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Valuation Techniques Review

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January 8, 2003

Chicago
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L.E.K. Consulting LLC

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Sydney
The materials contained in this document are intended to supplement a discussion.
These perspectives will only be meaningful to those in attendance.

Learning Objectives

Discuss managements mission

Present the fundamental principle behind all value creating acquisitions and divestitures
Discuss why it is difficult for buyers to create value with mergers and acquisitions
Present a process for creating value with mergers and acquisitions
Make a distinction between price and value
Review different models used to estimate prices and values

Asset approaches
Multiples
Premiums
Market Capitalization
Discounted Cash Flow (DCF)

MANAGEMENT'S MISSION

Management's mission is to create value for shareholders

This mission has long been accepted, and is consistent with fiduciary duty and
responsibility

If shareholders are not adequately compensated, the firm will be unable to attract new
capital required to compete and eventually lose its ability to benefit any stakeholder

Focusing on shareholder value allows managers to take the actions necessary to

ensure the company's capital is put to its best use

Less clearly understood is how to:

measure value creation

make decisions that are consistent with this mission
measure the progress of the organization

MANAGEMENT'S MISSION

To create value, management must choose strategies that effectively balance the
needs of all stakeholders in the long run
Key Corporate Stakeholders

Employees

Value

Suppliers
Va

Customers
lue
Va

lu e

Strategy
Va
lue

e
lu
Va

Value

Government

Shareholders

Local Community

MANAGEMENTS MISSION

Shareholder value is the guiding link among management activities

Strategy
Formulation

Corporate
Development

Incentive
Compensation

Shareholder Value Management

Financial
Policies &
Practices

Performance
Measurement
and Information
Systems

Maximization
of
Shareholder
Value

Employee &
Investor
Communications

Shareholder value management is making all operating, investing and financing

decisions according to their impact on value. It means changing the way you think
about running your business and creating a culture of concern for value.

CREATING VALUE WITH M&A

The principle of finding the highest valued use for all assets guides all acquisition
and divestiture decisions

Find the Highest Valued Use

for All Assets

Principle:

Valuation
Condition:

Portfolio
Implications:

Value
to You

>

Value
to Others

Keep or Potentially Acquire

Value
to Others

>

Value
to You

Divest or Avoid Buying

CREATING VALUE WITH M&A

However, creating value from acquisitions can be difficult for buyers

Average Returns from Acquisitions

40%
1963-68
1968-80
1980-84

Shareholder Returns

30%
20%
10%
0%
-10%

Buyer

Target

Source: Bradley, Desai and Kim, Synergistic Gains From Corporate Acquisitions and
Their Division Between Stockholders of Target and Acquiring Firms, Journal of Financial
Economics, 21.1 (1988)
6

M&A PROCESS

There are several elements of successful acquisitions

Elements of Successful Acquisitions
Elements

Purpose

Key Questions

Right Strategy

Clear objectives and

criteria
Well selected candidates

Can you make an acquisition

candidate more valuable?

Right information

Correct strategy
formulation
Product/market dynamics
Assessment of synergies
Proper valuation

Do you know exactly what

you are buying?

Right Price

Establish "walk away"

price with synergies
Assess alternative
bidder's strategies

Will you create value for your

shareholders?

Right Implementation

Integration teams
Value-linked targets and
timetables
Monitoring and incenting

Can you quickly gain the

benefits?

M&A PROCESS

An appropriate acquisition process helps increase the probability that you will
create value with mergers and acquisitions

Strategic
Fit

Search and
Screen

Target &
Market
Assess

Deal
Structure

Valuation

*Sequence can vary significantly

Negotiation

Due
Diligence

Integration

PRICE VS. VALUE

Which prices and values are we calculating?

Price

Value

Current Stock

Break Up

Your Offer

Asset

Other's Offers

Market

Max. You Will Pay

Shareholder

Max. Others Will Pay

Stand-Alone

Closing Price

With Synergies
To You
To Others

PRICE VS. VALUE

The value created in an acquisition is the difference between the target's value to
you and the price you paid
Definitions of price and value:

Price is what you pay for something

Value is what it is worth to you

For acquisitions, these definitions have an obvious implication:

Value - Price = Value Created

10

PRICE VS. VALUE

The value of a company will be the highest of its acquisition, current and break up
values
The Value Spectrum

Break Up
Value

Current
Value
STRATEGY

Also known as
asset value or
liquidation value
Assumes that the
best strategy for
the business is to
cease operations

Acquisition
Value
SYNERGIES

Also known as
stand-alone value
Assumes that the
best strategy is the
current strategy

11

Also known as
value with
synergies
Includes synergies
the firm might be
able to create with
other businesses

PRICE VS. VALUE

Several methods can be applied to value companies, but they are not necessarily
equivalent
Common Valuation Methods
METHODOLOGY

CALCULATION

FOCUS

STRATEGY
VALUED

Net Assets

Assets - Liabilities

Value

Break-up

Comparable Multiples
- Price/Earnings
- Price/Cash Flow
- Market Value/Book Value
- Price/Sales

Calculate using current prices:

P/E x Earnings
P/CF x Cash Flow
Market/Book x Book Value
P/Sales x Sales

Price

Current

Comparable Transactions
- Premium to market value
- Premium to book value
- Acquisition Multiples

(Shares x Price ) + a premium

Book Value + a premium
Calculate using acquisition prices:
P/E x Earnings
P/CF x Cash Flow
Market/Book x Book Value
P/Sales x Sales

Price

Synergistic

DCF

Cash flows forecasted under the

current strategy discounted at the
weighted average cost of capital

Value

Current

DCF with synergies

Cash flows forecasted using

synergistic strategy discounted at
weighted average cost of capital

Value

Synergistic

12

PRICE VS. VALUE

Because of the dynamics of the bidding environment, only unique synergies can
be reliably saved for buyers' shareholders
Example: Two Bidder Transaction

Target's
Current
Value

Bidder A's
Walk Away
Bidder B's
Walk Away

Bidder A
Bidder B

Unique
Synergies
(go to
Buyer)

Common Synergies
(go to Seller)

Deal Price

It is not enough to be able to create synergies

You must be able to create more synergies than other bidders

13

DISCOUNTED CASH FLOW FRAMEWORK

DCF is the appropriate valuation method for most companies

DCF yields the value of a business, not just its price

DCF value is driven by the factors that affect value of all businesses

Cash flows
Timing
Risk

It can be used to estimate either current value or a targets unique synergistic value

Use expected cash flows under the current strategy to calculate a current value
Use cash flows that include the unique synergies to estimate a synergistic value

By using expected cash flows, DCF links value to changes in strategy

14

DISCOUNTED CASH FLOW FRAMEWORK

The DCF framework discounts operating cash flows to estimate a company's

value
(C)
Forecast Period

Residual Period
2003 2004 2005 2006 2007 2008 - - - - - - - CF1
(A)

CF2

CF 3

CF4

Present Value
of Operating
Cash Flow
Residual Value

+
(B)

CF5

Present Value
of Residual
Value

+
(D)

Non Operating
Assets

(E)

Corporate Value

Market Value
of Debt and other
Obligations

15

Shareholder
Value

ESTIMATING OPERATING CASH FLOW (A)

Because value is a function of cash flow, the components of operating cash flow
are known as value drivers
2002 Cash Flow from Operations
Acme Corporation
($MILLIONS)

Sales

$250.0

Cash Operating Expenses

Cost of Goods Sold
SG&A
Economic Depletion

(236.5)
(196.4)
(38.8)
(1.3)

Operating Profit

$13.5

Cash Taxes

(4.1)

Net Operating Profit After Tax (NOPAT)

$9.4

Incremental Fixed Capital Investment

(1.4)

Total Fixed Capital Investment

(2.7)

Economic Depletion

1.3

Incremental Working Capital Investment

Operating Cash Flow

(2.9)
$5.1

16

ESTIMATING OPERATING CASH FLOW (A)

A simple set of value drivers can be used to forecast cash flows

Forecast Cash Flow from Operations
Acme Corporation
($Millions)

2003

2004

2005

Sales (10.8% Growth)

$277.0

$306.9

$340.0

Operating Expenses

(261.9)

(290.2)

(321.5)

Operating Profit (5.4% of Sales)

$15.0

$16.7

$18.5

Cash Taxes (36% of Op. Profit)

(5.4)

(6.0)

(6.6)

$9.6

$10.7

$11.8

Incr. Fixed Capital Investment

(5.0% of Change in Sales)

(1.3)

(1.5)

(1.7)

Incr. Working Capital Investment

(10.0% of Change in Sales)

(2.7)

(3.0)

(3.3)

$5.6

$6.2

$6.9

NOPAT

Operating Cash Flow

17

ESTIMATING OPERATING CASH FLOW (A)

The Value Drivers sheet of the Toolkit can be used to calculate value drivers

Value Driver Calculations

Company Name:
Scenario:
Units:
First Historical Year
Last Historical Year
Year

Acme Corporation
Base Case
$ millions
2000
2002
2000

2001

2002

2003

2004

2005

2006

2007

Sales

201.090

224.215

250.000

280.000

313.600

348.096

382.906

417.367

Operating Profit
Cost of Goods Sold (COGS)
+ SG&A
+ Other Operating Expenses
= Total Costs

159.658
13.843
17.535
191.035

177.643
15.403
19.510
212.556

197.655
17.138
21.708
236.500

219.969
19.072
24.158
263.200

243.744
21.134
26.770
291.648

270.836
23.335
29.558
323.729

300.663
26.148
33.120
359.931

329.098
29.735
37.665
396.499

10.054

11.659

13.500

16.800

21.952

24.367

22.974

20.868

2.369
0.922
0.256
0.307
2.728

3.061
1.192
0.330
0.397
3.526

3.516
1.369
0.380
0.456
4.050

5.251
2.044
0.567
0.680
6.048

6.861
2.671
0.741
0.889
7.903

7.616
2.965
0.822
0.987
8.772

7.181
2.796
0.775
0.930
8.271

6.523
2.539
0.704
0.845
7.513

2.500
1.300
1.200

2.700
1.300
1.400

2.809
1.309
1.500

3.146
1.466
1.680

3.229
1.505
1.725

3.259
1.518
1.740

3.226
1.503
1.723

1.066
7.975
11.212
3.641
23.894

1.217
9.161
12.745
4.157
27.280

1.378
10.430
14.379
4.708
30.896

1.586
11.817
16.247
5.210
34.860

1.840
13.563
18.106
5.891
39.400

2.134
15.617
20.109
6.357
44.217

2.497
17.943
21.582
7.362
49.384

2.948
20.665
22.919
8.393
54.926

3.667
0.273
0.793
4.733

4.212
0.313
0.911
5.436

4.796
0.357
1.037
6.190

5.543
0.412
1.199
7.154

6.457
0.481
1.397
8.334

7.517
0.559
1.626
9.702

8.823
0.657
1.908
11.388

10.447
0.777
2.259
13.484

2.683

2.862

3.000

3.360

3.450

3.481

3.446

Operating Profit
Operating Cash Taxes
Income Tax Provision
+ Interest Tax Shield
- Tax on Non-Operating Income
- Incr. in Deferred Tax Liability
= Operating Cash Taxes
Incremental Fixed Capital
Total Fixed Capital Investment
- Depreciation
= Incremental Fixed Capital
Incremental Working Capital
Cash
+ Accounts Receivable
+ Inventories
+ Other Operating Current Assets
= Total Operating Current Assets
+
+
+
=

Accounts Payable
Income Taxes Payable
Other Operating Current Liabilities
Total Operating Current Liabilities
Incremental Working Capital

Value Drivers
Sales Growth (G)
Operating Profit Margin (P)
Operating Cash Tax Rate (T)
Incr. Fixed Capital Investment (F)
Incr. Working Capital Investment (W)

2000
5.00%
27.13%

2001
11.50%
5.20%
30.24%
5.19%
11.60%

2002
11.50%
5.40%
30.00%
5.43%
11.10%

2003
12.00%
6.00%
36.00%
5.00%
10.00%

2004
12.00%
7.00%
36.00%
5.00%
10.00%

2005
11.00%
7.00%
36.00%
5.00%
10.00%

18

2006
10.00%
6.00%
36.00%
5.00%
10.00%

2007
9.00%
5.00%
36.00%
5.00%
10.00%

Cost of Capital (K)

Market Value of Debt
Preferred Stock
Market Value of Debt

2002
$10.800
$0.000
$10.8

Beta
Risk-Free Rate
Market Risk Premium (MRP)
Cost of Equity

1.00
4.50%
6.50%
11.00%

Cost of Debt
Cash Tax Rate
After-Tax Cost of Debt

8.50%
36.00%
5.44%

Current Stock Price

Number of Shares Outstanding
Market Value of Equity
Debt/Total Capital

$10.00
10.000
$100.0
9.75%

Cost of Capital (K)

10.46%

Chosen Cost of Capital (K)

10.46%

ESTIMATING OPERATING CASH FLOW (A)

The weighted average cost of capital is used to discount cash flows to a present
value
Weighted Average Cost of Capital Formula

Debt
K = Kd x (1 - T) x ( Debt + Equity) +

Where:

K
Kd
T
Debt
Equity
Ke

=
=
=
=
=
=

Equity
Ke x ( Debt + Equity)

Weighted Avg. Cost of Capital

Cost of Debt
Cash Tax Rate
Market Value of Debt
Market Value of Equity
Cost of Equity

It is the weighted average return required by a company's debt and equity investors
In order to create value, companies must earn a return greater than the cost of capital
Cost of capital varies across business units, companies and industries and is affected
by capital structure
If the cost of capital is not known, it is impossible to know whether value is being
created
19

ESTIMATING OPERATING CASH FLOW (A)

The cost of equity is calculated using the Capital Asset Pricing Model (CAPM)

Cost of Equity Formula

Market Risk
Premium

Adjustment
for Firm Risk
(Beta)

Cost of Equity

Return on a
Risk-Free
Investment

h Risk-free rate
qThe return investors could make by investing in a perfectly safe security
qUse the ten-year government bond yield
h Market risk premium
qThe amount above the risk-free rate that investors demand for accepting the systematic
risk that cannot be diversified away when investing in the stock market
h Adjustment for firm risk
qThe extent to which a company has more or less systematic risk than the market
qAlso adjusts for the amount of financial leverage a company has in its capital structure

20

ESTIMATING OPERATING CASH FLOW (A)

The cost of equity increases as debt is added to the capital structure

Suppose that you own 50% of a business:
100% Equity Financing

50% Debt Financing

+/- $10

+/- $10

Your Stake
50% Equity

Your Stake
100% Equity

Others Stake
50% Equity

Others Stake
100% Debt

$50

$50

Your Risk:

+/- $5

+/- $10

Your Volatility:

10%

20%

Value = $100

Your Ownership:

If some owners are insulated from risks (e.g., debt holders) the other
owners (e.g., shareholders) must face increased risk.

21

ESTIMATING OPERATING CASH FLOW (A)

Therefore, if you are using a peer group approach to calculate the cost of equity,
and the peers have different leverage than the business being valued, their betas
must be relevered
Cost of Capital as a Function of Leverage
20%
18%

Target
Leverage

16%

Peers

12%

Cost of Equity

10%

Pre-Tax Cost of Debt

Cost of Capital

8%
6%
4%
2%

Debt / Total Capital

22

%
72

%
64

%
56

%
48

%
40

%
32

%
24

%
16

8%

0%
0%

Rate of Return

14%

ESTIMATING OPERATING CASH FLOW (A)

You can use the Peer Group Beta sheet to perform this calculation

Peer Group Beta Analysis

Peers for:

Acme Corporation

Peer Group Weighted Average

Relevered Beta:

1.00
Peer Information

Peers
Peer 1
Peer 2
Peer 3
Peer 4

Peer
(Levered)
Beta
0.93
1.29
1.20
1.33

Peer
Operating
Peer Debt to Cash Tax
Rate %
Equity %
15.4%
35.0%
124.0%
37.2%
5.8%
36.0%
45.1%
38.0%

Unlevered
Beta
0.84
0.73
1.16
1.04

23

Company Information
Company
Operating
Target Debt Cash Tax
Rate %
to Equity %
9.8%
35.0%
9.8%
35.0%
9.8%
35.0%
9.8%
35.0%

Relevered
Beta
0.90
0.77
1.23
1.11

Weight
1.00
1.00
1.00
1.00

RESIDUAL VALUE (B)

To calculate residual value, use the model that corresponds to the economics of
the firm after the forecast period
Economic Assumption at the End of the Forecast Period

Valuation Model

All assets sold, and all liabilities retired

Net Asset

The business will be sold at the current average premium

Comparable
Transaction Multiple

No value is created after the forecast period (i.e. all new

investments return the cost of capital)

DCF Perpetuity

Value is either created or destroyed indefinitely into the future

DCF Perpetuity with

Growth

24

RESIDUAL VALUE (B)

The straight perpetuity method implies that value is neither created nor destroyed
after the forecast period
The economic assumption is that companies earning rates of return in excess of the
cost of capital will attract competition that will eventually drive investment returns
down to the cost of capital
This implies that the average rate of return on new investments will equal the cost of
capital, hence no incremental value is created for investments made beyond the
forecast period. There may be growth in the business, but not in value
Economic
Returns
Cost of Capital

Forecast Period

Residual Period

Time

25

RESIDUAL VALUE (B)

If value is neither created nor destroyed in the residual value period, then NOPAT
is the basis for calculating a perpetuity residual value
Last Forecast Year:
Sales
- Operating Expenses
- Economic Depletion of Assets (Depreciation)
- Cash Taxes on Operating Profit
Net Operating Profit After Tax (NOPAT)
+ Economic Depletion of Assets
- Fixed Capital Investment
- Working Capital Investment

Investments made
in residual period
have no value impact

Operating Cash Flow

Since incremental investments in residual period yield NPV=0, the straight perpetuity
values a perpetual stream of the last forecast periods NOPAT using the formula:
Straight Perpetuity
Residual Value

NOPAT
Cost of Capital

Adjustments to last forecast year NOPAT may be required if it is not representative of

future levels

26

FORECAST PERIOD (C)

When using the straight perpetuity method, the forecast period must be chosen to
coincide with the period of time investors believe a company will create value with
their current strategy - the value growth duration (VGD)
This can be different than standard forecast periods, or management's assessment of
their competitive advantage period
Factors to consider when estimating the forecast period

Proprietary technologies
Patented products
Product life cycles
Established brands
Distribution channels
Company strategy
Industry
Industry Value
Value Growth
Growth Durations
Durations
Industry
Industry

Value
Value Growth
Growth Duration
Duration
(Using
(Using Straight
Straight Perpetuity)
Perpetuity)

Banking
Banking
Food
Food Products
Products
Fast
Fast Foods
Foods
Pharmaceutical
Pharmaceutical
Beer
Beer and
and Wine
Wine
Airlines
Airlines

1-5
1-5 years
years
3-10
3-10 years
years
3-15
3-15 years
years
15+
years
15+ years
2-20
2-20 years
years
3-10
years
3-10 years

Source: APT!, Value Line 1Q/2000, L.E.K. Analysis

27

THE DISCOUNTED CASH FLOW FRAMEWORK

The DCF framework discounts free operating cash flows to estimate Acmes
shareholder value
(C)
Forecast Period

Residual Period
2003 2004 2005 2006 2007 2008 - - - - - - - ($000)

(A)

CF1

Cumulative
Present Value
of Cash Flow
$32.1

CF2

CF 3

CF 4

Residual Value
$127.7

+
(B)

CF5

Present Value
of Residual
Value
$77.6

+
(D)

Non Operating
Assets
$1.0

=
Corporate Value
$110.8

(E)
Market Value
of Debt and Other
Obligations
$10.8

28

Shareholder Value
Total
$100.0

THE DISCOUNTED CASH FLOW FRAMEWORK

You can calculate a business value using the Shareholder Value sheet
Shareholder Value Calculator
Company Name:
Scenario:
Units:
Shareholder Value
Shareholder Value Per Share
Value Growth Duration (Years)
Residual Value Approach or Value
Value Drivers:
Historical Sales
Sales Growth (G)
Operating Profit Margin (P)
Operating Cash Tax Rate (T)
Incremental Fixed Capital Investment (F)
Incremental Working Capital Investment (W)
Cost of Capital (K)
Non-Operating Assets
Market Value of Debt
Number of Shares Outstanding
Operating Cash Flows & Value:
Sales
Operating Costs
Operating Profit

Acme Corporation
Base Case
$ millions
$100.0
$10.00
5
NOPAT/K
2002
$250.0

$250.0

2003

2004

2005

2006

2007

12.00%
6.00%
36.00%
5.00%
10.00%
10.46%
$1.00
$10.80
10.000

12.00%
7.00%
36.00%
5.00%
10.00%
10.46%
$1.00
$10.80
10.000

11.00%
7.00%
36.00%
5.00%
10.00%
10.46%
$1.00
$10.80
10.000

10.00%
6.00%
36.00%
5.00%
10.00%
10.46%
$1.00
$10.80
10.000

9.00%
5.00%
36.00%
5.00%
10.00%
10.46%
$1.00
$10.80
10.000

280.0
263.2
16.8

313.6
291.6
22.0

348.1
323.7
24.4

382.9
359.9
23.0

417.4
396.5
20.9

6.0
10.8

7.9
14.0

8.8
15.6

8.3
14.7

7.5
13.4

1.5
3.0
6.3

1.7
3.4
9.0

1.7
3.4
10.4

1.7
3.5
9.5

1.7
3.4
8.2

Cash Taxes
Net Operating Profit After Taxes (NOPAT)
Fixed Capital Investment
Working Capital Investment
Cash Flow (CF)
Discount Factor

0.9053

0.8196

0.7420

0.6717

0.6081

Present Value (PV) of CF

5.7

7.4

7.7

6.4

5.0

Cumulative PV of CF

5.7

13.0

20.8

27.1

32.1

Residual Value (NOPAT Perpetuity Method)

127.7

PV of Residual Value
Non-Operating Assets

77.6
1.0

Corporate Value
Market Value of Debt

110.8
10.8

Shareholder Value (SHV)

$100.0

Share Price

$10.00

29

THE DISCOUNTED CASH FLOW FRAMEWORK

What long-term expectations explain Acmes $100 per share stock price?
Acme Corporation
Cash Flows

Value Driver
2002 Sales
Forecast Period

5 years

Sales Growth

10.8%

Profit Margins

5.4%

Cash Tax Rate

36.0%

Incremental Fixed
Capital Investment

PV Operating
Cash Flows

$250.0M

PV Residual Value
PV Investments
Debt and Obligations

$25.4M
84.4M
1.0M
(10.8M)

Shareholder Value

$100.0M

Shareholder Value
Per Share

$10.00

Stock Price

$11.00

5.0%

Incremental Working
Capital Investment

10.0%

Cost of Capital

10.5%

30

THE DISCOUNTED CASH FLOW FRAMEWORK

The Sensitivity Analysis sheet identifies the value drivers with the greatest
impact on value
Sensitivity Analysis
Company Name:
Scenario:

Acme Corporation
Value Line
Range

Value Driver
Sales Growth (G)
Operating Profit Margin (P)
Operating Cash Tax Rate (T)
Incremental Fixed Capital Investment (F)
Incremental Working Capital Investment (W)
Cost of Capital (K)

Additive
Modifier
1.0%
1.0%
1.0%
1.0%
1.0%
1.0%

Multiplicative Modifier
10.0%
10.0%
10.0%
10.0%
10.0%
10.0%

Value
10.8%
5.4%
36.0%
5.0%
10.0%
10.5%

Low Range
9.8%
4.4%
35.0%
4.0%
9.0%
9.5%

High Range
11.8%
6.4%
37.0%
6.0%
11.0%
11.5%

Sensitivity Analysis Results

Change in Shareholder Value
$ millions

Additive

Multiplicative
Low
($2.7)
($11.7)
$6.6
$0.6
$1.1
$12.4

Sales Growth (G)

Op. Profit Margin (P)
Cash Tax Rate (T)
Incr. Fixed Cap. (F)
Incr. Working Cap. (W)
Cost of Capital (K)

High
$3.1
$12.8
($7.2)
($0.6)
($1.2)
($11.2)

Low
($2.7)
($23.7)
$2.0
$1.2
$1.2
$13.1

Multiplicative Sensitivity

Sales
Growth (G)

Sales
Growth (G)
Op. Profit
Margin (P)

Cash Tax
Rate (T)
Incr. Fixed
Cap. (F)
Incr. Working
Cap. (W)
Cost of
Capital (K)
-$5

$0

$5

$10

$15

-$30

-$20

Op. Profit
Margin (P)

Cash Tax
Rate (T)

Cash Tax
Rate (T)

Incr. Fixed
Cap. (F)

Incr. Fixed
Cap. (F)

Incr. Working
Cap. (W)

Incr. Working
Cap. (W)

Cost of
Capital (K)

Change in Shareholder Value

High
$2.3
$42.3
($2.0)
($1.2)
($1.2)
($10.7)

Range Sensitivity

Op. Profit
Margin (P)

-$10

Low
($3.2)
($5.1)
$2.0
$1.2
$1.2
$13.1

Additive Sensitivity

Sales Growth
(G)

-$15

Range
High
$2.8
$23.7
($2.0)
($1.2)
($1.2)
($10.7)

-$10

Cost of
Capital (K)
$0

$10

Change in Shareholder Value

31

$20

$30

-$20

-$10

$0

$10

$20

$30

Change in Shareholder Value

$40

$50

SUMMARY

Valuation Techniques Review

The goal of mergers and all other strategies is to create value
Creating value with acquisitions is difficult
The fundamental principle behind all acquisitions and divestitures is:

Find the Highest Valued Use

for All Assets
The best way to determine whether an acquisition will add value is to ask, "Why is this
target worth more to us than to any other bidder?
Only unique synergies can be reliably saved for the buyer's shareholders
Dont confuse valuation techniques that calculate prices with those that calculate
values
- Value is what something is worth to you
- Price is what someone pays for it
DCF acquisition value is the best way to ascertain an acquisitions unique value to your
company

32

Appendices:

Value Driver Reference Sheets

Net Asset Valuation Example
Current Multiples Example
Transaction Multiples Example
Proof of the Equivalence of Perpetuity Residual Value Approaches

33

VALUE DRIVER REFERENCE SHEET

Value Driver

Description

Sales Growth
(G)

Sales growth rate

anticipated during the
forecast period

Operating
Profit Margin
(P)

Pre-Tax Operating profits

as a percent of Sales

Cash Tax Rate

(T)

Cash Taxes that would

have been paid if the firm
had no debt as a percent of
Operating Profits

Incremental Fixed The addition to fixed

Capital Investment capital, over and above
maintenance capital
(F)
expenditure, as a percent
of change in sales
Incremental
Working Capital
Investment
(W)

The addition to working

capital as a percentage of
change in sales

Formula

Hints

Future Sales
Last Historical Sales
Where: N = # years

P=

1
N

-1

Sales Op. Expenses

Sales

Subtract economic depletion of

assets in OP. Exp. (or use
Depreciation as a proxy).

T = Cash Taxes / Op. Profit

Where Cash Taxes =
+ Book Taxes
- Non. Operating Taxes
+ Interest Tax Shield
- Incr. In Deferred Tax Liability

F=

W=

Total CAPEX Econ. Depl. Of Assets

Change in Sales

Ch. In Working Capital

Change in Sales

Where Working Capital =

Operating Current Assets (-)
Operating Current Liabilities

34

Calculate this rate using % Growth,

exponent, or PV, FV keys on a
calculator

Interest Tax Shield is the tax savings

resulting from Debt
(Interest Expense x Tax Rate)
The tax advantage of debt will be
included in valuations by using the
after-tax cost of debt in the weighted
average cost of capital. Not in cash
flows.
Depreciation can be used as a proxy
for Economic Depletion of Assets.

Exclude cash not necessary for

operations (add it to non-operating
assets).
Exclude Short Term Debt.
Exclude Deferred Taxes

VALUE DRIVER REFERENCE SHEET

Value Driver

Description

Formula

Hints

Cost of Capital
(K)

The weighted
average return
that a company's
debt and equity
holders require
given the levels
of risk of their
investments

K = [K x %Eq] + [K x (1-T) x %Debt]

e

For public companies get Beta from

published sources. Use peer group
analysis for private firms/divisions.
Betas may need to be relevered if the
target capital structure of peers differs
from that of the firm being valued.

Where:
K

= Cost of Equity
= Risk-free Rate + (Beta x MRP)
K
= Cost of Debt
d
T
= Cash Tax Rate
%Eq = Equity/(Debt + Equity)
%Debt = Debt/(Debt + Equity)

Cost of debt is the weighted average

yield to maturity for public firms. Use
comparables or bond rating analysis
for private firms.
%Eq and %Debt should be the firm's
target capital structure for the future.
Use Market values for debt and equity.

Number of
Forecast
Periods (N)
(Value Growth
Duration)

The number of
periods investors
today are willing
to bet the firm
being valued will
be able to create
value with its
current strategy

Estimate qualitatively by asking how

long it would take for a company to enter
the industry, emulate the strategy and
"compete away" the firm's advantage.
OR
Estimate quantitatively by using market
signals analysis

35

Consider:
Proprietary Technologies
Distribution Channels
Patented Products
Product Life Cycles
Established Brands
Other Competitive Advantages

VALUE DRIVER REFERENCE SHEET

Value Driver

Description

Residual Value
(RV)

The value of a
firm after the
forecast period
(N)

Formula

Hints

If returns = K after the fcst period:

RV = NOPAT / K

Returns equal K is almost always the

best assumption for going concerns.

If value is created in perpetuity:

CFT + 1
RV =
(K - G)

Value creation in perpetuity should only

be used for monopolies and other
instances where an advantage can never
be competed away.

If firm will be sold after fcst period:

RV = After-tax Sale Price

Don't forget to take the present value of

residual value.

Non-Operating
Assets (NOA)

Anything that has NOA =

value that has
Marketable Securities
not been
+ Real Estate
included in
+ Investments in Affiliates
Working Capital
or cash flows

Use market values or recently appraised

values to estimate non-operating assets.

Market Value of
Debt (MVD) and
other obligations

Anything that
could detract
from the value of
the firm to
shareholders not
reflected in cash
flows

Use market values, recently appraised

values or expected values to estimate
market value of debt.

MVD =
Mkt. Value of Debt Instruments
+ Underfunded Pensions
+ Environmental Liabilities
+ Litigation Liabilities

36

Any time the yield to maturity is different

than the coupon rate, book value will
misstate market value for debt.

VALUATION METHODS

Asset value can be used to estimate break-up values

Asset-based valuation has several advantages:

Asset value data is often easy to obtain

The calculation is theoretically simple

Value = Assets - Liabilities

However, it is not relevant for valuing going concerns and can be difficult to apply

Market values for illiquid assets may be difficult to ascertain

Book value accounts may be old
Foreign accounting practices may make adjustments difficult
Example: Acme
Value
=
$61,480M =

Assets - Liabilities
$72,280M - $10,800M

37

COMPARABLE MULTIPLES

Comparable multiples analysis can be used to estimate the current value of

private companies
Current Multiples Analysis
Company Name:
Units:

Peer Companies
Peer 1
Peer 2
Peer 3
Peer 4
Peer 5

Acme Corporation
$ thousands

Share Price
$17.0
$12.0
$3.5
$8.0
$14.0

Number of Market Equity

Shares
Value
2,153.0
$36,601.0
13,670.0
$164,040.0
14,659.0
$51,306.5
4,230.0
$33,840.0
6,661.0
$93,254.0

Debt
$11,301.0
$45,001.0
$33,294.0
$14,993.0
$36,121.0

Corporate
Value
$47,902.0
$209,041.0
$84,600.5
$48,833.0
$129,375.0

Sales
$97,874.1
$308,334.4
$135,093.3
$127,974.3
$247,594.1

EBITDA
$7,487.4
$26,346.9
$11,967.7
$8,547.3
$17,996.2

Earnings
$3,011.8
$14,706.2
$4,720.1
$3,495.3
$7,288.8

Book Equity
Value
$20,148.6
$89,206.0
$38,367.3
$21,189.3
$70,029.0

$379,041.5

$140,710.0

$519,751.5

$916,870.2

$72,345.5

$33,222.3

$238,940.3

$250,000.0

$14,800.0

$7,105.0

$61,480.0

Peer Total
Acme Corporation

Peer Companies
Peer 1
Peer 2
Peer 3
Peer 4
Peer 5

$10,800.0

Sales Multiple
Value
0.5
0.7
0.6
0.4
0.5

Weight
1
1
1
1
1

EBITDA Multiple
Value
6.4
7.9
7.1
5.7
7.2

Weight
1
1
1
1
1

P/E

Multiple

Value
12.2
11.2
10.9
9.7
12.8

Weight
1
1
1
1
1

Market/Book Ratio
Value
1.8
1.8
1.3
1.6
1.3

Weight
1
1
1
1
1

Peer Weighted Average

0.54

6.86

11.33

1.58

Average

Implied Equity Prices

$124,087.2

$90,737.5

$80,502.9

$97,401.1

$98,182.2

Implied Corporate Prices

$134,887.2

$101,537.5

$91,302.9

$108,201.1

$108,982.2

38

TRANSACTION MULTIPLES

Comparable transactions can be used to calculate acquisition prices of private

companies
Transaction Multiples Analysis
Company Name:
Units:

Acme Corporation
$ thousands

Target
Target 1
Target 2
Target 3
Target 4

Acquirer
Company 1
Company 2
Company 3
Company 4

Transaction Market Equity

Date
Value
12/11/2002
$3,213.0
9/20/2002
$72,387.0
3/5/2002
$23,373.0
10/11/2001
$1,512.0

Debt
$1,344.4
$56,729.7
$8,678.0
$703.1

Corporate
Value
$4,557.4
$129,116.7
$32,051.0
$2,215.1

Sales
$6,636.9
$175,096.9
$47,183.7
$3,720.3

EBITDA
$496.6
$12,010.6
$2,906.7
$108.4

Earnings
$228.5
$4,444.5
$1,338.2
$2.7

Book Equity
Value
$1,660.8
$34,276.8
$11,183.0
$751.1

$100,485.0

$67,455.2

$167,940.2

$232,637.9

$15,522.3

$6,013.9

$47,871.8

$250,000.0

$14,800.0

$7,105.0

$61,480.0

Peer Total

$10,800.0

Acme Corporation

Target
Target 1
Target 2
Target 3
Target 4

Sales Multiple
Value
0.7
0.7
0.7
0.6

EBITDA Multiple
Weight
1
1
1
1

Value
9.2
10.8
11.0
20.4

Weight
1
1
1
0

P/E

Multiple

Value
14.1
16.3
17.5
558.1

Weight
1
1
1
0

Market/Book Ratio
Value
1.9
2.1
2.1
2.0

Weight
1
1
1
1

Peer Average

0.67

10.32

15.94

2.04

Average

Implied Equity Prices

$157,872.6

$141,902.7

$113,245.7

$125,257.0

$134,569.5

Implied Corporate
Prices

$168,672.6

$152,702.7

$124,045.7

$136,057.0

$145,369.5

39

VALUATION METHODS

The various proxies for Acme's value can be placed along a value spectrum
Value Spectrum for Acme

Asset Value

$61.4

Current P/E Multiple

$80.5

Current EBITDA Multiple

$90.7

Current Mkt/Bk Multiple

$97.4

DCF Stand Alone

$100.0

Trans. P/E Multiple

$113.2

Current Sales Multiple

$124.1

Trans. Mkt/Bk Multiple

$125.3

Trans. EBITDA Multiple

$141.9

Trans. Sales Multiple

$-

$157.8
0.0 40.0 60.0 80.0 00.0 20.0 40.0 60.0 80.0
2
$
$
$
$
$1
$1
$1
$1
$1
($ millions)

40

Proof of the equivalence of perpetuity residual value approaches

Definitions:

Relationships:

CF
=
NOPAT =
g
=
r
=

1. Cash Flow is NOPAT minus Investment

ROC
K

Cash Flow
Net Operating Profit After Tax
Growth Rate of Cash Flows
Percentage of Cash Flows Reinvested
(Reinvestment Rate )
= Return on Capital Invested
= Cost of Capital

CF = NOPAT * (1 - r)
2. The percentage growth in Cash flows is
the percentage of Cash Flow reinvested
multiplied by the expected return on
investment
g = r x ROC

Proof:
Insert
Relationship 1

CF
K-g

Insert
Relationship 2

NOPAT * (1 - r)
K - (r x ROC)

Assume
ROC = K

41

NOPAT * (1 - r)
K * (1 - r)

NOPAT
K