Valuation approaches to Mergers & Acquisitions

Transcription

1 Valuation approaches to Mergers & Acquisitions Sagar Gokani, Chief Manager M&A & IR, Piramal Healthcare Limited 7 th July 2012

2 Contents Approaches to Valuation Discounted Cash Flow Relative Valuation Valuing Synergy

3 Approaches to valuation Discounted Cash Flow Relates the value of an asset to the present value of expected future cashflows on that asset Relative Valuation Estimates the value of an asset by looking at the pricing of 'comparable' assets relative to a common variable like earnings, book value or sales Other Approaches Non traditional approaches such as replacement value, salvage value etc.

4 Contents Approaches to Valuation Discounted Cash Flow Relative Valuation Valuing Synergy

5 Discounted Cash Flow A primer What is it? The value of an asset is the present value of the expected cash flows on the asset Philosophical basis Every asset has an intrinsic value that can be estimated, based upon its characteristics in terms of cash flows, growth and risk Information required To estimate the life of the asset To estimate the cash flows during the life of the asset To estimate the discount rate to apply to these cash flows to get present value

6 DCF Choices: Firm Valuation versus Firm Valuation Firm Value: Sum of free cash flows to the firm over the life of asset Equity Value = Firm Value Debt Sum of free cash flows to the equity shareholders, i.e. after subtracting interest cost and debt repayment

7 Preparing FCF forecasts What is free cash flow to firm? EBIT Less: EBIT * Tax Rate Add: Depreciation Less: Change in Working Capital Less: Capital Expenditure Free Cash Flow to Firm

8 Preparing FCF forecasts Practical Issues How do you forecast EBIT? Forecasting Sales Growth linked to: Market Growth Increasing market share in existing markets Introduction of new products Geographic expansion Price Increases Estimating Variable costs such as material cost, direct labor, conversion cost, sales commission etc. Operating Expenses Estimating Fixed costs such as G&A expenses

9 Preparing FCF forecasts Practical Issues How do you forecast working capital and capex? Forecasting working capital Start with the what the company did in the most recent years but do look at the company s history and industry averages Working capital levels could be higher if a firm is expanding by launching new products or entering new geographies Forecasting capex Capex should include both: maintenance capexthat is commensurate with the existing and planned infrastructure and growth capexthat ties with the growth forecasts of the business

10 Preparing FCF forecasts Practical Issues How long should the forecast be? Is linked to life of asset For assets with finite life, forecasts can be prepared for the full life For forecasts of business, forecasts should be for the period where one has visibility of growth that is much higher than perpetuity growth PERPETUITY GROWTH is the normal growth that a business will continue to grow at after the business reaches maturity stage When the business hits maturity, one can take terminal value Terminal value: CF for last year (cost of capital perpetuity growth)

11 Preparing FCF forecasts Practical Issues What should be the discount rate? Discount Rate: Weighted Average Cost of Capital (WACC) WACC = cost of equity * (equity/equity+debt) + after tax cost of debt * (debt/equity+debt) Market value should be used to calculate WACC Cost of equity is the returnthat equity shareholders would expect from a company/business: Dividend Growth Model k c = + g D1 Po Capital Asset Pricing Model (CAPM) β k j = k rf + j (k m -k rf ) Cost of Debt is interest cost plus floatation cost, this should be tax adjusted

12 DISCOUNTED CASHFLOW VALUATION Cashflow to Firm EBIT (1-t) -(Cap Ex -Depr) -Change in WC = FCFF Firm is in stable growth: Grows at constant rate forever Value of Operating Assets + Cash & Non-op Assets = Value of Firm - Value of Debt = Value of Equity Terminal Value= FCFF n+1/(r-gn) FCFF1 FCFF2 FCFF3 FCFF4 FCFF5 FCFFn... Forever Discount at WACC= Cost of Equity (Equity/(Debt + Equity)) + Cost of Debt (Debt/(Debt+ Equity)) Cost of Equity Cost of Debt Weights Based on Market Value Riskfree Rate : - No default risk - No reinvestment risk - In same currency and in same terms (real or nominal as cash flows + Beta - Measures market risk Type of Business Operating Leverage X Financial Leverage Risk Premium - Premium for average risk investment Base Equity Premium Country Risk Premium

13 Discounted Cash flow Points to ponder 1. Sensitivity to discount rates and perpetuity growth rates is very high, example: Year Terminal year FCF DCF at a range of cost of capital and perpetuity growth rate WACC/Perpetuity 0% 1% 2% 3% growth rate 6% 2,332 2,697 3,244 4,155 8% 1,726 1,904 2,141 2,473 10% 1,364 1,465 1,591 1,753 12% 1,123 1,186 1,262 1, Long term targed debt-equity ratio should be taken for taking into account WACC

14 Contents Approaches to Valuation Discounted Cash Flow Relative Valuation Valuing Synergy

15 Relative Valuation A primer What is it? The value of an asset is compared to the values assessed by the market for similar comparables Philosophical basis There is a comparable asset in the market which is already valued, which can form the basis of valuation of this asset To identify comparable assets and obtain market values for these assets To convert these market values into standardized values, since the absolute Information required price cannot be compared To comparethe standardized value or multiple for the asset being analyzed to the standardized value for comparable asset, controlling for any difference between the firms that might affect the multiple, controlling for any difference between the firms that might affect the multiple, to judge whether the asset is under or over valued

16 Relative Valuation relevance Most valuations inpublic marketsare relative valuations. Almost 85% of equity research reports are based upon a multiple and comparables. More than 50% of all acquisition valuations are based upon multiples Rules of thumb based on multiples are not only common but are often the basis for final valuation judgments. While there are more discounted cashflowvaluations in consulting and corporate finance, they are often relative valuations masquerading as discounted cash flow valuations. The objective in many discounted cashflowvaluations is to back into a number that has been obtained by using a multiple. The terminal value in a significant number of discounted cashflowvaluations is estimated using a multiple.

17 Understanding relative valuation Define the multiple osamemultiple can be defined in different ways by different users. o Important that we understand how the multiples have been estimated Describe the multiple o Mutiples can have a skewed distribution o One cannot just take averagee as indicator of typical multiple Analyse the multiple ocriticalthat we understand the fundamentals that drive each multiple o Nature of the relationship between the multiple and each variable Apply the multiple odefine the comparable universe and o Adjust multiple for target company

18 Relative Valuation various methods The following metric can be used as a basis for relative valuation: Sales EV/Sales EBITDA EV/EBITDA EBIT EV/EBIT Earnings/Net Profit - Price-to-Earnings Ratio Book Value Price to Book Cash Flow EV/Cash flow Industry specific variable (Price per ton capacity of steel, per store value in the days of retail boom, price per click in e-commerce)

19 Relative Valuation Practical Issues Which multiple should one use? While a range of values can be obtained from a number of multiples, the best estimate value is obtained using one multiple Use the multiple that seems to make the most sensefor that sector, given how value is measured and created: In retailing: The focus is usually on same store sales (turnover) and profit margins. Not surprisingly, the revenue multiple is most common in this sector. In financial services: The emphasis is usually on return on equity. Book Equity is often viewed as a scarce resource, since capital ratios are based upon it. Price to book ratios dominate In technology: Growth is usually the dominant theme. PEG ratios were invented in this sector.

20 Relative Valuation Practical Issues What should be the control premium? If one is using multiples of publicly traded companies, one will have to assigned control premium to the multiples The value of controlling a firm derives from the fact that you believe that you or someone else would operate the firm differently (and better) from the way it is operated currently The expected value of control is the change in value from changing the way a firm is operated

21 Contents Approaches to Valuation Discounted Cash Flow Relative Valuation Valuing Synergy

22 Valuing Synergy The key to the existence of synergy is that the target firm controls a specialized resource that becomes more valuable if combined with the bidding firm's resources. The specialized resource will vary depending upon the merger: In horizontal mergers: economies of scale, which reduce costs, or from increased market power, which increases profit margins and sales. In vertical integration: Primary source of synergy here comes from controlling the chain of production much more completely. In functional integration: When a firm with strengths in one functional area acquires another

23 Closing Comments Most M&A transaction are value destructive for the acquiring company The reason for most of these is value overpaid by acquirer try to buy a trophy asset As advisors we should help companies/promoters to look at things more objectively

24 Congratulations! You are now all valuation experts! End of module!