VALUATIONS Investors in a company that are aiming to take over another one must determine whether the

purchase will be beneficial to them. In order to do so, they must ask themselves how much the company being acquired is really worth. Naturally, both sides of an M&A deal will have different ideas about the worth of a target company: its seller will tend to value the company at as high of a price as possible, while the buyer will try to get the lowest price that he can. There are, however, many legitimate ways to value companies. The most common method is to look at comparable companies in an industry, but deal makers employ a variety of other methods and tools when assessing a target company. Here are just a few of them:

METHODS

1. Comparative Ratios
Enterprise-Value-to-Sales Ratio (EV/Sales) - With this ratio, the acquiring company makes an offer as a multiple of the revenues, again, while being aware of the price-to-sales ratio of other companies in the industry.

Here, we have found the Enterprise-value-to-sales ratio for the PIXAR. Its calculation is as follows.
Implied multiples Enterprise Value SALES 2010 EBITDA 2010 Implied EV/SALES Implied EV/EBITDA 44,87,553 9,08,400 6,35,880 4.9x 7.1x

Now, the Walt Disney should have made an offer as a multiple of 4.9x. here, X is the expected revenue in the terminal year. 2. Replacement Cost - In a few cases, acquisitions are based on the cost of replacing the target
company. For simplicity's sake, suppose the value of a company is simply the sum of all its equipment and staffing costs. The acquiring company can literally order the target to sell at that price, or it will create a competitor for the same cost. Naturally, it takes a long time to assemble good management, acquire property and get the right equipment. This method of establishing a price certainly wouldn't make much sense in a service industry where the key assets - people and ideas - are hard to value and develop.

3. Discounted Cash Flow (DCF) - A key valuation tool in M&A, discounted cash flow analysis
determines a company's current value according to its estimated future cash flows. Forecasted free cash flows (net income + depreciation/amortization - capital expenditures - change in working capital) are discounted to a present value using the company's weighted average costs of capital (WACC). Admittedly, DCF is tricky to get right, but few tools can rival this valuation method.

It can be hard to understand how stock analysts come up with "fair value" for companies, or why their target price estimates vary so wildly. The answer often lies in how they use the valuation method known as discounted cash flow (DCF). However, you don't have to rely on the word of analysts. With some preparation and the right tools, you can value a company's stock yourself using this method. This tutorial will show you how, taking you step-by-step through a discounted cash flow analysis of a fictional company. In simple terms, discounted cash flow tries to work out the value of a company today, based on projections of how much money it's going to make in the future. DCF analysis says that a company is worth all of the cash that it could make available to investors in the future. It is described as"discounted" cash flow because cash in the future is worth less than cash today. (To learn more, see The Essentials Of Cash Flow and Taking Stock Of Discounted Cash Flow.)

Now, We will calculate the Free cash flow for PIXAR. ASSUMPTIONS 1. 2.

3. 4. 5. 6. 7. 8.

The calculation of the free cash flow has been calculated with help of the past 3 years data of the company. The % growth in sales is the result of the observational value as in last few years sales data and seeing the growth in the animation industry in near future and company having almost monopoly in the same industry; we have assumed it to be 45% in coming years. (Media and Entertainment industry growth is expected to be 26% to 27% in coming years with the time view frame of 2006 onwards while the animation industry was expected to grow at 30+%) EBITDA margins was found by the average of last 3 years % growth. The % growth in Depreciation & amortization is assumed to be 7%, considering 5% growth in Capital Expenditure. The Tax is taken as 30% flat for the coming years. The growth in capital expenditure is assumed to be 5%. The growth in current assets is to be assumed as 35% considering the increase in sales of 45%. The current liabilities are assumed to be 24.6% based on the last 3 years data of current liabilities.

The whole calculation and the valuation sheet are as follows.

Calculation of WACC Here, the debt to total capitalization ratio is 29.1% for PIXAR while the equity to total capitalization is 70.9%. The Risk free rate of return is 4%, which is the prevailing rate of interest on government bond as on 2005. The risk premium is 7.1%, while the beta is 1.22 (given), and the size of premium is 1.7% (also given) So, as per the CAPM model the cost of equity will come to 14.3%. The calculation of cost of debt would be 4.2% as calculated under.

Calculation of WACC
Input WACC Calculation Target Capital Structure (1) Debt to Total Capitalization Equity to Total Capitalization Debt to Equity Ratio 29.1% 70.9% 41.8%

Cost of Equity Risk-free rate (2) Market risk Premium (3) Levered Beta (4) Size Premium (5) Cost of Equity Cost of Debt Cost of Debt Taxes After Tax Cost of Debt WACC

4.0% 7.1% 1.22 1.7% 14.3%

6.0% 30.0% 4.2% 11.4%

Calculation of Terminal Value The calculation of terminal value of the cash flow is calculated as under.

Calculation of Terminal Value

Terminal Value Terminal Year Free Cash Flow Perpetuity Growth Rate Terminal Year EBITDA Terminal Value Implied Exit Multiple Discount Period Discount Factor Present Value of Terminal Value % of Enterprise Value 4,98,461 3.0% 6,35,880 61,48,132 10.2x 5.0 0.6 35,91,513 80%

Here, we can see the exit multiplier is 10.2x (X = terminal value) The discount factor is 0.6 so this will land the present value of Terminal value to 35,91,513, And it is 80% of the enterprise value.

Calculation of Enterprise value Present value of Free cash Flow is 8,96,040 as calculated earlier and the terminal value (PV) is 35,91,513 is also we have calculated earlier. So the total value for PIXAR is 44,87,553 (000$).

Output Enterprise value Present value of Free Cash Flow 8,96,040

Terminal Value Discount Factor Present Value of Terminal Value % of Enterprise Value

61,48,132 0.58 35,91,513 80%

Enterprise value

44,87,553

Sensitivity Analysis
Sensitivity Analysis Perpetuity growth % ## 44,87,553 9.4% 10.4% WACC 11.4% 12.4% 13.4% 2.0% 53,71,829 46,42,248 40,72,325 36,15,594 32,41,978 2.5% 57,17,963 48,98,616 42,68,211 37,69,005 33,64,558 3.0% 61,18,600 51,89,861 44,87,553 39,38,822 34,98,980 3.5% 65,87,714 55,23,618 47,34,835 41,27,827 36,47,049 4.0% 71,44,500 59,09,929 50,15,757 43,39,464 38,10,952

Annual sales growth % ## 44,87,553 50.0% EBITDA % 60.0% 70.0% 80.0% 90.0% 25.0% 17,05,668 19,98,846 22,92,024 25,85,202 28,78,380 35.0% 24,04,685 28,21,975 32,39,264 36,56,554 40,73,843 45.0% 33,23,630 39,05,592 44,87,553 50,69,515 56,51,477 55.0% 45,11,548 53,08,154 61,04,760 69,01,366 76,97,972 65.0% 60,24,329 70,96,329 81,68,328 92,40,328 1,03,12,327

From the above table, we can see the sensitivity analysis for the valuation for PIXAR. So, the value of the firm will vary from $1.7bnto $10.3bn but considering the growth rate of 3% and WACC of 11.4% (as calculated earlier) the value of the firm will come to $4.48bn. And if we calculate it with the help of EBITDA and Annual sales growth%, then also this value will come to $4.48bn. Calculation of Premium paid Walt Disney has paid $7.4bn to PIXAR as the price of the merger. But as per our calculation the value of the firm comes to $4.48bn. So the excess amount paid by the Walt Disney is the premium amount paid. Calculation of Premium
Value paid Actuly value of the firm 7400000000 4487553292

Premium Paid

2912446708

Now the premium is 39.36% of the amount paid. A reasonable purchase price - A premium of, say,
10% above the market price seems within the bounds of level-headedness. A premium of 50%, on the other hand, requires synergy of stellar proportions for the deal to make sense. Stay away from companies that participate in such contests. Synergy: The Premium for Potential Success For the most part, acquiring companies nearly always pay a substantial premium on the stock market value of the companies they buy. The justification for doing so nearly always boils down to the notion of synergy; a merger benefits shareholders when a company's post-merger share price increases by the value of potential synergy.

Let's face it, it would be highly unlikely for rational owners to sell if they would benefit more by not selling. That means buyers will need to pay a premium if they hope to acquire the company, regardless of what pre-merger valuation tells them. For sellers, that premium represents their company's future prospects. For buyers, the premium represents part of the post-merger synergy they expect can be achieved. The following equation offers a good way to think about synergy and how to determine whether a deal makes sense. The equation solves for the minimum required synergy:

In other words, the success of a merger is measured by whether the value of the buyer is enhanced by the action. However, the practical constraints of mergers, which we discuss in part five, often prevent the expected benefits from being fully achieved. Alas, the synergy promised by deal makers might just fall short.