Cogent Analytics M&A Manual

Mergers and Acquisitions A

beginners guide


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Valuation
M&A involves using more than one valuation technique to
arrive at a valuation that we think is fair. The most common
techniques used are:

! Comparable Publicly traded companies (Public Comps) this analysis
indicates how the stock markets are valuing companies that are similar to
the target
! Precedent Comparable Transaction analysis (Transaction Comps) this
analysis indicates the valuations at which prior M&A transactions have
been done in the same industry as that of the target.
! DCF analysis is one of the most important valuation techniques
! Sum-of-the-parts analysis If a target has more than one lines of
business, the financial advisor will value each business separately.
Therefore, each part might have its own Public Comps, Transaction
comps and DCF (with different WACCs for each part). The total value is
the sum of the parts
! Other depending on the unique characteristics of the transaction,
financial advisors will perform a number of other analyses to arrive at fair
value like Leveraged Buyout (LBO) Analysis, Historical Exchange
Ration analyses etc.

PUBLIC COMPS

Compare the current trading level of a Company to its peer group of
companies
The peer group is a set of 5 to 10 companies that are most similar to the
target in terms of business mix and strategy, geographic risks(same
country), margins and size. (i.e. processed meats and raw meats are
different).
To find a good peer group start broad (all companies in the SIC code) and
then narrow the list to the most comparable peers. Also refer to equity
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research reports, industry reports, the companys 10K where its discusses
competitors and Bloomberg (Quote 2) to identify the most comparable
peers. (look at filing 8K, prospectuses when they do a filing for new debt or
equity in freeedgar.)
The goal of the analysis is to understand how the markets is valuing the
peer group in terms of Price to Earnings, Price to Book value, Price to
Cashflow to Equity, What the PEG ratio is, Enterprise Value to Revenues,
EBITDA, Net Assets etc. Also understand if merger premium is already
built into price industry group should know this.
There are always some industry specific comps (Telecom Enterprise
Value to POPs and SUBs, Electric Utilities - $/Mw etc.). Make sure you
capture these in your analysis.
Using these, we will try to value the target bearing in mind that public
comps dont reflect the control premium that an acquirer will pay for
buying control of the target. The control premium is generally around 30%
for U.S. transactions. Also, some companies that are widely perceived to
be acquisition targets may have some premium built into their stock price.
Most common multiples are:
1. Equity Multiples: P/E (Price / LTM EPS, Price / 1-Year forward EPS, Note
that the Earnings need to be after Preferred Dividends so that they are
earnings that are available to Common shareholders), Price to Book
(Price / Book value of equity per share).
2. Enterprise Value Multiples: EV/Revenues, EV/ EBITDA, EV/EBIT (Note
that the Revenues, EBITDA and EBIT multiples could be computed for
LTM and 1-Year forward projected numbers)

TRANSACTION COMPS
The goal here is to understand the multiples at which transactions in the
targets industry sector have been announced or completed. The
importance difference with public comps is that in this case, a control
premium is built into the offer price and therefore the multiples.
Specifically, determine the pricing of past deals as compared to the
targets financial performance and unaffected (pre-announcement) market
value
Understand why Equity
valuation and Enterprise
valuation are different
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Transactions selected should be as comparable to our proposed
transaction as possible, so one should look for recent deals, where a
company with highly similar business was acquired, in the same country
as the target etc.
The most common ones are same as in the case of public comps but,
additionally, transaction comps also cover Premium paid (Offer price
premium as % of 1-day, 1-week and 4-week trading prices).

DCF (Merger model has this already built into it)
Discount unleveraged projected free cash flows (or in some cases
dividendable income) at Companys cost of capital to obtain an economic
present value of assets. Subtract market value of outstanding net debt
and preferred capital from the present value of assets to get present value
of equity. Free cash flow is after-tax operating earnings plus non-cash
charges less increases in working capital less capital expenditures. (On
leveraged DCF analysis, free cash flow is reduced by after-tax interest
expense)
Sensitivities on discount rates, terminal value assumptions and operating
scenarios are frequently used to estimate the uncertainty in the values
obtained

LBO
Goal is to understand how much value a financial buyer (with no operating
synergies) could buy the target for
To understand the economics of an LBO lets do an example: Company
As equity market capitalization is $100MM and it has Debt of $75MM.
This year it reported EBITDA of $50MM. A financial sponsor realizes that
the even if it bought the stock at a 30% premium to market for $130MM, it
could generate attractive returns. So, the sponsor approaches
management and structure a deal where the firm borrows an additional
$100MM to buy back stock. The sponsor supplies the remaining $30MM
required to buy the public float and ends up owning a 100% of the equity
of the firm. The new firm has $75MM of old and $100MM of new debt
outstanding which is sustained by the $50MM of annual EBITDA and an
equity cushion of $30MM.
To finance a LBO, the restructured company has to have a Debt to Total
Capitalization (Debt+Equity) not exceeding 80% and a Debt to EBITDA
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ratio that does not exceed 5.0x. Note that these could vary based on the
nature of the industry.
Assume current market scenarios for pricing the new debt
The exit mechanism is an important element since it defines what the
sponsor will do in, say, 5 years to exit the investment. In other words, is
the sponsor planning an IPO or sale to strategic players? The sponsors
returns will be driven by EBITDA growth rate, margins improvements,
Capex, and exit multiples
In a LBO, the entire equity is privately held, while in a Leveraged
Recapitalization, there is usually a small percentage owned by publicly.
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Selected Public Comps statistics explained

(1) Closing price: most recent closing stock price (from Bloomberg, ILX
or Populator). Prices for all companies should be as of the same
date.
(2) Equity value: last closing stock price multiplied by number of shares
outstanding. Shares outstanding from front page of latest 10K, 10Q,
or other public document adjusted for options or other instruments in
existence (if applicable). Note date of shares outstanding on the
exhibit. The following is a list of definitions of shares outstanding:
Basic: The actual outstanding shares which can be found on the cover of
the latest 10Q or 10K.
Diluted: This is the Basic shares plus the dilutive impact of any in-the-
money options or warrants that are outstanding as calculated by the
Treasury stock adjustment method. Look for average strike price and if
lower than closing price then assume would convert. Look at public
comps template. Option info is in 10K.
Fully diluted: Basic + All options and warrants (as if all converted into
equity)
Average: This calculates the average shares that were outstanding during
the year or quarter
(3) Firm value (or Enterprise Value): Equity market value + LT debt +
ST debt + preferred stock + Minority Interest (-) cash. (Enterprise
value may value from firm to firm or industry to industry sum of total
value of firm. Comes from cash flows of business.)
Use net income to common for common share price
Up to EBIT still enterprise #s. As soon as you pay interest the
net income belongs to equity holders.
LT debt: from latest 10K/Q under N/C liabilities LT debt plus
redeemable pfd. (Other types of pfd. stock are not considered LT
debt.)
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ST debt: from latest 10K/Q under current liabilities ST borrowings,
bank notes, loans, plus accrued interest and current maturities
of LT debt (if any)
Preferred stock: from latest 10K/Q under stockholders equity. Use
market values, if possible, otherwise book values. (Market value can
frequently be obtained from Bloomberg.)
Cash: from latest 10K/Q cash and cash equivalents plus
marketable securities (if any)
Common Firm Value multiples are: FV/Revenues, FV/EBITDA,
FV/EBIT, FV/Cashflow, FV/Customers etc. We do NOT calculate
FV/Net Income or FV/Book Value since the denominators in these
belong to equity holders and so they are Equity multiples not Firm
value multiples.
(4) Equity value multiples: While the Firm value multiples reflect how
the business is valued, equity multiples reflect how equities are valued
relative to the net income or EPS (LTM and projected) and Book value
(latest available).
Divide the LTM NI by the weighted average number of shares
outstanding from the most recent 10Q to calculate LTM EPS.
(Do not use LTM average shares!)
Divide stock price by LTM EPS
Projected P/E: Get median I/B/E/S estimates for the next two years.
(Available on Bloomberg, Infocenter, Insight, or Populator by inputting = IDD
(ticker, FY1MEDIA or FY2MEDIA, 0). These estimates are reported on
fully diluted basis and updated every Thursday. Always use median I/B/E/S
(not mean) to avoid skewed data values. Calendarize earnings estimates as
needed
Projected net income multiple: Multiply forward I/B/E/S by I/B/E/S projected
weighted average shares outstanding (=IDD (ticker, ibesshrs, 0) to obtain
projected net income. (Note that I/B/E/S shares are not fully diluted and
are source from Exlel not street analysts. It is thus important to
check to see that I/B/E/S projected shares outstanding are consistent
with credible brokerage reports; if not, use most recent 10-Q shares
outstanding to derive fully diluted shares.) Divide projected net income
into current equity value.
(5) Long-term EPS growth rate: Get median I/B/E/S estimate from
Infocenter, Insight, or Populator by typing = IDD (ticker, MEDLTG,
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0). These estimates are updated every Thursday. It is advisable to
crosscheck this with analyst reports. (Bloomberg)
(6) Other equity multiples:( look at PEG ratios)
Price/book value per share: Book value equal to sum of common
equity accounts on most recent financial stated divided by most recent
number of shares outstanding; this result then divided into most
recent stock price.
Price/cash flow per share: Cash flow refers to operating cash flow,
or NI plus D&A plus deferred taxes plus other non-cash charges,
divided by average number of shares outstanding; this result is then
divided into most recent stock price.
(7) Last 12-Month (LTM) statistics: In order to see how a firm trades
it is customary to calculate LTM Revenues, EBITDA, EBIT, Cashflow
and Net Income or EPS (before any extraordinary items). Say, you
are spreading comps in September 2001 for a company that has a
Jan-Dec financial year. You would calculate the LTM EBITDA as
follows: FYE 12/31/00 EBITDA (from 10K) + 6-Month EBITDA for
2001 (from the 10Q dated 6/30/01) (-) 6-Month EBITDA for 2000 (from
the 10Q dated 6/30/01).
(8) Projected firm value statistics: In addition to LTM multiples, its
customary to look at the multiples of 1 and 2 year forward Revenues,
EBITDA, EBIT etc. We usually cite recent equity analyst reports as
sources for publicly available projections. However, we could also
make our own (private) projections and use them for calculation
multiples. To adjust projected net income:
EBT = (NI + (Pref. Dividends + Minority Interest)) (1 - marginal tax
rate)
EBIT = EBT + net interest expense
EBITDA = EBIT + Depreciation + Amortization