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BUSINESS ACQUISITIONS

Fundamental Valuation Techniques

BASIC ACCOUNTING
Balance Sheet Income Statement Statement of Cash Flows GAAP and Consistency Consolidation & Combination Notes to Financial Statements

BASIC ACCOUNTING
BALANCE SHEET FORMULA
Assets - Liabilities = Net Worth or Assets = Liabilities + Net Worth Net Worth = Shareholders Equity

CONSOLIDATED BALANCE SHEET ACME WIDGET COMPANY DECEMBER 31, 2000 (In Thousands) ASSETS CURRENT ASSETS: Cash and cash equivalents Accounts Receivable, less allowances of $420 Inventories Prepaid Expenses Total Current Assets PROPERTY AND EQUIPMENT: Land and land improvements Buildings Leasehold Improvements Fixtures and equipment Less-accumulated depreciation OTHER ASSETS Cash surrender value of life insurance Goodwill, net of amortization of $3,560 Total Other Assets $

5,393 12,345 10,645 1,272 29,665 5,340 23,948 2,327 22,375 12,983 41,007 575 14,240 14,815 85,487

LIABILITIES AND SHAREHOLDERS INVESTMENT CURRENT LIABILITIES Accounts payable Accrued expenses Revolving credit facility Current Maturities of long term debt Total current liabilities LONG TERM DEBT SHAREHOLDERS INVESTMENT Common stock Capital in excess of par value Retained Earnings Total shareholders' investment

8,325 3,848 6,256 752 19,181 21,118

5,876 8,121 31,191 45,188 85,487

INCOME STATEMENT a/k/a Statement of Operations


Gross Sales Net Sales (net of allowances & returns) Cost of Sales (COGS) Gross Margin Operating Expenses (R & D, Admin., Selling) Operating Income Other Income & Expense (e.g., Interest) Taxes Net Income

CONSOLIDATED STATEMENTS OF OPERATIONS ACME WIDGET CORPORATION For the Fiscal Year Ending December 31, 2000 Gross Sales Allowances and Rebates Net Sales Cost of sales Gross Profit Operating expenses Product research and development Selling and marketing General and administrative Total operating expenses Income from Operations Other income (expense): Interest expense Interest income Other, net Other expense, net Income before income taxes Provision for income taxes Net income $ 223,256 5,211 218,045 165,714 52,331 5,235 10,876 18,723 34,834 17,497 (2,491) 213 11 (2,267) 15,230 5,787 9,443

Statement of Cash Flows


Determine Changes In Cash By Reason Of: Cash from Operations Net Income + Depreciation +/- Working Capital Changes Cash Flows from Investing (Purchases and Sales of Assets) Cash Flow From Financing (From Debt and Payments of Debt and Dividends)

ACME WIDGET CORPORATION COMBINED STATEMENTS OF CASH FLOWS Cash flows from operating activities: Net income Adjustments to reconcile net income to net cash provided (used) BY operations Depreciation and Amortization Changes in operating assets and liabilities: Accounts receivable Payables Inventory Accrued expenses Net cash provided (used) in operations Cash flows from investing activities Purchases of property and equipment Acquisition of business, net of cash acquired Net cash used in investment activities Cash flows from financing activities: Increase in revolving credit facility Proceeds from term loans Payments on notes and term loans Dividends paid Net cash provided by financing activities Net Increase in Cash Cash and equivalents at beginning of year Cash and equivalents at end of year

9,443

2,583

(1,320) 576 (1,236) 598 10,644 (3,123) (8,261) (11,384) 1,898 5,000 (2,327) (1,222) 3,349 2,609 2,784 5,393

CONCEPT OF EBITDA
Earnings before Interest, Taxes, Depreciation, & Amortization
a/k/a Operating Income + Depreciation and Amortization

ACME WIDGET EBITDA

Net Income Interest expense (net) Taxes Depreciation and amortization EBITDA

$9,443 $2,278 $5,787 $2,583 $20,091

TRADITIONAL VALUATION
WHAT A WILLING BUYER WILL PAY AND WHAT A WILLING SELLER WILL ACCEPT, UNDER NO COMPULSION AND BOTH BEING AWARE OF THE RELEVANT FACTS Revenue Ruling 59-60

Asset Value

THREE MAJOR VALUATION METHODS


Book Value Net Worth Liquidation Value

Comparable Companies
Prior Sales Stock Market Valuation Standard Multiples of Cash Flow or EBITDA

Earnings Approach
Multiple of Earnings Discounted Cash Flow Analysis

VALUATION IS NOT A SCIENCE


Although Based on Financial Statements, Projections and Formulae, there are Many Subjective Valuation Judgments Valuation is a Persuasive Process - a Negotiation Between Buyer and Seller. There Are a Number of Factors, Other Than Those Indicated by Financial Statements, That May Affect Value to the Buyer or Seller

BEAUTY IS IN THE EYES OF THE BEHOLDER


Value From Perspective of a Financial Buyer
No additional synergies

Value From the Perspective of a Strategic Buyer


Synergies enhance EBITDA (i.e., cash flow)

ASSET VALUE APPROACH


Use of Balance Sheet Net Worth
Easy to Use Very Misleading

Adjust Assets to their Fair Market Value


Gives Orderly Liquidation Value However, Does Not value the Business as a Going Concern

ASSET VALUE APPROACH


Net Worth + F/M/V of Assets - Book Value of Assets = Asset Value Acme Widgets Net Worth is $45,188,000. Acmes Value using Asset Value Approach is Net Worth + F/M/V of Assets in Excess of Book Value Problem: How do you value assets, particularly intangible assets and goodwill?

USE OF COMPARABLES
Based upon Comparisons to Publicly Traded Companies Based upon Comparisons to Publicly Reported Sales of Businesses Values Target based upon Comparable:
Market Value/Book Value Market Value/Sales Market Value/Earnings Market Value/EBITDA

PROBLEMS OF USING COMPARABLES


No Two Businesses are Exactly Alike Tends to Value Companies Based Upon Only Current Results or Financial Condition Uses One Dimensional Formulae that may not have Much Relevance to True Value Assumes that the Market which Establishes the Comparable Formula is Perfectly Rational

MOST COMMONLY USED COMPARABLE FORMUAL IS THE MULTIPLE OF EBITDA APPROACH


Multiple X EBITDA = Enterprise Value Enterprise Value - Debt + Excess Cash = Shareholder Value

Value Based on Multiple of EBITDA


ACME EBITDA Industry Multiple Enterprise Value Less Debt Revolving credit $ Current maturities $ Long Term $ Total Debt Excess Cash Business Value $20,091 7 $140,637 6,256 752 21,118 $28,126 $3,000 $115,511

ADJUSTED EBITDA
For purposes of presentation to a prospective Buyer, EBITDA is normally adjusted to indicate the add back of expenses that will be saved by the prospective Buyer Examples are
Excess owner compensation Travel and entertainment expenses Money saved through synergies

DISCOUNTED CASH FLOW ANALYSIS


Theory Is That Every Business Has the Same Value:
The Discounted Net Present Value of its Future Cash Flow Less Debt, and Plus Excess Cash (i.e., cash and marketable investments not used in the business)

THE ISSUES WITH DCF ANALYSIS


What will be the Future Cash Flow of Target? What Discount Rate Should we use?

TWO IMPORTANT CONCEPTS


TIME VALUE OF MONEY: A Dollar Received in the Future is Worth Less than a Dollar Received Today RISK/REWARD An Investor Deserves and Expects a Higher Return on Investment as Risk of the Investment Increases

DISCOUNTED CASH FLOW ANALYSIS

V0 = CF1/(1+i)1 + CF2/(1+i)2 + CF3 (1+i)3 + ... +CFn/(1+i)n V0 = CFn / (1+i)n V0 = CFt = i= n= value of asset at time zero cash flow expected at the end of year t discount rate time period

DISCOUNTED CASH FLOW ANALYSIS


Future Cash Flows are Determined by Projected EBITDA, Less Anticipated Future Investment The Discount Rate is a Function of Cost of Capital, Expected Return on Investment and Perceived Risk

ISSUES TO RESOLVE
Prediction of the Future Cash Flows Determining the Correct Discount Rate to Use, Based Upon
Cost of Borrowings Unsystematic Risk (What Should be Expected from a Stock Investment) Systemic Risk (The Particular Risk Attendant with the Target)

HISTORICAL AND PROJECTED FINANCIAL RESULTS 1999 $174,436 2000 $218,045 2001 $235,489 178,971 56,517 2002 2003 $254,328 $274,674 193,289 61,039 208,752 65,922

Net Sales

COGS 132,571 165,714 Total Gross Profit 41,865 52,331 Operating Expenses: Research & Development 4,876 5,235 Selling & Marketing 8,921 10,876 General & Administrative 15,256 18,723 Total Operating Expense 29,053 34,834 Operating Income $12,812 $17,497 Depreciation & Amortization 1,956 2,583 EBITDA $ 14,768 $ 20,080

5,887 6,358 6,867 11,774 12,716 13,734 19,659 20,642 21,674 37,321 39,717 42,275 $19,196 $21,322 $23,647 2,583 2,583 2,583 $ 21,779 $ 23,905 $ 26,230

EBITDA N/P/V 2001 2002 2003 2004 Terminal Present Value @ 15% $166,076 $21,779 $23,905 $26,230 $28,772 $191,813 Present Value @ 10% $257,565 $287,720 Present Value @ 20% $120,777 $143,860

DETERMINATION OF DISCOUNT RATE


Three Factors:
Cost of Borrowing Unsystematic Risk Systematic Risk

Use the Capital Asset Pricing Model (CAPM) to Determine the Discount Rate
But Some Companies use a Standard Hurdle Rate as their Discount Rate

CAPM Ke=Rf+( X Rp)


Ke = Cost of Capital (i.e., the Discount Rate) Rf = Risk Free Rate of Return (i.e., Treasury Bill Rate) = Beta, or the additional Risk associated with the Target RP = the General Risk Associated with Investing in Equity (Instead of Treasury Bills)

EXAMPLE
Treasury Bills = 4% Expected Additional Equity Return = 7% Beta (Additional Risk Associated with Target Company) = 1.3 Ke=Rf+( X Rp) Discount Rate = 4% + (7% x 1.3) = 13.1%

DETERMINING TERMINAL VALUE


Easy method is to multiply last years cash flow by assumed industry multiple Another method is to divide last years cash flow by the applicable discount rate. Another common method is to assume a perpetual growth rate

TERMINAL VALUE FORMULA


Terminal Value = (last years cash flow) (1 + growth rate) (applicable discount rate) - (growth rate)
Assuming Discount Rate of 20% and Long Term Growth Rate of 5%: Terminal Value =$28,772 * 1.05 / (.20 - .05) = $30,211 / .15 = $201,404

DISOUNTED CASH FLOW Note the Following


As Discount Rate Rises, Value Decreases The Terminal Value is Obtained by Dividing the Last Years EBITDA by the Discount Rate. This is a proxy for selling the business after the last year based on a multiple of EBITDA and based on a capitalization of the discount rate.

USING THE DISCOUNTED CASH FLOW METHOD AND BASED UPON ASSUMPTIONS OF CASH FLOW AND DISCOUNT RATE The Enterprise Value Using NPV @ 15% is $166,076,000. With Debt of $28,126,000 (and assuming that there is no cash in excess of needs) the Value of the Business (i.e., Shareholder Value) is $137,950,000.

DISCOUNTED CASH FLOW OR INCOME ANALYSIS CAN BE A METHOD OF STOCK PICKING

SYNERGIES
The Acquired Business may be Synergistic with the Purchasers Business This may cause either additional profits or lower expenses, thereby increasing EBITDA. This may make the business more valuable to the Purchaser Therefore, a Synergistic Purchaser Usually has an Advantage over a Financial Purchaser (i.e., a Purchaser with no Synergies)

THE NEGOTIATING ISSUE


WHO GETS THE BENEFIT OF THE INCREASE IN CASH FLOW CAUSED BY THE SYNERGIES? THE BUYER OR SELLER?

Change in Shareholders Wealth Acquirer Target

$13.79 0 5 10 15

$18.00 20

Bargaining Range = Synergy

Price Paid for Target

Do mergers really create value?


According to empirical evidence, acquisitions do create value as a result of economies of scale, other synergies, and/or better management. Shareholders of target firms reap most of the benefits, that is, the final price is close to full value.
Target management can always say no. Competing bidders often push up prices.

THERE ARE SUBJECTIVE ISSUES IN VALUING A BUSINESS


Stability of Cash Flow
Concentration and Stability of Customers Term of Significant Contracts Stability of Suppliers

Stability and Prospects of Industry Reliance on Key Employees

OTHER SUBJECTIVE FACTORS


The Acquirors Tolerance to Risk Could Affect the Discount Rate There are Often Irrational (i. e., nonmathematical) preferences in Decision Making Which Skew Perception of Value (See Daniel Kahneman and Amos Tversky, Choices, Values and Frames)

KAHNEMAN AND TVERSKY


Risk Aversion Causes Preference for a Sure Gain over a more Mathematically Correct Risk Loss Aversion Causes Preference to Take More Risk in order to Avoid a Loss Choices are Made Based Upon Gains and Losses, Instead of Ultimate States of Welath People or risk seeking in dealing with improbable gains and risk adverse in dealing with improbable losses Choices and Valuation are Often Made Based Upon How the Issue is Framed (e.g., as

THESE VALUATION ISSUES COULD AFFECT THE STRUCTURE OF THE PURCHASE PRICE
Provide for a portion of the price to be contingent on future performance Provide for a portion of the consideration otherwise paid to the shareholders to be paid to key employees based upon continued employment and performance.

PURCHASE PRICE STRUCTURE


All Cash Part Cash and Remainder by Promissory Installment Note Earn Out or Contingent Purchase Price All or Part in Buyers Stock

INSTALLMENT SALE
Interest Rate Security for Payment Relationship to Buyers Bank Debt What Happens on Default? Is the Note Security for Buyer to Protect Against Sellers Representations and Warranties?

EARN OUT
Based Upon:
Levels of Net Income Levels of Operating Income Levels of Gross Margin Levels of Sales

Accounting Issues Keeping Acquired Business Separate The Seller Has No Control

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