

A comparable peer group should embody the same operational and financial attributes so that their public trading values represent a reasonable proxy for those of the company under consideration


Even with standard metrics, certain multiples are more relevant for some industries than othersFor many industries, EV/EBITDA multiples are

the most common trading metric (e.g. Industrials, Transportation, Distribution, etc.)

For other industries, P/E multiples are more widely followed (Pharmaceuticals, Restaurants, Biotech, etc.)

Financials trade on P/B (price-to-book)

Reading analyst reports will help you understand the metrics analysts use to value the sector and the industry

Trading comps (contd..) Certain sectors have unique metrics

Telecommunications: Enterprise value to

Number of subscribers

Route miles, fiber miles

Access lines

Natural resources: Enterprise value to

EBITDAX (Earnings Before Interest, Taxes, Depreciation, Amortization and Exploration Expenses)

Reserves

Production

Retail/Real estate: Enterprise value to

Square footage

EBITDAR (Earnings Before Interest, Taxes, Depreciation, Amortization and Rent)

Trading comps (contd..) Getting the comps correct

Ensure you have correctly captured the equity and net debt components Diluted shares (includes options and convertibles if in the

money)Net debt includes preferreds, out of the money converts, capital

leases, etc. Ensure your income statement projections are uniform across your

compsAdjust for extraordinary items and one time chargesCalendarize so that projections reflect the same time periodsCheck analyst projections to make sure they are treating all

expense components the same across the comps (e.g., amortization of intangibles)

Determining a value range Thoughtfully consider the multiple range—using the mean/median

is not thoughtful Calculate the value correctly (Firm value versus Equity value issue)


What if there are no publicly traded comps?Comparables may be:

private

divisions of lager companiesCompany may be the first of its kind

Use educated guesswork and creativity

Place more emphasis on other valuation methodologies

Comparable transaction analysis

Comparisons with similar transactions private market sales of similar businesses M&A transactions in the same industry as the

company (or segment of a company)

Price reflects control premiums and synergies

Key factors to consider: Timing and surrounding events (industry trends) Nature (friendly, contested, hostile) Consideration paid (cash, stock, combination of both)

Transaction comps (contd..)

Very similar analysis as trading comps (use of multiples), but a different perspective

Looking at prior acquisitions, insight can be gained as to the premium paid to gain control (i.e., control premium) of the target company, valuation multiples, social issues, and technical transaction elements

In addition, “private market” values sometimes differ from public market values Measure private market value, including control

value, strategic benefits and synergies


1. Determine the appropriate deal list

2. Gather the appropriate financial information

3. Enter the financial information into your spreadsheet calculate Transaction Value (TV) and Offer Value

(OV) normalize for non-recurring items

4. Calculate relevant multiples (TV/Sales, TV/EBITDA, OV/Net Income, OV/Book Value; Offer Price per Share/EPS)

5. Derive implied valuation range

Transaction comps (contd..) Comparable transactions are where the companies involved

have similar business and financial characteristics to the company you are advising

Factors to consider: operations, line of business size financial aspects (growth, margins, etc) consideration paid (market share, technology, etc.) Timing: Recent transactions are a more accurate reflection

of the values buyers are currently willing to pay than acquisitions completed in the further in the past because market fundamentals are subject to dramatic change over the periods of time

the then market conditions (industry trends)


Premium (%) = (Offer Price / Target Price) – 1

It is common to use various time frames to control for leaks. Premium to: 1 day/week/month prior other points: 52 week high and low; last month

average

The idea is to use “unaffected share price” – i.e. prior to announcement of possible sale or before the “evaluating strategic alternatives” press release


Offer Value is similar to Equity Value

Offer Value =

Total Shares Outstanding x Purchase Price per Share – Option Proceeds

Total Shares Outstanding =

Basis Shares + In-the-money-options + Shares from in-the-money convertible securities

Transaction comps (contd..) Convertible securities

If Conversion Price > Purchase Price Per Share

the convertible security is underwaterassume securities do not convert into common shares

If Conversion Price < Purchase Price per Share

the security is “in-the-money”assume securities do convert into common shares

No. of Shares Underlying the Convert. Sec. =

Face Value of the Security / Conversion Price Example: Face Value = $1,000; Conversion Ratio: 40

(Conversion Price $25); Purchase (Offer) Price per Share $30

No of shares = 1000/25 = 40


Transaction Value is similar to “Enterprise Value” for acquisition comparables analysis

Transaction Value =

Offer Value + Total Debt + Pref. Stock + Minority Interest – Cash & Equiv.

Total Debt excludes convertible securities that are assumed to convert into common shares (do not double count)


Relevant multiples will vary by industry Transaction Value / EBITDA almost always used Similar to public comparables analysis Unlike trading multiples, acquisitions multiples will

generally be higher as they include control premiums and synergies

Last twelve months (LTM) multiples are most common

Also, use forward multiples if possible Could be difficult with private targets Obtain research with Sales, EBITDA and EPS estimates

just prior to the transaction announcement date

Transaction comps (contd..) Each acquisition is unique and buyers and sellers typically

do not know all the factors and motives that went into the formulation of another acquisition price, acquisition multiples often suggest a wide range of values and must be used with care.

Because the acquisition market is not continuous in time, the fact that a particular multiple was paid in the past does not necessarily mean that it still applies today. Unlike the stock market, there is no current P/E benchmark other than the most recent industry transaction which may be several months or even years old.

Many transactions occur at the subsidiary or division level for which no trading valuations exist

DCF Valuation

Attempts to compute present value of expected cash flows Forces an in-depth understanding of the business Can derive values qua product lines, businesses,

transactions Permits sensitivity analysis Typically used for acquisitions and evaluation of new

projects Key elements in DCF valuation

Forecasted free cash flows Terminal value Cost of capital

The Preferred Method

Discounted cash-flow (DCF)

DCF method entails estimating the free cash flow available to debt and equity investors (i.e., the annual cash flows generated by the business, and the terminal value of the business at the end of the time horizon) and discounting these flows back to the present using the weighted average cost of capital as the discount rate to arrive at a present value of the assets

DCF (contd..) DCF is often the primary valuation methodology in M&A

Comparable public company and comparable acquisition analysis are often used as confirming methodologies

DCF is the PV of 2 main types of free cash flows:1. Free cash flows to all capital providers (debt and equity)2. Free cash flows to equity capital providers

special case: dividend discount model

Fundamental in nature, DCF allows for questioning all of the assumptions and for performing sensitivity analysis

One can easily estimate equity value from firm value by subtracting the market value of debt today

DCF (contd..)

1. Project the free cash flows of a business over the forecast period Typical forecast period is 10 years. However, the range

can vary from five to 20 years

2. Use the weighted average cost of capital (WACC) to determine the appropriate discount rate range

3. Estimate the terminal value of the business at the end of the forecast period

4. Determine the value for the enterprise by discounting the projected free cash flows and terminal value to the present

5. Interpret the results and perform sensitivity analysis

DCF (contd..) Calculation of free cash flow begins with financial projections

Comprehensive projections (i.e., fully-integrated income statement, balance sheet and statement of cash flows) typically provide all the necessary elements

Quality of DCF analysis is a function of the quality of projections Confirm and validate key assumptions underlying projections Sensitize variables that drive projections

Sources of projections include Target company’s management Acquiring company’s management Research analysts Bankers

DCF (contd..)

Validate and test projection assumptions

Carefully consider all variables in the calculation of the discount rate

Consistency of assumptions concerning interest rates, inflation rates, tax rates and the cost of capital is critical

Thoughtfully consider terminal value methodology

Do sensitivity analysis (base projection variables, synergies, discount rates, terminal values, etc.)

Valuations

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Publicly-tradedcomparablecompanies analysis

Comparable transactionsanalysis

Discountedcash flowanalysis

Leveragedbuyout/recapanalysis

Other

Valuation Parameters

Various Industries

Aluminium

•Cyclicality of the industry,•Is a value-add commodity. •Highly capital intensive sector (Rs 200 bn/ 1 million tonne) •Growth prospects function of economic growth/User Industries•London Metal Exchange (LME)•Player positioning•Value added products•Competition•Cost efficiency critical •Integration advantage•Operating performance

Valuations: • Two important ratios to look Price to Earnings (P/E) ratio & the Price to Book Value (P/BV)• P/E multiple of the stock should more or less hover around the country’s GDP growth.• Companies with greater exposure to international markets (exports) and/or larger presence in the downstream segment could command a higher valuation. • The P/BV ratio can also be used as a parameter for comparison.

Cement• Cyclicality of the industry,

• Highly capital intensive sector (Rs 300 bn/ 1 million tonne)

• High Fixed cost, hence Volumes critical

• Access to raw materials (limestone and coal) & consuming markets

• Bulk cement as well as RMC

• Demand-supply mismatch

• Level of fragmentation & competition

• Capacity utilization , Power & Freight

Valuations: • Apart from the P/E ratio, the PCF ratio (Price to Cash flow is important because cement is a capital-intensive industry and hence depreciation forms a huge part of the total outgo.

• Growth in the cement industry has always been 2%-3% greater than the GDP growth rate

• Cement stock should be given a P/E, which is a couple of percentage points higher than the GDP growth rate in the country.

•A Company with consistently higher operating margins than its peers should command a higher valuation.

•.

Steel• Cyclicality of the industry,

• Highly capital intensive sector (Rs 300 bn/ 1 million tonne)

• High Fixed cost, Volumes critical

• Access to raw materials

• Demand from infra, housing, automobiles & consumer durables

• Contract sales, Value Added CR, Competition

• Integrated Steel Producers (ISP)/Primary producers or Secondary

• Semis, Long or Flat

Valuations: • Two important ratios to look Price to Earnings (P/E) ratio & the Price to Book Value (P/BV)• P/E multiple of the stock should more or less hover around the country’s GDP growth.• Companies with greater exposure to international markets (exports) and/or larger presence in the downstream segment could command a higher valuation. • The P/BV ratio can also be used as a parameter for comparison.

Telecom• Entry fee, access deficit

charge and license fee.

• sales, general and administrative (SG&A) and employee expenses

• Management vision and depth

• Scale of operations

• Capex plans

• Sales growth, ARPU, Subscriber growth

• EBIDTA margins or Operating margins

• Interest coverage [Profit before interest and tax/Interest]

• EBIDTA per share

• Return on equity, ROCE, FCFValuations:

•ARPU•P/CF•EV/Subscriber•P/E

Banking • Net interest margin

• Operating profit margins

• Cost to income ratio

• Other income to total income

• Credit to deposit ratio

• Capital adequacy ratio

• NPA ratio

• Provision coverage ratio

• ROA

• Interest income, Profits, Business per employee /branch

Valuations: Price to book value: • A bank’s market valuations cannot be only measured from its price to earnings ratio (P/E ratio). • This is due to the reason that a bank’s net earnings are influenced by the amount of non- performing assets provision, which again depends on the bank’s internal policy. Consequently, the bank could make low provisions to show a better picture. • Therefore it’s prudent to remove non-performing assets for which no provisions are made from the net worth of the bank to arrive at the adjusted book value. Market cap to total income: This ratio helps in judging the market valuations of the bank’s total income. It is similar to the market cap to sales ratio for a manufacturing company.

Engineering

• Engineering sector have to be viewed with respect to the specific user industries

• Competency & Entry Barriers

• Foreign competition

• Order book & operating margins

• Balance Sheet size

• Revenue growth

Valuations:

Valuation ratios: One of the key factors used when it comes to putting a value for an engineering company is market capitalization to sales. Why the emphasis of assigning a value to revenues and not to earnings? The ability to grow for any engineering company is dependent on the kind of order book, which then translates into revenues. Internationally, the average of 0.4 times to 0.5 times is a benchmark. If price to earnings is used, it has to be remembered that the sector is highly dependent on the economy. So, a P/E in line with the long-term economic growth could be useful.

Construction• Balance sheet strength, Order book,

Execution period

• Order mix

• Construction Cost

• Management

• Segment presence

• order book to sales ratio, working capital to sales, debt to equity, operating margins and return on capital employed ratios.

• Possible dilution in equity going forward.

Valuations:

• Price to sales ratio (P/S) ratio, is an appropriate metric for valuing Construction companies along with P/E

•One should refrain from using some of the frivolous parameters like ‘price to order book

Revenues growth drivers

Software• Scalability

• Utliization

• Employee retention

• Valuation

• Onsite/Offsite

• Competition

• Management

• Employee productivity

• Concentration

Valuations:

• P/E (relative to the sector), Return on Equity, Return on Assets and Return on Capital (for profitability) and Operating margins (for efficiency). Some companies command a higher premium due to subjective factors like management quality and their position on the value chain.

Retail• Sales growth and revenue per sq ft

Utliization

• Operating margin

• Gross Margin

• Rental strategy

• current ratio and/or working capital to sales inventory levels

• return on asset (whether the company has be able to leverage space to boost topline), return on invested capital

Valuations:

Retail industry is not fixed cost or capital intensive but is highly co-related to consumption patterns that decide spending. The growth prospects are indirectly related to the economic growth. Further, it is a working capital intensive industry. A look at price to earnings ratio will help to compare to the two companies and provide earnings visibility. Companies with better margins, working capital efficiencies and execution capabilities (fulfilling consumers’ demand, expansion plans on track etc.) will command premium. One must also take a note of the management quality, as ultimately the company’s future prospects are dependent upon the management’s moves.

FMCG• Logistic strength

• Product folio

• Marketing and Branding skills

• Last 5 years revenue growth (CAGR)


• Gross Margin

• current ratio and/or working capital to sales inventory levels

• return on asset (whether the company has be able to leverage space to boost topline), return on invested capital

Valuations:

•P/E (price to earnings multiple) and market capitalization to sales

•One must also take a note of the management quality, as ultimately the company’s future prospects are dependent upon the management’s moves.

Pharma• bulk drugs & DPCO

• formulations & NPPA

• Novel Drug Delivery System (NDDS) and developing a New Chemical Entity (NCE)

• Lifestyle segment

• Traditional segment

• Generics

• Geography

• R&D

• Government policies

Valuations:

•P/E (price to earnings multiple) and R&D to sales

•One must also take a note of the management quality, as ultimately the company’s future prospects are dependent upon the management’s moves.

Auto• Free cash flow

• Revenue Segment

• R&D


• Capex

• Per capita Income & Economic growth

Valuations:

•Given the high dependence on economic performance, earnings tend to be very volatile and therefore, price to earnings ratio will not be a consistent valuation metric. The ability to generate cash and fund expansion plans is of greater significance and as a result, we believe price to cash flow (PAT + depreciation) is a consistent valuation metric. Good quality companies, which have consistently shown superior cash generation and higher EBIT margins, become attractive to us if they are trading at a price to cash flow of around 7-9 times and the risk return ratio turns adverse if the same ratio touches 12 times forward cash flow per share.

M&A Scene - The Macro Picture

Mergers - Swap ratio Mergers require determination of swap ratio Absolute values need not be indicated; swap ratio is an

indicator of relative values Subject to approvals from regulatory authorities such as

High Court & RBI High Court’s role Limited scope for review of valuations / valuation reports Hindustan Lever Employees’ Union vs HLL (83 Comp Cases

30)Hindustan Ciba Giegy (14 SCL 115) Not to disturb ratio unless proved to be grossly wrong /

unfair

Valuation techniques are identical

Listed and Unlisted - Issues

“External” Merger Lack of authentic data, if unlisted Recognition of hidden reserves/provisions Due diligence required

“Internal” Mergers Valuation - sensitive issue

Access to insider information

Intra-group dealings Two independent valuations advisable

Demerger - Valuation

Pure “demergers” Valuation more in the nature of a capital structuring

exercise Capital of the “demerged“ undertaking contingent upon

-

Nature of income streams

Quantum of revenues generated

Serviceability of capital

Others cases Valuation akin to a merger

Acquisition/Divestment ... Valuation overview

Principles consistent with other situations (i.e. earnings, standalone etc)

However .... bargaining position is the key!

The theory to beat all other theories on valuation ….A business is worth what someone is prepared to pay for it

And therefore ....

Key conclusions ….

Businesses are valued for the future, not the past Dynamic and fast changing scenarios is making

valuations increasingly difficult Shareholder activism and regulatory constraints

make valuation even trickier

Valuation for mergers has special aspects: to be applied on the same foundation

Industry specific issues need cognisance Brands are usually part of business valuation: can

be valued separately if “separable”

.... Key conclusions

Structural considerations

ValuationsValuation

considerationsAccounting

consideration

Dilution to existing shareholders

Minimising the dilution for existing shareholders

Realize synergies

Ability of the structure to realize full synergies

Financing ability

Leveraging capacity to raise debt Transaction cost

Tax considerations

Applicability of stamp duty & sales tax

Key considerations

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M&a Treatise Valuation