Valuation

We now discuss preliminary valuation using relative valuation methods. For acquisitions or divestitures, we need to estimate the value of the target. There are three primary approaches to this valuation: discounted cash flow analysis, comparable company analysis, and comparable transaction analysis.

1. Discounted Cash Flow (DCF) Analysis

DCF analysis entails estimating the target’s future free cash flows using estimates of earnings, capital expenditures, working capital investments, and other inputs. These future free cash flows are discounted to generate an estimate of value. We will cover this in more detail in the Equity Valuation topic area.

2. Comparable Company Analysis

Comparable company analysis uses relative valuation metrics of comparable firms to estimate value, and then adds a takeover premium to determine a fair price for the acquirer to pay for the target.

Comparable company analysis (CCA) involves the following steps:

Because the estimated value of the target under CCA does not include a control or takeover premium, CCA is most commonly used in the valuation of spin offs rather than acquisitions.

Advantages of CCA:

Data for comparable companies is easy to access. The assumption that similar assets should have similar values is fundamentally sound. Unlike a discounted cash flow approach, estimates of value are derived directly from the market rather than assumptions and estimates about the future.

Disadvantages of CCA:

The approach implicitly assumes that the market’s valuation of the comparable companies is fair.

Comparable companies provide an estimate of a fair stock price, rather than a fair takeover price. An appropriate takeover premium must be determined separately.

Sometimes the target may be unique and therefore there may not be any true peers.

3. Comparable Transaction Analysis

Comparable transaction analysis (CTA) is similar to CCA but uses actual takeover transaction prices rather than market prices of stock: in CTA, the comparables are actual takeover targets. Since the transaction price already includes a takeover premium, we don’t have to estimate it separately to add to the CCA estimate of value.

Advantages of CTA:

Since the approach uses data from actual transactions, there is no need to estimate a separate takeover premium. Unlike a discounted cash flow approach, estimates of value are derived directly from recent prices for actual deals completed in the marketplace, rather than from assumptions and estimates about the future.

Disadvantages of CTA:

The CTA approach implicitly assumes that the M&A market valued past transactions appropriately. If past transactions were over or underpriced, those mispricings will be carried over to the estimated value for the target. There may not be enough comparable transactions to develop a reliable estimate of the target value.

An analyst who is unable to find enough similar companies might use M&A deals from other industries that are dissimilar to the deal being considered.

Historical transactions may have occurred under different conditions (industry growth, regulatory frameworks, etc.) and hence may not represent current value reliably.

Premium Paid Analysis

In a takeover transaction, the acquiring firm typically pays a premium over the current market price as an incentive for the target to accept the offer. This premium can be estimated as:

premium = (DP − UP)/UP where:

DP = deal price and UP = unaffected (i.e., pre announcement) price

Some effect of pre announcement rumors may be incorporated in the trading price of the target prior to the announcement; hence care should be taken when estimating UP. Analysts might use a week old market price or volume weighted trading price over the prior week as the UP to mitigate this issue.

We now turn to the modeling and valuation phase. The first step in this phase is to generate pro forma financial statements that reflect the impact of the corporate action. The steps in this process are as follows:

From these results, we can estimate the future EPS of the combined entity.

Estimating WACC

Restructuring can alter the cost of debt and equity capital. Several factors influence these costs: profitability (EBITDA to sales, or EBIT to sales), volatility of revenues or EBITDA, leverage (debt to EBITDA), collateral (asset specificity, liquidity, existence of an active market), and prevailing interest rates. Weights of debt and equity are calculated using market values, and include any financing raised or additional equity issued.

Using the data from pro forma financial statements, and the estimate of future WACC, the analyst can use discounted cash flow techniques to value the target.