2009 Valuation Handbook a UBS Guide

STRICTLY CONFIDENTIAL

Valuation Handbook A UBS guide

August 2009

Valuation handbook 2009 protected.doc

Table of contents SECTION 1

SECTION 2

SECTION 3

SECTION 4

Introduction ______________________________________________________________ 1 1.1

Introduction ______________________________________________________ 2

1.2

Principal valuation methodologies ____________________________________ 3

1.3

Pros and cons of valuation methodologies _____________________________ 5

1.4

General principles to consider _______________________________________ 8

1.5

Capital structure adjustments________________________________________ 8

1.6

ROCE vs. ROE ____________________________________________________ 10

1.7

Enterprise value (“EV”) vs. equity value_______________________________ 10

1.8

Effect of gearing on valuation ______________________________________ 11

1.9

Valuation process_________________________________________________ 11

1.10

Tips for success __________________________________________________ 12

Comparable company analysis ____________________________________________ 13 2.1

Introduction _____________________________________________________ 14

2.2

Defining the numerator: enterprise value _____________________________ 21

2.3

Defining the denominator _________________________________________ 34

2.4

Pro forma adjustments for acquisitions, disposals and other corporate transactions _____________________________________________________ 38

2.5

Some additional consideration for multiples based valuations ____________ 38

2.6

Data sources_____________________________________________________ 39

2.7

How to check efficiently ___________________________________________ 39

2.8

Common errors __________________________________________________ 40

2.9

Tips for success __________________________________________________ 40

Precedent transaction analysis ____________________________________________ 41 3.1

Introduction _____________________________________________________ 42

3.2

Why do we use precedent multiples? ________________________________ 42

3.3

Premium for control ______________________________________________ 42

3.4

Choosing transactions_____________________________________________ 43

3.5

Key metrics______________________________________________________ 43

3.6

Adjustments _____________________________________________________ 44

3.7

Link to UBS model ________________________________________________ 44

3.8

Drawbacks of methodology ________________________________________ 44

3.9

Data sources_____________________________________________________ 44

3.10


3.11

Common errors __________________________________________________ 45

3.12

Tips for success __________________________________________________ 45

Discounted cash flow ____________________________________________________ 47 4.1

Introduction to DCF concepts_______________________________________ 48

4.2

Free cash flow ___________________________________________________ 50

4.3

Terminal value ___________________________________________________ 54

4.4

The discount rate—Weighted Average Cost of Capital (WACC) __________ 57


Table of contents

SECTION 5

SECTION 6

APPENDIX A

4.5

How to discount _________________________________________________ 63

4.6

Additional things that you need to know for a DCF ____________________ 64

4.7


4.8

Data sources_____________________________________________________ 67

4.9


4.10

Common errors __________________________________________________ 68

4.11

Tips for success __________________________________________________ 68

4.12

Example of UBS model ____________________________________________ 68

Leveraged buy-out (LBO) _________________________________________________ 72 5.1

Overview________________________________________________________ 73

5.2

LBO returns _____________________________________________________ 74

5.3

Understanding the components of return_____________________________ 74

5.4

Required returns _________________________________________________ 75

5.5

Management participation and impact on institutional returns ___________ 76

5.6

Typical LBO structure and components of financing ____________________ 76

5.7

LBO Modelling ___________________________________________________ 80

5.8


5.9

Data sources_____________________________________________________ 84

5.10


5.11

Common errors __________________________________________________ 84

5.12

Tips for success __________________________________________________ 85

5.13

Example of UBS model ____________________________________________ 85

Alternative valuation methods ____________________________________________ 88 6.1

Sum of the parts analysis (SOTP) ____________________________________ 89

6.2

Economic Value Added (EVA)_______________________________________ 93

6.3

Dividend discount model (DDM) ____________________________________ 99

6.4

Appraisal Value (AV) ______________________________________________ 99

6.5

Special cases_____________________________________________________ 99

Comps & Precedents adjustments ________________________________________ 100 A.1.

Adjustments ____________________________________________________ 101

APPENDIX B

Glossary _______________________________________________________________ 104

APPENDIX C

Further reading _________________________________________________________ 108


SECTION 1

Introduction 1


Introduction 1.1

Introduction

This book is intended as a reference guide for IBD executives. It encompasses best practice, practical examples, advice and generally adopted methodologies that all IBD teams can use as part of their valuation analysis. It does not cover in-depth theoretical or academic discussion underlying valuation techniques but rather seeks to point out the key pros and cons of the various methodologies available to us. In addition to this document, UBS Equity Research has a team dedicated to analysing the latest developments in accounting and valuation. Various materials are available from them in the “Valuation & Accounting” section of researchweb, and they may be contacted (on a no-names basis) for advice as to some of the issues raised in this document. At UBS we approach valuation in a number of ways. Whilst these methodologies are all useful in their own right, ultimately valuation is at least as much of an art as a science and it is important to have a proper qualitative overlay to analysis presented both internally and to clients. Specifically, it is critical to have a full understanding of the business being valued in order to exercise judgement in drawing conclusions from quantitative analysis. Nevertheless, a rigorous quantitative approach must underlie every valuation exercise we do. It is particularly important to remember that valuations rely on forward-looking perspectives (rather than historical) and the date of valuation is key as benchmarks or standards which are accepted as a “given” may well become rapidly outdated. Valuations can be categorised as follows:  Trading valuation – reflects the theoretical value of one share as part of a listed entity  Transaction valuation – reflects the value an acquirer can derive from controlling a company  Fundamental valuation – reflects the net present value of the cash flows of the business The chart overleaf lists the “standard” methodologies which are used under each of the headings above and illustrates how this is typically laid out as a valuation summary in client presentations, using a “football field” chart. Please note that not all of these methodologies are applicable in every scenario:

SECTION 1: Introduction

2


EV 1 (GBPm)

Methodology 57.3

Current price 2 12-month VWAP Trading

52-week trading range

50.9 57.7

45.2

Analyst price targets

50.1

63.2

Comparable companies 3

55.6

62.6

Trading sum-of-the-parts (SoTP) 4

55.8

62.8

Transaction

6-month VWAP plus 30–40% premium Precedent transactions 5

Discounted cash flow (DCF) 7

66.4 74.5

68.4

Take-out SOTP 4 Leveraged buyout (LBO) 6

Fundamental

63.4

72.5

66.0 60.8

63.4

67.4

69.2

Notes: 1 Net debt, minorities, pension obligations and other liabilities of GBP23.3m 2 As at close of 24 December 2008 3 8.0–9.0x 2008E EV/EBITDA (EBITDA GBP6.96m) 4 Based on geographic split 5 10.5–11.5x LTM EV/EBITDA (EBITDA GBP6.52m) 6 Base case IRR of c. 20–25% and exit multiple of 9.0x EV/EBITDA 7 Assuming a WACC of 8.2%, a terminal growth rate of 2.0% and an exit multiple of 8.0x EV/EBITDA

1.2

Principal valuation methodologies

Set out below are some of the key features of the principal valuation methodologies which are described in detail in the relevant chapters.

1.2.1

Comparable company analysis (trading valuation)—Chapter 2

Objective: Compare the trading and operating performance of a company to that of its peers. This methodology determines how the market has capitalised the earnings and cash flows of the company and similar companies. We also analyse other parameters such as book value, leverage and margins. We compare these ratios to the company's performance and/or use them to impute a market value for the company. Key points to note:  Comparability is key, both in terms of identity of relevant peers and in treatment of financial information across different companies – be aware of the result from applying the multiple, e.g. applying a P/E multiple results in market capitalisation and cannot be compared with the enterprise value obtained by applying an EV/EBITDA multiple  Resulting analysis does not include a control premium or a value for synergies  Interpretation of data requires familiarity with the industry and the companies involved  The market is not always efficient; small capitalisation and thinly traded stocks may not trade actively and the share price therefore may not reflect fundamental value


3


1.2.2

Precedent transaction analysis (transaction valuation)—Chapter 3

Objective: Determine the value offered in past acquisitions of similar companies. This methodology determines the pricing of past transactions as compared to a company’s financial performance and unaffected market value. Key points to note:  Interpretation of data requires familiarity with the industry and the companies involved as there will be very specific circumstances surrounding each transaction  Analysis is typically based on historical data and is not forward looking  Control premium percentages should be applied to equity values rather than enterprise values  It should be noted that differences in the forecasts used by the buyer and seller (for instance, as a result of a buyer taking a hair-cut to management forecasts) can result in different multiples depending on whose perspective the multiple is calculated from (i.e. the buyer may believe it is paying a lower multiple due to more aggressive or synergised forecasts)

1.2.3

Discounted cash flow analysis (fundamental valuation)—Chapter 4

Objective: Calculate NPV of cash flows. Specifically, this methodology discounts the unlevered, after-tax projected free cash flow at a company's weighted average cost of capital to obtain an economic present value of assets. We subtract debt and other enterprise value adjustments from the present value of cash flows to derive the equity value. Sensitivities are used to demonstrate the impact of changes in the key underlying assumptions. Key points to note:  Need realistic five- to ten-year projected financial statements  Sales growth rate, margins, terminal multiples, discount rates and perpetual growth rate are key to value  Capital structure affects value only through its impact on WACC  DCF captures the full theoretical value of a company—it would be illogical to then apply a control premium  Very sensitive to terminal value, which can be quite subjective to calculate and therefore should be sensitised

1.2.4

LBO (transaction valuation)—Chapter 5

Objective: Determine the returns available to the providers of equity under a leveraged capital structure, assuming an eventual exit at an assumed valuation. This methodology models a company's financial performance under a leveraged capital structure. We assume the transaction occurs in today's borrowing environment and determine the maximum initial debt a company can realistically repay in a timely manner. We calculate the Internal Rate of Return (“IRR”) to the equity provider with an exit after 3 or 4 years at an assumed exit multiple. The output is sensitised to a variety of inputs including different operating and business environment scenarios. Key points to note:  LBO analysis determines a relevant valuation for private equity acquirers.  It is also relevant for strategic acquirers as it shows what competing private equity acquirers can pay.  Sales growth rates, margins, exit multiples and interest rates are key to value


4


1.2.5

Other valuation methods—Chapter 6

There are numerous additional valuation methodologies which are used to supplement the 4 key techniques outlined above. Different valuation exercises require different approaches and it is important to tailor your approach in selecting the appropriate methodology to use. Below we highlight a number of methodologies which are found in our analysis with varying frequency. Sum of the Parts (“SOTP”) A SOTP approach is taken when valuing a company which has numerous divisions which, if standalone entities, would be valued differently. A SOTP valuation can be done either on a trading basis (by reference to comparable listed companies), on a transaction (“break-up”) basis (by reference to precedent transaction multiples) or on a fundamental basis (by calculating the NPV of cash flows of each separate part). The valuations of the individual parts are added together, offset by corporate adjustments (e.g. central costs, dissynergies created by operating divisions separately), to obtain the implied enterprise value of the company. Economic Value Added (“EVA”) EVA is a theoretical valuation methodology which compares the returns a company generates on its capital against its cost of capital (which represents the economic cost of the capital employed in generating such returns). To the extent that the returns generated exceed the cost of capital, value is “created” and we can calculate a valuation by taking a net present value of the projected value creation over a time horizon. Adjusted Present Value (“APV”) The APV methodology is a variant of the DCF. It is used to calculate the net present value of a company or project assuming it were financed entirely by equity and then adds the net present value of the effect of using debt in the capital structure (costs/benefits, including tax shield). The APV valuation method can be particularly effective in valuing companies with changing capital structures or extremely high growth. Dividend Discount Model (“DDM”) DDM is most commonly used when capital requirements are prescribed by a regulatory body for a particular industry (e.g. banks and insurance companies) or for companies with a stable dividend stream. This approach assumes that the return generated by a company above the required level to maintain capital ratios is paid out to shareholders as a dividend. Such dividends are then valued into perpetuity at a cost of equity to obtain the theoretical net present value of the equity. Appraisal Value (“AV”) Appraisal Value is the key methodology for the valuation of life insurance and pensions companies. It is the intrinsic valuation methodology similar to a DCF or DDM but based on industry-specific metrics like Embedded Value (“EV”) and Value of New Business (“VNB”).

1.3

Pros and cons of valuation methodologies

1.3.1

Comparing valuation methodologies

Clients are accustomed to seeing valuation presentations which utilise the four principal methodologies. This reflects the need both to triangulate to a “fair” valuation range and the practical applications of our valuation methodologies. For example, if we are asked to value a subsidiary for a potential divestment, we need to look at a number of possible scenarios:  Multiples for comparable quoted companies (divestment through a demerger or IPO)  Multiples of precedent transactions in the sector (divestment through a sale to a strategic or financial purchaser)  LBO (divestment through a sale to financial purchaser)  DCF (theoretical value of cash flows to the owner of the company) Each of these methodologies could result in a different valuation range and requires appropriate qualitative overlay to judge the likelihood of any given outcome for our client. For example, in an industry with significant overcapacity, there might well be significant synergies with a trade buyer, who ought to be able to pay good price. On the other hand, there may be few likely buyers but favourable equity market conditions which might make an IPO not only possible but the means of achieving best value.


5


A DCF valuation is often used as a cross-check for other valuation methods. However, on some occasions, it can be the most (or indeed the only) appropriate method to use—for example in the case of a project with finite cash flows, or a wasting asset such as a mine or a pharmaceutical patent. In addition, the reliance placed to a DCF valuation may increase if there is a lack of comparable transactions or companies (for example, when Eurotunnel was floated, the bankers working on that deal had no real relevant comparable companies and so based most of their analysis on DCF methodologies). DCF is also useful for companies seeking to evaluate potential acquisitions and particularly whether the price they might pay is justified by all of the cash flows of the deal (including synergies, additional costs incurred etc) when discounted at a specific hurdle rate.


6

Method

Pros

Cons

Comparable quoted companies analysis

 Market efficiency should ensure that trading values reflect industry trends, business risk, market growth, etc  Values obtained should be a reliable indicator of the value of the company as a listed entity  Possible to take into account expectations of future performance  Well understood methodology and primary driver of most public company analyst valuations

 Truly comparable companies are rare and differences are difficult to account for  Results can be distorted by stock market sentiment or fluctuations  Stocks with a small capitalisation, low liquidity in the market and/or limited broker coverage may not fully reflect appropriate value in their share prices

Precedent transactions analysis

 Reflects value that purchasers have been prepared to pay for control of “similar” assets  “Real” benchmark in the sense that past transactions were successfully completed at certain prices  Indicates a range for premia offered (for quoted companies only)  Trends, such as consolidating acquisitions, foreign purchasers, or financial purchases may become clear

 Past transactions are rarely directly comparable either due to company specific factors or the fact that acquisitions happened at a different point in the cycle  Public data on past transactions can be incomplete, non-existent or misleading  Typically based on historic financial information for target companies— full analysis around expected future performance is required

Discounted cash flow analysis (“DCF”)

 Reflects “fundamental” value of a company’s cash flows  Less influenced by public market conditions which can be volatile  Forward-looking cash flow based analysis, less affected by accounting rules  Can be used when there are no comparable transactions or multiples data or if entity is not profit making in the short term  Good communication tool: clearly identifies business and financial value drivers  May be particularly useful for projects with finite cash flows or wasting assets, such as mines  Synergy values can be built in by modelling their cash flows  Allows a valuation of different components of a business  A reverse DCF can also be used to calculate the implicit assumptions used by the market in arriving at a current trading price

 Valuation is highly sensitive to underlying assumptions for cash flows, terminal value and discount rate  Terminal value often represents a significant proportion of total value  Values obtained can vary over a wide range and thus may be of limited usefulness  Involves forecasting future performance, which is inherently subjective  Often viewed as subject to “manipulation” of assumptions and therefore less reliable

Leveraged buy-out analysis (“LBO”)

 Provides a valuation that is independent of stock and M&A markets  Determines value that a private equity firm is theoretically able to pay

 Standalone LBO will underestimate strategic sale value by ignoring synergies with acquirer  Value obtained is sensitive to projections, aggressiveness of operating assumptions and views on exit multiple

Absolute valuation methods

Relative valuation methods



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1.4

General principles to consider

1.4.1

Price vs. value

 There is a difference between price and value. Value can be derived from the analysis undertaken with an appropriate qualitative overlay as described in this handbook. Price, however, is the amount of money a buyer is actually willing to pay for any asset. As we often see in negotiations, the two quite often lie apart!  In practice, the "ceiling" price that an acquirer may be prepared to pay for an asset is often assessed by reference to the impact of the acquisition on the acquirer from multiple perspectives of EPS enhancement, return on investment (compared to cost of capital or a specified hurdle rate) and value creation (typically calculated as the value of synergies net of costs to achieve and any premium paid to effect the acquisition)  Acquirers typically use these reference points to justify the price paid in transactions. However, they do not always reflect underlying “value” as they rely on numerous external factors: – an acquisition funded by debt will be EPS accretive if the P/E of the acquired equity is lower than the P/E of acquisition debt (calculated as the inverse of the post-tax interest cost). This is typically the case in normal credit markets except for exceptionally highly-rated companies – an acquisition funded by equity will be EPS accretive if the target’s P/E is lower than the acquiror’s – an acquisition will be value enhancing if its post-tax return on investment is in excess of the reference cost of capital and this does not necessarily correlate with EPS enhancement

1.4.2

Trading value vs. transaction value

We most commonly undertake valuations to find:  Trading (stock market investment) value: the value of a company as if it were publicly listed; effectively the price of a single share multiplied by the number of shares in issue  Transaction value (assuming a change of control): the value of buying an entire company or a controlling stake in it  Value of a “strategic stake”: the value of a large but non-controlling stake

1.4.3

Control premium

This represents the difference between trading value and transaction value of the equity of the business. It reflects the value that a buyer can extract by owning and controlling the company and its cash flows.

1.4.4

Ensuring a consistent approach (numerator vs. denominator)

Regardless of the methodology, it is critical that the denominator and the numerator of the calculation are fundamentally consistent with one another. For example when using multiples with enterprise value as the numerator (reflecting the market value of the capital employed in the business, including both equity and debt) the denominator should encapsulate the return to all of the providers of such capital (e.g. EBITDA or EBIT – a profit measure before deducting interest, or the return to debt providers). Equally when using multiples based on market value (reflecting the value of the equity capital) the denominator should encapsulate an equity return. As such it is meaningless to show a multiple of EV/net income or equity value/EBITDA as the output will not reflect the capital structure of the company. This principle of consistency holds true for all types of adjustments such as pension deficits or leases both in the context of valuation multiples and also in calculating returns to capital providers (i.e. ROCE, ROE etc).

1.5

Capital structure adjustments

The principle of consistency means that we need to be sure what is equity and what is debt in the capital structure of the company being valued. It can sometimes be more difficult to establish this if the company has instruments or securities which combine features of both debt and equity (“hybrids”). One general principle in determining whether a given instrument is equity or debt is to establish the order of priority of claim on the company’s cash flows (i) in a "normal" going concern situation, and (ii) in extremis, for example


8


in a liquidation scenario. Equity typically has a subordinate claim on cash flows (i.e. dividends are only paid out after interest has been paid to debt providers) and debt has a senior claim.

1.5.1

Debt

Debt should be included in the capital structure at its market value. In the majority of cases this will simply be equal to book value shown on the balance sheet, but for companies with long dated bonds that were issued in a different interest rate environment, or for companies in financial distress, an adjustment to market value should be made.

1.5.2

Existence of convertible securities, warrants and options

We need to consider the likelihood of conversion into equity. For example, if a company’s shares are trading at 100p and the conversion price is 150p, the convertible is out of the money (“OTM”) and should be treated as debt. However, if the share price/valuation is much closer to the conversion price, there may be a case for arguing that we should treat the instrument as if it has converted into equity. Alternatively, if a quoted market value is available for such an instrument, this should reflect the fair value of the instrument as either debt or equity as appropriate albeit without factoring in a change of control.

1.5.3

Preference shares

Regular preference shares without equity features would typically be included in the capital structure at their market value. If the preference shares are listed, this value may be observable in the market. If not, it can be derived by discounting back future preference dividends at a rate representing the yield on similar instruments which are listed. Preference shares with votes attached may well have an increased value relative to non-voting preference shares. Preference shares if convertible into ordinary equity may also be considered in the same way as a convertible bond. Equally there may be a case for treating non-convertible preference shares as equity if they are perpetual or have a feature allowing the issuer to defer interest payments. Ultimately, judgements need to be made on a case by case basis depending on the facts of the situation.

1.5.4

Other debt-like liabilities

We also need to consider liabilities which may not appear on the face of the balance sheet; e.g.:  Off-balance sheet structures where the share of attributable net assets is consolidated but not the share of debt (e.g. a joint venture where the debt is not consolidated)  Contingent liabilities (e.g. warranty claims on sales of businesses, environmental, litigation) which may be near to crystallising  Deferred payments (e.g. on acquisitions with earn-out formulas) that may crystallise  Pension deficits which may have to be made whole in the event of a change of control or wind-up

1.5.5

Leases

Companies frequently have a choice as to whether to own or lease assets used in its business. If the asset is owned, this is reflected by the debt or equity on its balance sheet which has been raised to purchase the asset and through the depreciation in its P&L. Alternatively, if a company operates with a number of leased assets, it will have lower debt but a lease charge flowing through the P&L. To compare two such companies (asset owner vs. lessee) we need to adjust the balance sheet, capitalising the rents, thereby reflecting a truer picture of the capital structure of the businesses.

1.5.6

Minority interests

If a company has a subsidiary which it does not 100% own and is material to the group, it is best to value such a subsidiary as a stand-alone entity, and then attribute the pro-rata share of its value to the parent group (rather than simply taking the book value of such minority interests). We should remember that, when a group has a partly owned subsidiary, it does not have direct access to the cash flows and assets, usually does not have unfettered rights of management control, and there may be restrictions on its ability to sell the stake. While a controlling stake of 60% should have a value higher than 60 stakes of 1% each, the above factors need to be taken into account in the valuation of the 60% stake attributable to the group.


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Alternatively, where less information is readily available, consider applying a P/E multiple to the total minority interest in the P&L. This is likely to be more accurate than book value.

1.6

ROCE vs. ROE

In valuing a company, it is helpful to consider the returns that it makes and delivers to its capital providers. This can be compared against returns generated by similar companies and is also a means of benchmarking whether a business plan is realistic or aspirational. Ultimately, these returns can, in theory, be compared with the company’s cost of capital and assessed to determine whether the company “creates value”. The two return metrics typically referenced are return on capital employed (“ROCE”, sometimes referred to as Return on Invested Capital (“ROIC”)) and return on equity (“ROE”). Both are referenced to book value of capital and so the results must be considered carefully, particularly if there are accounting impacts on book value. As such, they must be cross-referenced with other benchmarking and valuation methodologies to ensure that they do not generate a skewed result. ROCE is the return a business generates on its total capital employed. Capital will include all sources of funding (shareholders funds + debt). To be consistent with this the return should be taken prior to interest (the return to lenders) and can be shown pre or post tax: EBIT ÷ (average shareholders funds + net debt) = ROCE pre tax (EBIT x (1-tax rate)) ÷ (average shareholders funds + net debt) = ROCE post tax It is a measure of the profit earned by the business irrespective of the capital structure. ROE is the return a business generates only on its equity capital. It is impacted by the level of debt but is normally higher than ROCE (companies typically generate greater returns on their equity than the interest rate they pay on their debt). Net income ÷ average shareholders’ funds = ROE The DuPont formula, also known as the strategic profit model, is a common way to break down the ROE into three components: profit margin, asset turnover and equity multiplier. ROE = (Net profit ÷ sales) * (sales ÷ assets) * (assets ÷ equity) This analysis allows identifying where superior return is derived from by comparison with companies in similar industries or between industries. Certain industries will rely on high profit margins (e.g. fashion), others on high asset turnover (e.g. retailers), whilst others on high leverage (financials). The best way to analyse debt is to look at the historical trend in debt financing compared to the trend in ROE to see whether a company has maintained a level of ROE by increasing its debt. This could indicate that a company is compensating for declining profit margins and increased asset efficiency with more debt to maintain the same level of shareholder return. When calculating both ROCE and ROE it is usually more accurate to calculate an average denominator for the calculation to reflect changes during the year in which the relevant return is generated. Also ensure the numerator and denominator treat minority interest consistently, i.e. either net income and equity including minority interests or excluding it.

1.7

Enterprise value (“EV”) vs. equity value

Enterprise value represents the total value of a business/enterprise to all providers of capital (debt, minorities, preference, equity). Equity value represents the value to the providers of equity, after net debt, minorities and preference shares have been deducted. This concept is critical to valuation in terms of ensuring that we adjust for capital structure (see section 2.2 for a detailed discussion of EV).


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1.8

Effect of gearing on valuation

Two companies with the same EV can appear to be valued very differently, if we do not take into account their capital structures. Consider the following example: A Market cap Net debt EV

B

Low debt

High debt

90 10

50 50

100

100

The EV is the same, so, if the companies generate the same EBITDA, the EV/EBITDA multiples will be the same. However, if you use an equity value multiple, you get a very different picture. This needs to be taken into account when comparing P/E multiples across companies. A

B

Low debt

High debt

EBITDA D&A EBIT

20 (5.0) 15.0

20 (5.0) 15.0

Interest

(1.0)

(5.0)

PBT

14.0

10.0

Tax @ 30%

(4.2)

(3.0)

Net income

9.8

7.0

EV/EBITDA P/E

5.0x 9.2x

5.0x 7.1x

Note that company B pays less tax due to the tax shield on its debt.  EV multiples (e.g. EV/EBITDA) for companies with identical operations will be the same regardless of capital structure  Equity multiples (e.g. P/E or RoE) do not take account of the level of debt in the business, and consequently will result in different equity values for identically operating businesses. Furthermore, the two companies will have different earnings due to the level of interest and tax shield on this interest, and thus the equity multiples will differ. Additionally, the multiples will be more susceptible to distortion as a result of accounting differences (e.g. depreciation policy) Returns are most often measured by RoE and ROCE. The former measures the return on the shareholders’ funds only. In order to take debt into account, ROCE is used, which measures the return on the total capital employed, the sum of shareholders’ funds and net debt (see Section 1.6 for detailed discussion).

1.9

Valuation process

A comprehensive valuation exercise requires a consistent set of steps:  Thorough understanding of the business to be valued  Understand where appropriate adjustments may be necessary e.g. – non-recurring items – pro forma adjustments to reflect recent changes such as acquisitions or disposals – quantification of change in cost structure under new ownership (if business is being sold)  Production of pro-forma profits/cash flows


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1.9.1

Quantitative factors

As emphasised earlier, at the heart of any valuation is a rigorous mathematical framework and it is essential to define the required parameters and inputs accurately:  Comparable companies (relevant population)  Comparable transactions and appropriate premia  DCF data (cash flows, WACC, terminal value)  LBO (cash flows, terminal value, capital structure, required rates of return etc) The valuations do not take account of qualitative factors unless assumptions reflect such factors (e.g. increased competition in the industry leading to lower margins over time).

1.9.2

Qualitative factors

To the extent that qualitative factors have not been reflected in the profits, cash flows or other assumptions in the mathematical framework, the numerical output must be considered in the appropriate context when presenting a valuation range to clients. Such qualitative factors can include:  Quality and likely future performance of the business relative to comparable quoted companies and precedent transactions  Strategic value to an investor  IPO market conditions and likely impact on IPO valuation  Number, type (trade or financial sponsor) and mindset of potential purchasers  Importance of incumbent management to valuation  Likely availability of debt financing for potential purchasers  Contingent and other liabilities to the extent not captured in the mathematical framework

1.9.3

Exercise of judgement in triangulating for the “right” answer

 In determining advice in respect of a “fair valuation”, the quantitative and qualitative factors must be drawn together to come to a “view”  Typically we “triangulate” to the most appropriate answer placing different weightings on the various factors to be considered  As such, a series of judgments have to be made which can shade valuations up or down  This process may include running the evaluation of multiple scenarios in order to understand possible outcomes (e.g. expected, pessimistic or optimistic scenarios), sensitivity analysis, and/or reliance on mere “gut feel”, based on experience  Often a process of “trial and error”, sense checking and group discussions are needed in order to finalise our advice

1.10

Tips for success

Each section in this handbook points you to specific common errors and tips for success but if you want to produce high quality analysis, adopt the following principles and you can’t go too wrong:  Source and tag everything so there is a clear audit trail  Check and re-check  Ask yourself the difficult questions (and find answers!) before someone else does  Ensure consistency between methodologies, data sources and within calculations  Triangulate  Do not be satisfied with output that looks odd


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SECTION 2

Comparable company analysis 2

SECTION 2: Comparable company analysis

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Comparable company analysis 2.1

Introduction

This analysis is used to compare the trading and operating performance of a company being valued to that of its peers. The economic rationale underlying this method is the theory of efficient markets which infers that similar assets should have a comparable value (i.e. should trade at similar multiples). Specifically, we seek to understand how the market has capitalised the earnings and cash flows of similar companies and to analyse other parameters such as operating ratios, book value, leverage and margins in order to put the analysis in context. This context allows us to determine the level of comparability between companies and the relevance of applying a given multiple to the company being valued. Comparable company analysis is very well understood and largely relied on by equity investors and analysts as a primary valuation tool. It has the advantage of using market-derived data which should ensure that trading values reflect the very latest information on industry trends, business risk, market growth whilst taking into account estimates of future performance. The main drawback is that truly comparable companies are rare and differences can be difficult to account for. When using comparable company analysis, it is vital to remember the principle of consistency and to adjust financial inputs so that they are shown on a pre-exceptional basis.

2.1.1

Benchmarking

Benchmarking is used to compare performance against peers and “absolute standards”. Once a company’s performance has been classified against its peers, we are able to place it in context and apply appropriate valuation metrics. Different industries use different valuation metrics and value drivers to benchmark the performance of companies against one another. Below are some of the most common measures used:  Key performance indicators including growth, margins and returns  Valuation multiples including EV/Sales, EV/EBITDA, EV/EBITA, P/E and EV/FCF The table below shows typical output from a comparable company analysis. Remember that benchmarking can be sector-specific and it is important to consider more specific operational metrics where data is available.

(Dec Y/E) Company name

Centrica PLC Cez A.S. Drax Group PLC Electricite de France S.A. Energias de Portugal S.A.

Price 10-Apr-09 (€)

% of 52-week high (%)

Market Enterprise value value (€bn) (€bn) 1

EV1/revenue

EV 1/EBITDA

EV 1/(EBITDACapex)

Revenue growth

CY 08 (x)

CY 09 (x)

CY 08 (x)

CY 09 (x)

CY 08 (x)

CY 09 (x)

CY 08 (x)

CY 09 (x)

CY 08 (%)

P/E

CY 09 (%)

EBITDA margin CY 08 (%)

CY 09 (%)

2.5

75

13.0

15.5

0.7

0.6

5.7

4.8

7.6

5.5

12.7

9.8

30.6

1.0

11.5

13.5

29.8

57

16.0

18.9

2.7

2.6

5.6

5.4

11.4

8.8

9.1

8.3

4.1

7.4

49.5

47.4

5.9

62

2.0

2.3

1.2

1.5

4.0

5.7

4.9

7.9

5.4

8.0

40.5

(20.0)

29.1

25.8

31.4

44

57.1

131.4

2.0

2.0

8.8

7.5

24.2

nm

13.4

11.7

7.8

4.2

23.2

26.1 26.6

2.8

66

10.2

28.1

2.0

2.3

9.0

8.5

nm

45.9

9.2

11.3

26.2

(10.4)

22.5

EnBW AG

36.2

67

9.5

16.9

1.0

0.9

6.8

6.5

13.6

13.7

10.5

8.3

10.8

9.2

15.3

14.6

Endesa S.A.

15.3

53

16.2

36.4

1.6

1.8

5.0

5.3

4.5

12.3

7.1

6.7

28.8

(9.7)

31.8

33.4

Enel S.p.A.

3.9

53

24.0

89.0

1.5

1.5

6.5

5.9

13.4

11.2

4.7

6.5

13.1

(3.8)

22.4

25.5

E.ON AG

23.1

50

44.0

92.8

1.0

1.1

10.6

6.7

nm

24.0

47.0

8.0

25.6

(1.8)

9.8

15.9

Gas Natural SDG S.A.

11.0

32

9.9

15.0

1.1

1.3

5.9

5.8

10.3

40.9

4.7

6.4

34.1

(14.2)

18.5

22.1

GDF Suez

23.8

53

52.3

98.4

1.2

1.2

7.3

7.0

33.4

32.2

11.0

9.6

11.9

(3.8)

16.2

17.7

Iberdrola S.A.

5.7

58

27.8

64.2

2.5

2.5

9.8

8.5

18.9

11.9

11.3

10.2

5.0

3.5

26.1

28.9

International Power PLC

2.5

50

3.8

11.2

2.9

2.9

9.1

7.7

11.9

8.8

7.9

7.5

28.4

(0.6)

32.1

38.1

RWE AG

55.9

64

31.4

47.4

1.0

1.0

5.7

5.4

12.3

13.1

11.4

8.3

15.2

(1.1)

17.0

18.0

Scottish & Southern PLC

11.6

68

10.7

15.6

0.9

0.9

8.9

8.0

23.5

17.9

10.2

9.4

8.8

0.9

10.1

11.1

Mean

1.6

1.6

7.2

6.6

(11.8)

18.1

11.7

8.7

19.4

(2.6)

22.3

24.3

Median

1.2

1.5

6.8

6.5

12.1

12.7

10.2

8.3

15.2

(1.1)

22.4

25.5

Source: Company fillings and consensus estimates Notes: 1 Enterprise value = fully diluted market value + debt outstanding – cash; assumes in-the-money convertibles are equity 2 “nm” denotes EV/revenues multiples greater than 10x or negative, EV/EBITDA multiples greater than 50x or negative and P/E multiples greater than 50x or negative


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2.1.2

Value drivers

2.1.2.1

Growth

Growth is often seen by equity markets as a key driver of valuation. As such we compare sales, profitability and cash flow growth of comparable companies. Benchmarking a company’s growth relative to industry peers is a key input in determining relative performance. Typically we consider compound annual growth rates (“CAGRs”) for a period of 3–5 years or more, in order to eliminate year on year inconsistencies and to capture medium term trends. The formula for calculating CAGR is as follows: (Year “n” value ÷ Year 1 value) ^ (1 / n) – 1

2.1.2.2

Margin

The ratio of profits to revenues for a company or business segment shows how much of each dollar of revenue generated by the company is translated into profits. Margins will vary from company to company, and certain ranges can be expected from industry to industry, as similar business constraints exist depending on both structural (e.g. ability to charge higher prices) and asset ownership distinctions (e.g. asset ownership vs. operating leases). Key ratios are EBITDA and EBIT margins although where leases or rental expenses form a significant part of the capital structure, EBITDAR margins should also be compared. High margins sometimes attract a higher valuation multiple because they indicate a high quality, robust business that will be sustainable in a downturn, but this logic does not always follow, e.g. a low margin might mean an opportunity to cut costs and achieve high profit growth, therefore justifying a high current valuation multiple.

2.1.2.3

Return

ROCE and ROE are both measuring returns of a company. ROCE gives a sense on how well a company is using its money to generate returns and ROE reveals how much profit a company generates with the money shareholders have invested (see section 1.6 for formula). It should be noted though that these measures are subject to the various accounting policies of the company, and therefore subject to manipulation. Cross sector comparison is not meaningful given that asset intensity can vary significantly. For example, an aircraft manufacturer needs more assets than a software company. However, whatever industry the company is in, it must strive for a ROCE (with capital marked to market) in excess of the targeted return, often WACC—otherwise the company is theoretically destroying rather than creating wealth. Similarly, the ROE should not be used to compare companies in different businesses. It is normally lower in capital intensive businesses. The comparison can also be distorted by different financial structures: a more heavily indebted company would have a higher ROE for example, as illustrated in the formula in section 1.6. A clear example of this occurs when companies engage in a sale and leaseback of assets (most often property). They are able to return the capital raised by selling the assets. This reduces shareholders funds, increasing ROE. However, the company then faces additional fixed costs which both reduce profit and increase operational gearing.

2.1.2.4

Sector specific value drivers

Below we list some examples of value drivers used in different sectors/industries: Healthcare Hospitals  Revenues or EBITDAR/number of beds, maintenance capex/sales (measures how much the company needs to spend to keep their operations running) Biotech  Technology value: calculated as “market value less cash” and shows how strongly investors believe in the pipeline products of the company Consumer products and retail  Revenues or EBITDA/plant or factory (in agriculture, typically calculated as Revenues or EBITDA/hectare), revenues/employee, sales/EBITDAR, sales densities, like-for-like growth


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Infrastructure  EBITDAR/fleet: measures the return the company generates on the fleet employed (at either substitution or replacement cost) Energy Integrated companies and/or E&P (Exploration and Production)  Total production measured in millions or thousands of barrels of oil equivalent ("boe"), 1P reserves (mmboe), 2P reserves (mmboe), Reserve life (production over reserves, years), Production growth, F&D (Finding and development) costs (US$/boe), Total replacement costs (US$/boe), RRR (Reserve replacement ratio) as % (both shown as incl. and excl. acquisitions/disposals), EV/DACF (applicable to integrateds) Leisure Gaming  Offline = admissions, spend per head  Online = active customers, new active customers, yield per active customer, cost per customer acquisition Hotels  Occupancy, ARR (average room rate), RevPAR (revenue per available room, a function of occupancy and room rate) Cruise  Occupancy, net revenue per diem (pricing per actual berth day sold), net yield (net revenue per available berth day, a figure similar to RevPAR in that it takes into account price and utilisation) Restaurants  Like for like sales, spend per head and roll-out of new restaurants Pubs  Beer volumes, wet sales per head, food spend per head, rental income from pub tenants Theme parks  Visitors, average admission price, in–park revenue per capita Travel  Capacity (i.e. holiday packages on offer), load factor (a measure of how efficiently the airline capacity is used), average spend per package and average cost per package Fitness  New member sales, attrition %, average member sales, membership income per head, secondary spend per head

2.1.3

Valuation multiples

2.1.3.1

Why do we look at different multiples?

Evaluating simply one type of multiple (e.g. EV/EBITDA) will not necessarily capture the whole picture. For example, differences in capital structure, growth rate, cash flow generation, capital intensity etc may not be fully reflected in such a “two-dimensional” analysis. In order to come up with a more considered view, we factor in many multiples across the capital structure and over a number of time periods. There are a wide range of multiples available including capacity measures (for example EV/number of beds for hospitals) and other industry specific measures. Multiples can also be applied to cash flow metrics and this is becoming ever more popular amongst equity analysts given an increasing focus on the ability of a company to generate sufficient cash flow to fund itself. Overleaf we analyse the most commonly used multiples.


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2.1.3.2

EV/sales

This a valuation measure that compares the enterprise value of a company to the company's sales. It gives investors an idea of how much it costs to buy the company's sales. Pros – the least susceptible to accounting differences as revenue is not easy to manipulate or distort – particularly relevant in cyclical, distressed and high growth industries or start up companies (e.g. technology) where near term profits may not reflect the true measure of a business’s potential – usually not as volatile as other multiples Cons – it can be a crude measure that does give an indication about the profitability of a company – does not capture differences in cost structures across companies

2.1.3.3

EV/EBITDA

EV/EBITDA is the most commonly used multiple as it is unaffected by a company's capital structure. It compares the total value of a business including debt capital, to earnings before interest, tax and D&A and avoids problems of different accounting policies for depreciation and amortisation. Pros – – – –

EBITDA is often seen as a “proxy” for cash flow useful comparing firms with different degrees of leverage is not distorted by situations where capex is historically at a different level to that forecast less susceptible to distortions as a result of accounting differences (compared to P/E)

Cons – there are industries which experience differing levels of capital intensity (high capex/working capital requirements) and EV/EBITDA multiples do not capture such features – EV/EBITDA may give misleading answers when comparing companies from different jurisdictions as it does not pick up differences in tax rates

2.1.3.4

EV/EBITA and EV/EBITDAR

EV/EBITA can be more comparable than EV/EBITDA where capital intensity differs as it captures some degree of capex through stripping out depreciation (i.e. implicitly making the assumption that depreciation is equal to maintenance capex) but it can be affected by differences in depreciation accounting policies. EV/EBITDAR is typically used where leases or rental expenses are material and form part of the capital structure. It is advisable to use EBITA (or EBITDA) rather than EBIT because goodwill amortisation and amortisation of purchased intangibles is purely an accounting measure and not a cost to the business. Other forms of amortisation will have to be considered on a case-by-case basis. For example, in the film and television industry, programming amortisation is arguably a regular business cost which should therefore be deducted from EBITA even though it features in the P&L as intangible amortisation.

2.1.3.5

Price/Earnings (“P/E”)

Historically, P/E has been a key driver of equity valuation as it shows how much investors are willing to pay per dollar of earnings. It is calculated by dividing the current share price of the company by the earnings per share (“EPS”). Pros – most commonly used valuation method – earnings encompasses all factors within the P&L which affect the return achieved by shareholders


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Cons – different companies in the same sector may have different accounting policies/rules, which may distort earnings after tax and lessen comparability of P/E across companies – one-off expenses or income may suppress or increase earnings, distorting your view of the company’s long-term profitability. It is therefore important to adjust earnings for any non-recurring, extraordinary items – a company’s leverage (amount of debt) can affect earnings but is not a driver of the long-term profitability – earnings can be negative even for companies which have positive value, in which case P/E is meaningless – can be difficult to ensure comparable number of shares are used (e.g. basic/diluted, year-end/average)

2.1.3.6

EV/FCF or EV/OpFCF

These multiples are becoming increasingly popular as a valuation input as they capture many of the features which undermine the comparability of other multiples such as Capex and working capital requirements. When these two items are particularly important in terms of value, it is important to compare the EV to the FCF to ensure those are taken into account. Free cash flow is the cash left for a company to spend at its discretion (reinvest, payout as dividends, pay debt, etc). It's a purer measure of strength than net earnings, which are easily manipulated. The numbers to calculate FCF are found on the cash flow statement (a more detailed calculation is provided in Section 4): FCF = Cash from operations – capital expenditures (property, plant and equipment) Pros – cash flow is harder to manipulate than earnings – reliance on cash flow rather than earnings handles the problem of differences in the quality of reported earnings – ultimately, a business is worth the cash it generates rather than the profits it reports under a particular set of accounting rules Cons – cash flow can sometimes be more volatile depending on the industry and the cycle – do not benefit from the accruals concept used by accountants in producing the P&L which matches the timing of revenues and costs It is important to try to strip out growth capex (e.g. one off expenditure on a new factory) in order to get to a sustainable figure for FCF.

2.1.3.7

Price to book multiple (“P/B”)

This ratio is used to compare a stock's market value to its book value. It is calculated by dividing the current closing price of the stock by the latest quarter's book value per share. This ratio is also known as the "price-equity ratio." P/B Ratio: Stock Price / Shareholders Equity per share

Pros – book value is theoretically more stable than earnings, so it may be more useful when earnings are volatile or negative – does not reflect the role of intangible economic assets such as human capital


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Cons – should only be used in asset-heavy industries (e.g. real estate or banking) – can be misleading when there are significant differences in the asset size of the company because in some cases the company’s business model dictates the size of its asset base (e.g. outsourcing) – different accounting conventions can obscure the true value; inflation and technological change can cause the book and market value of assets to differ significantly In some industries, intangible assets are excluded from shareholders equity in order to arrive at P/B. This in particular excludes the impact of goodwill arising from acquisitions. P/B will be more useful to the extent that assets are subject to regular revaluations, for example in the real estate industry.

2.1.3.8

EV/Capital employed

EV/Capital employed reflects the premium or discount that the market applies to a company’s capital. As such it is a measure of whether a company is seen to be creating value. It can be a good valuation metric as it captures the whole capital structure but can be affected by accounting which impacts the level of the denominator, and hence needs to be treated with care. Capital employed is usually represented as total assets less current liabilities, or non-current assets plus working capital. It is the sum of sources of long-term funds. Capital employed = Shareholders funds + Gross debt Pros – reflects the value that investors attribute to the total capital invested in the company – in theory capturing the return that the company is able to generate – useful for sectors where tangible assets are key Cons – depends on accounting policies, which can distort the true value of the assets

2.1.3.9

EV/Capacity measures

These are a useful cross-check but in some industries can be the principal yard-stick. Reference can be made to the below multiples per sector: Mining  EV/Resource: EV divided by Mineral Resources (typically Measured & Indicated) in terms of contained metal (for base & precious metals) or tons of ore (coal, iron ore)  EV/Reserves: EV divided by Mineral Reserves (Proven & Probable) in terms of contained metal (for base & precious metals) or tons of ore (coal, iron ore)  EV/Production: EV divided by target production capacity (typically only used for comparing development projects and optional to include capex)  P/NAV: Price over broker net asset value to assess valuation premium (for all gold, silver and platinum companies) or discount (again mostly for development companies) Paper and Packaging  EV per tonne: EV divided by capacity volume measured in tonnes Infrastructure  EV/Fleet: EV divided by the value of the fleet (at substitution or replacement cost) Telecoms  EV per line or POP


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Energy Integrated and/or E&P (Exploration and Production)  EV/Reserves (shown in US$/bbl), NAV per share, Share price premium/(discount) to NAV, EV/DACF R&M (Refining and Marketing)  EV/Capacity (refining capacity in US$/bbl)  EV/Complexity barrels (in US$/bbl): Complexity barrel calculated by multiplying capacity (bpd) by Nelson complexity index and divided by 1 million OFS (Oilfield services)  EV/backlog Valuations by reference to such measures of production capacity effectively assume that certain “normal” profit margins on the relevant operations can be obtained.

2.1.3.10

Importance of looking at value over the economic cycle

It should be noted that comparable companies analysis (and any multiples-based valuation) is based on current market valuations at the time the analysis is performed. Therefore, when using comparable company analysis in order to assess long term or future value (e.g. for calculating exit values for LBOs or terminal values for DCFs), it is extremely important to ensure that the multiple reflects the longer-term expected multiple at that time. This is particularly important in cyclical industries where valuation multiples can change substantially over time. The standard way of adjusting longer-term multiples is to calculate the average multiple at a number of points in time over at least one, but ideally more economic cycles. Analysis of EV/EBITDA multiples over last economic cycle (example) 10 9 8

Average = 7.6

EV/EBITDA (x)

7 6 5 4 3 2 1 0 2003

2004

2005

2006

2007

2008

2009

EV/EBITDA multiples for each year can be calculated as the EV at year-end divided by the following year’s EBITDA, or the EV at the mid-year divided by the average of the current and following year’s EBITDA, in either case it is important to footnote the methodology used. This should then be supplemented with qualitative information regarding the current stage of the cycle, and whether there are any exceptional events in past cycles which skew the results. All judgements of this type should be flagged at the highest level of your deal team given the significant impact on value they have.


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2.2

Defining the numerator: enterprise value

2.2.1

Key components of enterprise value

Enterprise value (EV) is the value of the underlying business operations, or otherwise expressed, the total value of a business/enterprise to all providers of capital, not just the providers of equity. EV is the aggregate value of all the various claims on enterprise profits and cash flows. These are  Equity value  Net debt  Minority interests  Pension deficits  Off-balance sheet items  Other, case-specific items EV = equity value + net debt + minority interests + pension deficit + off-balance sheet items + other debt-like items Below we consider each of these items in turn Enterprise value calculation—illustrative output Offbalance sheet items

Non-core assets (inc. associate)

Pension deficit Minority interests Net debt

Core enterprise value

Equity Value

2.2.2

Total enterprise value

Equity value

Equity value represents the value to the providers of equity, after the values of debt, minorities and preference shares have been deducted. For listed companies, the equity value can be observed as the market capitalisation reflecting the price investors are willing to pay for a share of the company. In calculating the fully diluted equity value of the company options, warrants and convertible debt or convertible preferred shares must be considered. Fully diluted equity value considers the worst case scenario for investors, assuming all potentially dilutive securities are converted.


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2.2.2.1

Options and warrants

Share options and warrants are dilutive only when their exercise price is less than the current market price of the stock. If this is the case, they are said to be “in the money” (“ITM”) as opposed to “out of the money”. (“OTM”) if the strike price is above the current market value. Dilutive share options and warrants theoretically increase the number of common shares outstanding. This increase is typically calculated using the treasury method. This method is generally accepted as capturing the dilutive effect of ITM options and warrants as it accounts for the hypothetical cash generated by the exercise of options and/or warrants. It assumes that the hypothetical proceeds that a company receives from an ITM option exercise are used to repurchase common shares in the market. The net new shares that are potentially created is calculated by taking the number of shares that the ITM options purchase, then subtracting the number of common shares that the company can purchase from the market with the option proceeds. The net new shares are added to the basic shares outstanding to get the fully diluted shares which are used to calculate the fully diluted equity value. Example:

Current share price Shares outstanding Options/warrants outstanding

US$50 400m 10m

Exercise price Proceeds from conversion Stock buyback (at premium) Diluted Shares

US$25 10 x US$25 = US$250m US$250/US$50 = 5m 400 + 10 – 5 = 405m

If it is a question of calculating the value of the options outstanding rather than a diluted number of shares, two other methodologies are used: Intrinsic value method: intrinsic value is the amount by which the option is in the money. It is the amount that the option owner would receive if the option were exercised. An option has zero intrinsic value if it is at the money or out of the money regardless of whether it is a call or a put Intrinsic value in options is the in-the-money portion of the option's premium. For example, if a call option’s strike price is US$15 and the underlying stock's market price is at US$25, then the intrinsic value of the call option is US$10. An option is usually never worth less than what an option holder can receive if the option is exercised. Fair value method: Fair value of all stock options (in the money and out of the money) is calculated using the Black-Scholes formula or a similar method. This takes into account a number of factors as well as intrinsic value.

2.2.2.2

Convertibles and preference shares

When a company has a convertible bond or preference share outstanding. It is important to ascribe the right treatment (debt vs. equity) in calculating the fully diluted equity value. As with options and warrants, the treatment depends on whether a convertible or preference share is ITM or OTM and on the nature of the instrument in question.

2.2.2.2.1

Accounting for convertibles

On issue, the value of a convertible is split between debt and equity. The debt component is calculated based on an appropriate discount rate for a similar, non-convertible instrument. The equity component is calculated as the remainder of total instrument value. Each year the interest expense on the debt component is equal to the discount rate, multiplied by the carrying value of the liability on the balance sheet. The interest expense will exceed the coupon paid (as the coupon on a convertible is lower than on an equivalent straight debt instrument as investors receive remuneration through the value of the conversion option), and therefore the difference is added to the liability. At maturity the liability will equal 100% of the convertible value. On conversion, the liability is extinguished by an issue of shares at the conversion price.


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Illustrative accounting treatment Amount issued: Term Coupon Discount rate on comparable bond (all-in)

100 5 yrs 2.5% 7.91%

Cost of similar non-convertible bond (PV)

78.3

At issue

yr 1

yr 2

yr 3

yr 4

21.7

21.7

21.7

21.7

21.7

(3.7)

(7.7) (12.0) (16.6) (21.7) Cumulative accrued interest

18.0

14.0

9.7

5.0

Beginning of year

78.3

82.0

86.0

90.3

95.0 Price of comparable non-convertible bond

Accrued interest

3.7

4.0

4.3

4.6

5.0 Difference between interest expense and coupon paid

82.0

86.0

90.3

Coupon paid

2.5

2.5

2.5

2.5

2.5 Coupon paid each year

Accrued interest

3.7

4.0

4.3

4.6

5.0 Difference between interest expense and coupon paid

Interest expense

6.2

6.5

6.8

7.1

7.5 Interest payable on comparable non-convertible bond x opening liability

yr 5 Calculation

Balance sheet Equity Option value P&L cum impact Net equity impact

21.7

21.7 Equal to issue price less price of comparable non-convertible bond 0.0 Option value less accrued interest

Liabilities

End of year

78.3

95.0 100.0 Sum of beginning of year plus accrued interest

Income statement/cash flow

2.2.2.2.2

Non mandatory vs. mandatory convertibles

Optional convertibles The majority of convertibles are optionally convertible i.e. the owner can choose whether or not to convert. Change of Control Events In the context of M&A, convertible bond investors frequently have the right to put the bonds at par (“investor put following change of control”). This should be factored into enterprise value (or use of cash resources) in analysing potential M&A situations – it is particularly relevant when a target company’s bonds are trading significantly below par. Mandatory convertibles A mandatory convertible automatically converts in to the underlying security on a specified date. These securities provide investors with higher yields to compensate holders for the mandatory conversion structure and have a fixed conversion date and a variable conversion rate. For valuation purposes, a mandatory convertible should normally be considered as equity (see following section), although the terms of the instrument should be checked to ensure this is consistent with treatment on change of control, etc. Rating agencies generally ascribe high equity content to mandatory structures (i.e. up to 100%).


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2.2.2.2.3

Convertible as equity

If the convertible is in the money it should be treated and thought of as equity. Taking into account the rule of consistency of numerator and denominator, this requires certain treatment in both EV and P&L terms. For equity value calculation  Calculate the implied number of shares (NOSH) to be issued assuming the bond converts using the conversion ratio  Exclude the convertible from the net debt calculation Effect on dilution of EPS: Remember that the calculation of the basic EPS is net income available to common shareholders divided by current number of shares outstanding. In the case of dilutive EPS, if there are dilutive securities (e.g. convertible bonds) then adjust for the following:  Calculate the implied net earnings as if the convertible were fully converted at the beginning of the year, by adding back to earnings the convertible after tax interest expense  Add the number of shares assuming full conversion to the existing number of shares Example of EPS with convertible debt: During 2008, Company A reported net income of US$115,600 and had 200,000 shares of common stock outstanding for the entire year. During 2007, Company A issued 600, US$1,000 par, 7% bonds for US$600,000 (issued at par). Each of these bonds is convertible to 100 shares of common stock. The tax rate is 40%. Compute the 2008 basic and diluted EPS. Answer: Step 1:

Compute 2008 basic EPS basic EPS = US$115,600 = 0.58 200,000

Step 2: Calculate diluted EPS:  Compute the increase in common stock outstanding if the convertible debt is converted to common stock at the beginning of 2008 shares issuable for debt conversion = (600) (100) = 60,000 shares  If the convertible debt is considered converted to common stock at the beginning of 2008, then there would be no interest expense related to the convertible debt. Therefore, it is necessary to increase Company’s A after-tax net income for the after-tax effect of the decrease in interest expense increase in income = ((600) (US$1,000) (0.07)) (1 – 0.40) = US$25,200  Compute diluted EPS as if the convertible debt were common stock diluted EPS =

net income + convert interest (1 – t) wt. Avg. shares + convertible debt shares

diluted EPS = US$115,600 + US$25,200 = US$0.54 200,000 + 60,000  Check to make sure that diluted EPS is less than basic EPS. (US$0.54 < US$0.58). If diluted EPS is more than the basic EPS, the convertible bonds are antidilutive and should not be treated as common stock in computing diluted EPS

2.2.2.2.4

Convertible as debt

If the convertible is out of the money it should be treated and thought of as debt. In this scenario, typically no adjustments are required and the convertible is included in net debt at book value unless it is trading at a discount.


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2.2.3

Net debt

Net debt included in EV calculations generally refers to interest bearing capital owed to third parties. It includes all long and short term interest bearing debt finance (including bank loans, bank overdrafts, bonds and capitalised finance leases) but does not include liabilities which are not interest-bearing such as trade payables, accruals, tax creditors and non-debt deemed provisions. Wherever possible, debt instruments should be included at their market value. Net debt is stated net of cash balances and marketable securities (generally investments included under current assets that are readily realisable). If there is a minimum level of operational cash which is needed for the running of the business, this is typically excluded from the calculation on the basis that this is not a capital item, but effectively an asset of the core business. Net debt = short-term + long-term interest-bearing liabilities—cash and cash equivalents (marketable securities) If valuing a subsidiary company (from its own perspective), intercompany debt should be included as a form of debt. From a group perspective, the same intercompany debt should be eliminated as the parent would have both "balance receivable" and "balance payable" in its consolidated accounts.

2.2.3.1

Preference shares

A company’s preference shareholders have priority over its ordinary shareholders when it distributes profit. The preference dividend is usually a stated amount per share which is fixed at the time of issuance. Preference shares should be considered as subordinated debt and included in the net debt calculation. However, if a preference share is convertible, it should be treated in the same way as a convertible bond, as described in section 2.2.2.2. There also may be a case for considering preference shares to be equity if perpetual and with dividend deferral features.

2.2.4

Minority interests

Another financing claim to be included in enterprise value is minority interest that reflects any third party ownership in a parent company’s subsidiary. Minority interest arises as the parent company fully consolidates a subsidiary but does not own 100% of the subsidiary’s shares. This means that minority shareholders provide part of the company’s overall capital, and part of the income of the subsidiary is attributable to minority shareholders. As a consequence, part of the total derived enterprise value will accrue to minority shareholders. In order to compare with fully consolidated profit figures, the value of the minority ownership must be included in EV. The valuation of minority stakes can be done with varying degrees of sophistication. The more complex and comprehensive approaches are probably only justified where the subsidiary is significant relative to the parent and the size of the minority stake is material. Book value  The balance sheet value of minority interests represents the minorities’ share of reported net assets in the balance sheet, except for goodwill which only relates to the parent shareholders. This amount is unlikely to be a good proxy for the fair value of minorities given that book value primarily reflects a historical cost measurement basis and does not account for intangible assets Price to book or P/E multiples  Applying the group P/B or P/E multiple to the minority earnings is better than simply taking book value but does not account for the relevance of the group multiple to the subsidiary (i.e. the subsidiary could be in a different jurisdiction, or in the case of a conglomerate, in a different industry from other wholly-owned group companies)  Applying appropriate peer group P/B or P/E multiples to the minority earnings is likely to yield a more accurate result


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Full valuation analysis  Minority interests can be valued using a detailed analysis of the value of subsidiaries which are not wholly owned. In practice such an approach can be very difficult to implement given the lack of disclosure often related to minority interests which are often related to unlisted subsidiaries Quoted market price  If the subsidiary that includes the minority shareholding is listed then the actual market value of the minorities can be identified and included in the enterprise value calculations In valuing minorities it is important to consider the impact of the majority control on the position of other shareholders. Apart from the quoted market price approach above, all the others implicitly assume that the minority value would be some proportionate share of the total value based upon the percentage shareholding. This may not be the case and a discount may be warranted when applying a valuation multiple to allow for situations where the majority shareholders may be claiming more than their share of value by transfer into other wholly owned group companies.

2.2.5

Pensions

Pension schemes can be divided into two broad types: Defined Benefit and Defined Contribution schemes. Defined benefit (“DB”) schemes were very common in industrial companies in the UK and the US until companies realised that they were bearing all of the risk relating to the performance of the assets in the pension scheme (as the liabilities are fixed relative to the salaries of retirees). More recently, defined contribution (“DC”) schemes have become the norm whereby the employee bears the risk of asset performance but the company makes fixed contributions to its employees’ schemes.

2.2.5.1

Defined contribution schemes

A DC scheme is a plan providing an individual account for each participant, who will receive benefits based solely on the amount contributed to the scheme and the returns on assets in which the scheme invests. The contributions are invested, for example in the stock market, and the returns on the investment (which may be positive or negative) are credited to the individual's account. On retirement, the member's account is used to provide retirement benefits, often through the purchase of an annuity which provides a regular income. Under a defined contribution scheme, the employer pays a specified amount into an employee’s scheme each year. Since this amount is known and there is no further risk associated with the payment from the company’s perspective, accounting for such schemes is fairly simple. On the P&L, the amount of the contribution would be recorded as an operating expense (typically under selling, general and administrative expense) in the period the employee earns the benefit. On the balance sheet, if the contribution is paid in the same period as the employee earns the benefit, no entries are necessary. If benefits earned in one period are paid in the next, the company will have to record a liability for the amount they owe the employee until it is paid. This amount will also typically be recorded in the P&L under accrued salary or other accrued expenses. Either way, since the amount is known and that amount is recorded on the P&L and (if necessary) the balance sheet or EV, no adjustments are necessary.

2.2.5.2

Defined benefit schemes

Under a DB scheme, the sponsoring company promises to make periodic payments to the employee after retirement, typically expressed as a percentage of their final salary. Unlike a DC scheme, the employer typically invests funds itself in order to meet this future obligation and assumes the risk and rewards associated with the scheme assets and liabilities. A company’s defined benefit pension obligations are calculated separately for each scheme it operates. A pension scheme is governed by trustees whose role is to safeguard the benefits of the scheme members. The trustees are also responsible for negotiating both ongoing and deficit catch up contributions with the company on behalf of the scheme members. Accounting for DB schemes is much more complicated than DC schemes, because the employer must estimate the value today of the future obligations made to its employees. To estimate this value, the company must make assumptions concerning the discount rate to use to calculate the present value of the future obligations, the expected increase in employee compensation, how long employees will work before they retire, how many will quit or be fired and how long they will live after they retire. A company with a DB scheme usually sponsors a pension fund, which is a portfolio of financial securities managed to generate income and principal growth necessary to fund future pension obligations. The amount the company reports on its balance sheet (the “accounting liability”) is the net amount: the difference between the value of the assets (the pension fund) and the present value of the future pension liability.


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2.2.5.3

Funded and unfunded schemes

To fund the post-employment benefits inherent in DB schemes the company can meet its pension obligations out of operational cash flow on a “pay as you go” basis (unfunded schemes) or save up for future liabilities by investing in pension assets (funded scheme). A funded scheme is one in which all liabilities are funded in advance. Contributions from participants and earnings on investments provide cash to cover the scheme’s expected liabilities. In a funded defined benefit arrangement, the company and pension trustees must agree upon the contributions that the company must make to ensure that the pension fund will meet future payment obligations. DC schemes are by definition, funded, but the “guarantee” made to employees is different from a DB scheme in that the employer commits to making contributions during the employee’s working life rather than promising fixed future payments on retirement. In an unfunded DB scheme, no assets are set aside and the benefits are paid for by the employer or other pension sponsor as and when they need to be paid. Pension arrangements provided by the state in most countries in the world are unfunded, with benefits paid directly from current workers' contributions and taxes. This method of financing is known as Pay-as-you-go. In other words, a pension scheme funded out of the employer's current income whenever funds are required by retiring employees or beneficiaries, rather than out of money put aside on a regular basis regardless of current need.

2.2.5.4

Pensions and enterprise value

For the calculation of enterprise value, DB obligations are viewed as a “debt-like” item; in other words, a loan provided by employees to the company to be repaid upon retirement. In addition, as the pension liabilities are recorded at present value, there is an implied annual interest cost. This, together with the long term nature of pensions, makes us treat these obligations as financing in nature. An unfunded pension liability is included in enterprise value whereas for funded DB schemes, it is the difference between pension liabilities and pension assets. This difference is called a scheme’s surplus (or over-funding) if the assets exceed the obligation, and a deficit (or under-funding) if not. This deficit can vary depending on whether accounting or actuarial estimates of the liability are used. We typically consider that the pension deficit should be included in enterprise value on a post-tax basis (note that a pension surplus is typically not taken into account). In many jurisdictions, companies receive a tax deduction for contributing cash to their funded defined benefit schemes. Therefore the burden of a pension deficit is effectively the gross amount reduced by the marginal tax rate. Where the deficit is a present value, the tax saving is also on the same basis. The tax saving will be recognised as a deferred tax asset in the company’s balance sheet.

2.2.5.4.1

Accounting vs. actuarial differences

In a funded DB scheme, the pension deficit calculated by reference to the accounting liability can differ significantly from the deficit as calculated by an actuary given the use of different assumptions. For example, in the UK under IAS 19, accounting liabilities are calculated by using a discount rate derived from the yield on AA rated corporate bonds whereas the actuarial liability is typically calculated by adding a fixed percentage to underlying gilt rates. Companies and pension trustees use actuarial calculations in setting contribution rates and these are often subject to considerable negotiation. Given that contributions will be reflected in a company’s future P&L and cash flow statement (depending on type of contribution – service costs versus deficit catch-up), arguably the actuarial figures are more appropriate for use in valuation. However, given that accounting liabilities are readily available (unlike actuarial figures), they are typically used in valuation exercises. It is important to recognise the potential for differences here and consider whether to make adjustments in cases where there is a significant difference.


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2.2.5.5

Pensions and P&L

Treating pensions as debt for the purpose of enterprise value also means that only the operating items related to pensions should be included as part of EBIT for multiples and estimates of enterprise free cash flow (FCF). Under IAS 19 the main gains and losses recognised in the P&L related to pensions are i)

service coost: the value of the pension rights earned by employees during the period

ii) interest accretion on the gross pension obligation: the effect of unwinding the effect of stating the liability on a discounted, present value basis iii) expected return on the gross pension scheme assets: an estimate of the long-term expected return on the different components of the pension fund. For bonds, this is relatively simple, being the bond yield, but for equities and other assets such as investments in property and hedge funds it is a more difficult assessment of risky asset returns and in particular an estimate of the equity risk premium. Typically, interest costs and the expected return on pension assets are treated as ‘financing in nature’, and hence these should be included as part of net financing income rather than operating income and added back to EBITDA or EBITA where a pension deficit has been included in EV. The service costs, reflecting the value of pension rights earned by employees in a particular accounting period, are a genuine operating expense to be included in EBITDA, EBIT and estimates of FCF when used for comparison with pension-adjusted EV. The challenge for analysts and investors is that under IFRS, companies have the discretion to present all pension P&L items as either financing or operating. Therefore, key performance metrics such as EBIT margins can be affected by the treatment of the expected return on assets and interest costs on the pension liability.

2.2.5.6

Country differences

France Subscribing to the State-controlled Pension Scheme is mandatory in France, and contributed to by both employees and employers. Private pensions schemes are comparatively rare, and as a result the sole accounting treatment of this item is a cost against profit in each period. There are no adjustments needed to EV. Germany There are different kinds of pension schemes in Germany:  Traditional system of fully unfunded pensions schemes on balance sheet (i.e. pensions to be paid out of future cash flow and provisions are included in EV as debt)  On balance sheet financing with certain pension assets (also on balance sheet), defined benefit set up, but only the funding gap should be included which will be disclosed in the notes  Total removal of pension obligations to an external pension scheme (usually non recourse to the actual corporation), defined benefit set up, pension obligation should not be relevant for debt calculation (depending on recourse/non recourse) In recent years, corporations have been moving to defined contribution schemes (managed by insurance companies etc) to remove the increasing pension provisions from the BS and solve the issue, however there are still “old” pensions on the BS. Italy Italian regulations (introduced in 2007) require companies to provide an entitlement for their employees by way of a payment expensed annually. This payment is called "Trattamento di Fine Rapporto" (Severance Treatment), or TFR. Contributions to fund the TFR are deducted from the employee's salary each month. Employees of large companies (50+ employees) can: (i) elect to receive the TFR-portion of their compensation in a single instalment, as severance payment, when they leave the company for any reason (voluntary change of employer, redundancy, retirement). The company is obliged to transfer the TFR payments received from the employee to the Italian Social Security system, which, once the employment is terminated, will pay the accrued TFR amount to the employee;


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(ii) not make any election, in which case the TFR-portion of their compensation is contributed by default into external certified pension funds, which operate as defined contribution schemes. Once the employee retires, he will receive from the fund an annuity integrating the regular, State-controlled pension payments In both cases, current TFR-related payments are already included in the cash personnel cost of the company, and therefore fully reflected in the company’s EBITDA. The pension liability is not on the balance sheet of the company but instead is reported on the balance sheet of either the Italian Social Security or the external funds. As a result, no adjustment to the calculation of the company’s EV is required to reflect the post-2007 TFR schemes. However, prior to January 2007, TFR’s sole purpose was to fund a severance payment. The TFR-portion of compensation was retained by the company, which had the obligation to pay the entire accrued TFR amount to its employees upon termination of employment. As a result, the TFR was a non-cash item, that created an unfunded liability on the company's balance sheet. The TFR provision related to pre-2007 schemes is still present on the balance sheet of Italian companies. As severance payments are made over time, the size of the TFR provision is gradually decreasing. Nonetheless, the pre-2007 TFR provision should be added to the company's EV. This value is clearly reported on the balance sheet, under both IFRS and Italian GAAP. Spain Corporate pension assets in Spain are externally managed by a specialised company to provide its beneficiaries with a greater guarantee of efficiency and security. As a result of such external management and the fact that companies do not bear the cost or risk of the pension schemes, no pension adjustment typically needs to be incorporated when valuing a company in Spain. US Over the years, US companies with defined benefit schemes have moved to defined contribution schemes. However, substantial legacy defined benefit schemes remain in some sectors and large unfunded positions when market headwinds prevail (e.g. steel, coal, auto, airlines). In addition, companies operating in the US offer post-retirement health benefits. These also have a defined benefit character. Thus the total defined benefit obligations of a company include defined benefit pension schemes and other post employment benefits (OPEB). Defined Benefit Schemes & OPEB Per US GAAP, the P&L includes pension income/costs that are unrelated to current period operations. Both the P&L and balance sheet are sensitive to actuarial assumptions, many of which are not disclosed. Furthermore, the figures reported on the balance sheet rarely convey the actual funding level. In fact, the balance sheet may show a net surplus or pension asset while the pension is actually in deficit. Adjustments to EV and EBIT/EBITDA should be effected with data coming from the footnotes: – add tax-adjusted “funded status” to EV – add to EBIT/EBITDA the entire Periodic Pension Charge except for Service Cost (which should not be backed-out) UK In the UK, DB schemes have historically been common although these have largely been closed to new members. DC schemes are now the norm for new employees and some companies are even converting existing DB schemes to DC schemes. Under IAS 19, the net pension liability arising from DB schemes (i.e. the deficit) will appear on the balance sheet net of deferred tax and should be added to enterprise value. The pension footnote will provide information on pension financing costs which should be added back to EBITDA or EBIT as described in section 2.2.5.5. It is important to note that the accounting deficit may differ materially from the actuarial deficit. The latter is the basis on which the trustees and the company agree a schedule of future contributions to make up the deficit. Such contributions are not captured in the P&L (they are accounted through the cash flow statement) and so it may be necessary to make a further adjustment to EV, for example by adding the NPV of agreed future deficit contributions. This should be reviewed on a case by case basis.


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2.2.6

Leases

It is important to consider the effect of leases on valuation in order to compare two companies who may choose to operate their businesses with different levels of asset ownership vs. leases. A lease is a contract between two parties: one party (lessee) has right to use an asset which is owned by another (lessor) for a fixed or indefinite period of time, whereby the lessee obtains exclusive possession of the property in return for paying the lessor a fixed or determinable payment. The lessor retains the legal ownership of the asset. There are two types of leases: Operating leases An operating lease is usually signed for a period considerably shorter than the useful life of the asset and the present value of lease payments are generally lower than the actual price of the asset. At the end of the life of the lease, the physical possession of the property reverts back to the lessor, who can either offer to sell it to the lessee or lease it to somebody else. Under an operating lease, the lessee may have the option to cancel the lease and return equipment to the lessor, before the expiry of lease agreement although this option is likely to carry additional cost for the lessee. Thus the ownership of the asset resides with the lessor, with the lessee bearing little or no risk if the asset becomes obsolete. An example of operating leases could be retail businesses which lease rather than own their shops or aircraft companies which lease their planes. Under an operating lease, the lessor may also provide services relating to the asset, such as maintenance, or operations. In accounting terms, an operating lease is considered to be the same as renting an asset:  The lessee simply has to record the payments it makes under the lease agreement as an expense in the P&L (and vice versa for the lessor) when they occur. There is no recognition of any asset or obligation to make payments under the lease in the financial statements of the lessee  The lease payments are operating expenses which are tax deductible. Thus, although lease payments reduce income, they also provide a tax benefit  The lessor continues to recognise the asset on its balance sheet and depreciate as normal. It does not recognise any future cash to be received as a receivable, and simply records the income in the P&L as it occurs Finance or capital leases A finance or capital lease generally lasts for the life of the asset, with the present value of lease payments almost equivalent to the price of the asset. A finance lease generally cannot be cancelled, and the lease can be renewed at the end of its life. In a lot of cases, the lessor is not obligated to pay insurance and taxes on the asset, leaving these obligations up to the lessee; as a result the lessee reduces the lease payments, leading to what are called net leases. A finance lease imposes substantial risk on the shoulders of the lessee. A finance lease is deemed to be the equivalent of the lessee buying an asset outright from the lessor. However, in a lease situation, legally ownership is never passed and the asset never legally belongs to the lessee. For valuation purposes, finance leases are treated as debt and corresponding lease payments as interest.

2.2.6.1

Effect of leases on Expenses, Income and Taxes

Finance leases are treated similarly to assets that are bought by the firm; hence the firm can claim depreciation on the asset and an imputed interest payment on the lease as tax deductions instead of the lease payment itself. The imputed interest payment is calculated by splitting the lease payment into interest and principal. If aggregated over a long period of time, the total tax deductions amount on imputed interest expenses and depreciation, which comprise the tax deductible flows arising from the lease, will still be equal to the sum of the lease payments. The only difference is in timing –– the capital lease leads to greater deductions earlier and less later on.


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2.2.6.2

Effect of leases on balance sheet

From the lessee's perspective, Operating leases are often referred to as off-balance sheet leases—the company is obtaining benefits from using an asset in its operations which is not required to be recorded on the balance sheet. Under a finance lease, the leased asset is shown as an asset on the balance sheet, with a corresponding liability capturing the present value of the expected lease payments. Accordingly, companies can switch between lease types and create the lease which gives them the desired result in their financial statements (i.e., the lease is considered operating if the company wants to reduce its gearing levels, so there is no requirement to record the contracted liability on the balance sheet.) Additionally, it is possible for a lessee and a lessor to classify the same lease differently (i.e., the lessee may think it is a finance lease whereas the lessor may qualify it as an operating lease). Given the discretion, many firms prefer the first approach, since it hides the potential liability to the firm and understates its headline financial leverage. While an operating lease is favourable for the lessee, it reduces the lessor’s tax deductions in terms of depreciation, interest etc. Despite this conflict of interest, firms manage to design lease agreements according to their requirements. The conditions for classifying operating and capital leases apply in most countries; exceptions being France and Japan where all leases are treated as operating leases. By adjusting all leases as if they are treated as capital leases (i.e. by capitalising them), adjusted net debt/EBITDAR multiples can be calculated. These are used in certain industries for the benchmarking of debt financing capacity where leases are an important business expense.

2.2.6.3

Finance vs. operating leases, understanding the differences

Valuations generally fall into two categories  Operating leases may not allow the asset to be virtually exhausted by the same lessee: a rental transaction must allow an asset to be used by a series of users. The finance lease, being long-term, covers the life of the asset  Operating leases do not put the lessee in the position of a virtual owner: the lessee merely uses the asset and does not have the same commitment to the asset he has in case of owned assets. Under finance leases, only the legal ownership does not change, but for all practical purposes the lessee assumes the risks and expenses in relation to the asset  In an operating lease, the lessor takes asset-based risk, he is directly affected by the state, efficiency and obsolescence of the asset. The value of the asset is important not only from the viewpoint of security of the lessor's investment, but the value itself determines the lessor's returns. In a finance lease the lessor takes both financial risks and asset-based risks  In operating leases, the lessor's rate of return is dependent upon the asset value, performance, or costs relating to the asset. The fixed lease rentals cannot give rise to an ascertainable rate of return on investment. Therefore, the implicit rate of return in an operating lease is always a matter of probabilities and is uncertain. Finance leases almost cover the whole life of the asset, ensuring that the lessor’s investment is returned through fixed lease rentals over the lease period

2.2.6.4

Capitalisation of operating leases

If a company chooses to lease rather than buy assets this source of capital needs to be captured in our valuation analysis. In calculating EV, the value of capitalised operating leases needs to be added in order to make the invested capital base inclusive of all assets employed. Capitalising operating leases also helps reveal true company leverage and equity risk. In addition, the commitment to make operating lease payments should not be treated differently than having a commitment to pay interest and debt. There are two methodologies that can be used to capitalised the operating leases. In practice, S&P uses the NPV methodology and Moody’s uses the multiple methodology when calculating ratios for credit rating purposes. For valuation purposes, either is acceptable, but should be consistent for each company being valued.


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Multiple methodology The simple technique to determine the operating lease liability is the application of a multiple to the current operating lease charge. For example, if a company has an operating lease charge of 350 in 2008, this is multiplied by, say, 7 to obtain the amount of liability and assets (2,450) that should be on the balance sheet. Different multiples are appropriate for different sectors, as illustrated by Moody’s methodologies for their ratings calculations below: Moody’s operating lease capitalisation multiples Sector/multiple (x)

Aerospace/Defense Automotive Chemicals Consumer Products Energy: Electricity Cooperative Energy: Electricity—Project Finance Energy: Electricity—Non Project Finance Energy: Oil & Gas—Drilling Energy: Oil & Gas—Exploration & Production Energy: Oil & Gas—Integrated Energy: Oil & Gas—Merchant Energy Energy: Oil & Gas—Midstream Energy: Oil & Gas—Project Finance Energy: Oil & Gas—Refining & Marketing Energy: Oil & Gas—Services Environment Forest Products Gaming/Lodging Healthcare—Hospitals and Services Healthcare—Medical Devices Homebuilding Leisure & Entertainment Manufacturing Media: Advertising & Broadcasting

Sector/multiple (x)

6 6 6 6 6 6 8 5 6 6 6 6 6 6 5 6 5 8 6 6 5 8 6 6

Media: Diversified, Paid TV & Subscription Radio Media: Printing & Publishing Metals & Mining Natural Products Processor Packaging Pharmaceuticals Public Utility Public Utility—Gas Distribution Public Utility—Gas Transmission Restaurants Retail Services—Business Services—Consumer Services—Contractors Services—Processors Services—Rental Services—Towers & Satellites Technology Telecommunications Transportation Services Airline Maritime Shipping Transportation Services—Airports & Toll Roads Wholesale Distribution

6 6 5 6 5 5 6 8 8 8 8 6 6 5 5 5 5 5 5 6 8 8 6 6

For consistency reasons when capitalising the operating leases, the necessary adjustments need to be made also to the P&L. Specifically when calculating EV/EBITDA multiples, remember to add back the operating lease expense to EBITDA so that any expenses related to leasing of assets are not included. For the calculation of EBIT and earnings multiples, adjustments for the depreciation and the interest component of the lease are required. The operating lease charge is typically reallocated on the P&L in a simple way assuming 1⁄3 relates to interest and 2⁄3 to depreciation. NPV methodology A more sophisticated technique is to calculate the NPV of future operating leases payments. In order to do this accurately, the future “normalised” level of lease payments is required, something that is not always available.


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2.2.7

Core versus non-core enterprise value

Although EV multiples have become a popular valuation methodology, there is frequently confusion about the calculation of enterprise value. An important issue is the treatment of associates and investments, both in EV and related results metrics like EBIT(DA). The question is whether these are an integral part of the parent company’s business or reflect related activities that are not deemed to be part of the core operations of the company. We distinguish between two types of enterprise value:  Total enterprise value: The value of all the activities of the business. It includes the value of investments and associates  Core enterprise value: Total enterprise value less the value of non core assets—operations not regarded as part of the core activities and which it is thought desirable to exclude for the purpose of calculating valuation multiples. Non-core assets include investments, associates and joint ventures but may also include other trading operations, which are very different in nature to the core activities of the enterprise It is typically preferable to use core EV for comparability across similar companies, as multiples for non-core activities such as investments and associates can be very different. We therefore generally treat associates/joint ventures and other investments as non-core for the purpose of enterprise value multiples and value them separately. In addition, trading operations, which are very different in nature to the core activities of the enterprise (i.e. say a financing division which is secondary to the company’s main business purpose) could also be treated as non-core. However, to get meaningful multiples, there needs to be consistency between the components of enterprise value and its related results component such as EBIT(DA). In deriving a consistent core EV multiple, we must not only remove investments and associates from enterprise value, but also any (associated) income should be excluded from EBIT(DA). It is important to deduct the market value and not the book value of non-core assets like investments and associates to get to a core enterprise value. This is relevant for all non-core assets but is particularly important for investments in associated companies as the market value may be substantially different from (historical) book value. If the associated company is not listed, the market value can only be estimated by, for example, applying a price/earnings multiple to the company’s share of the profit of the associate. Below we give a simple example of a company with total EV of €2,100m and total EBIT of €200m to illustrate the distinction between total and core EV multiples. Assume a company has an investment in an associate (book value €350m) and other investments (book value of €50m). Removing the market value of the investment in the associated company (€500m) and other investment (€100m) gives a core EV of €1,500m. This gives a core EV/EBIT multiple is only 8.6 compared with a total EV/EBIT multiple of 12.0. Deriving EV/EBIT multiples Enterprise value

€m

EBIT

€m

EV/EBIT multiples

Market cap Net debt Minorities EV (total)

750 1,200 150 2,100

EBIT (total)

200

EV/EBIT (total)

10.5x

Associates Investments EV (core)

500 100 1,500

Associate income Investment income EBIT (core)

25 0 175

EV/EBIT (Core)

8.6x

Source:

UBS


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2.3

Defining the denominator

2.3.1

Calendarisation

For the purpose of deriving trading multiples, estimates are often calenderised to a common year end. This is done to ensure consistency and enhance comparability. We often calendarise to the year end of the company being valued or the most common year end across the universe. In case of companies with different year ends, forecasted estimates are “calendarised”. Calendarisation is the process of prorating estimates that are available on fiscal year basis, to derive estimates on a calendar year basis. Consider the following example Fiscal year end of company XYZ

30 September

Forecasted revenues for FY 2008

US$1,200m

Forecasted revenues for FY 2009

US$1,440m

Revenues for calendar year 2008 shall be determined as under: Forecasted revenues for FY 2008 pro rated for 9 months

US$1200 x 9/12 = US$900m

Add Forecasted revenues for FY 2009 pro rated for 3 months

US$1,440 x 3/12 = US$360m

Forecasted revenues for calendar year 2008 (Jan–Dec 06)

US$900 + US$360 = US$1,260m

Data should always be calendarised for comparison purposes and to get LTM financials. Please note that seasonality can affect the calendarisation and for the most accurate results, this needs to be accounted for rather than assuming that earnings and cash flows are derived equally across the year.

2.3.2

Adjusting the earnings numbers for pensions

As discussed in section 2.2.5.5 above, treating pensions as a financing claim for the purpose of enterprise value also means that only the operating items related to pensions should be included as part of EBIT for multiples and estimates of enterprise free cash flow (FCF). Therefore, remember to add back to EBIT(DA) the non-operating pension related expenses, such as interest costs and expected return on pension assets. Only the service cost is considered as a genuine operating expense (see section 2.2.5.5 for an example).

2.3.3

Adjusting the earnings numbers for leases

As discussed in section 2.2.6.4, capitalising operating leases does not only impact the balance sheet but also the P&L. Remember that, the total lease expense is added back to EBITDA and EBIT is adjusted by 1⁄3 of leases accounting for the depreciation of assets, and interest expense increased by 2⁄3 of leases.

2.3.4

Deferred taxes and tax losses

2.3.4.1

Marginal tax rate and effective tax rate (ETR)

The statutory tax rate is the marginal tax rate (“MTR”) in the jurisdiction in which the firm operates. Marginal tax rates can be found in the relevant footnotes of the annual report or general accounting reports. KPMG produces a tax rate survey for each country every year which is available on their website. A firm's reported effective tax rate (“ETR”) is simply income tax expense divided by the taxable income. In practise, it is very common that the effective tax rate and statutory tax rate differ. The differences are generally the result of:  Different tax rates across different tax jurisdictions where the company operates  Permanent tax differences: tax credits, tax-exempt income, non-deductible expenses, and tax differences between capital gains and operating income  Changes in tax rates and legislation  Deferred taxes provided on the reinvested earnings of foreign and unconsolidated domestic affiliates  Tax holidays in some countries


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Accounting standards require a disclosure reconciling the difference between reported income tax expense and the amount based on the statutory income tax rate. Example (US company) (%)

Fed Statutory Rate Adj. for Non-tax Paying S&P 500 Companies State Income Taxes Effect of Foreign Taxes

35.0 34.5 1.6 (1.6)

Foreign Sales Corp Benefit of Tax-Exempt Income Benefit of Puerto Rico Operations (and Ireland) Acquisition/Merger Costs Dividend Tax Benefit

(0.1) (0.6) 0.3 0.0 (0.1)

R + D Tax Credits Impairment Charges Change in Valuation Allowance Net Operating Losses not currently benefited

0.0 (0.2) (0.3) (0.1)

Restructuring Charges Amortisation of Goodwill/Intangibles Repatriation of Foreign Earnings Adjustment to Prior Year Tax Liabilities Tax Settlements

(0.0) 0.0 0.0 (0.1) (0.3)

All Other—net Effective Tax Rate

2.3.4.2

(1.8) 32.5

When to use which tax rate?

In the event that you are seeking to normalise net income for certain non-core operations or extraordinary items, you need to be careful to use the correct tax rate. In some instances, it will be possible to find a disclosure of the tax impact of certain items in the notes to the financial accounts. If this is not the case, you should take care to assess the likely tax jurisdiction which the item is subject to in assessing which rate to use and the nature of the item in question. As a rule of thumb, general business expenses can be considered to be subject to the effective tax rate of the business. In the case of extraordinary or one off items, specific tax charges are likely to have been made at the marginal rate, and hence this rate should be used.

2.3.4.3

Timing vs. permanent differences

Taxable profit is computed based on taxation regulations as opposed to accounting policies and hence taxable profit and accounting profit can differ. The difference between taxable profit and accounting profit can be classified into:  Permanent differences  Timing differences Permanent differences:  Differences between taxable profit and accounting profit which DO NOT reverse in subsequent periods. For example, if the tax regulations only allow deductibility of part of a given expense, the disallowed amount would result in permanent difference (e.g. employee stock options)  The impact: as this type of difference does not reverse in subsequent periods, their impact on the amount of tax charged in the P&L of the current period is not measured and accounted for


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Timing differences:  Differences between taxable profit and accounting profit which arise because the period in which some items are included in taxable profit is different to the period in which they are included in accounting profit (e.g. capital allowances versus depreciation for fixed assets)  Note that the total of these items in both accounting profit and taxable profit are ultimately the same, but they occur in different periods  The impact: this type of item will reverse in subsequent periods, but will result in differences in the tax paid in each year

2.3.4.4

What causes deferred tax liabilities

Deferred tax is an accounting item that effectively smoothes the difference between the tax charge expected in the accounts (based on PBT multiplied by the corporate tax rate) and what is actually payable (based on the tax rules). It takes into account differences between when an item is recognised by tax regulations versus accounting policies. A deferred tax difference tends to originate in one period and reverse in a future period (or vice versa). A deferred tax liability (“DTL”) is created when the tax expense on the P&L is greater than taxes payable on the tax return due to temporary differences. These arise from different accounting treatments for tax and financial reporting purposes and are expected to reverse themselves (i.e. they are temporary differences). They result in future cash outflows when taxes are paid. The most common cause of deferred tax is differences between depreciation and the related tax allowance in respect of fixed assets. Other differences include: accruals, prepayments, deferred income etc.

2.3.4.5

What causes deferred tax assets

A deferred tax asset (“DTA”) is created when the tax expense on the P&L is lower than taxes payable on the tax return due to temporary differences. Similar to deferred tax liabilities, deferred tax assets are expected to reverse themselves through future operations and provide tax savings and therefore, are accounted for on the balance sheet. Warranty expenses, tax loss carryforwards and post employment benefits are the most common causes of deferred tax assets. If a company has an expense item (e.g. estimated warranty expense) on its financial statements that is not deductible for tax purposes currently, a deferred tax asset will be created. This represents the future tax savings that will result when the deduction is taken (e.g., when warranty expense is actually paid). Deferred tax assets are adjusted for the probability that they will actually be realised in future periods. This adjustment is made by creating or adjusting a "valuation allowance" on the balance sheet. This item serves to reduce the DTA to reflect the probability that the DTA will not actually be realised in future periods.

2.3.4.6

How do you account for deferred taxes

In the example overleaf, we assume year 1 accounting profit before depreciation of €1,000. Depreciation is €250 whereas the tax equivalent of depreciation amounts to €400. Assuming no other tax/accounting differences and a tax rate of 30%, the expected tax charge is €225 ((€1000 – €250) * 30%) whereas the actual tax charge is lower at €180 ((€1,000 – €400) * 30%). In year 2, assuming profits and depreciation remain at year 1 levels, if the tax allowances are €100 then the actual tax payable of €270 ((€1,000 – €100) * 30%) is now higher than the expected tax charge of €225.


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Example: Year 2

Year 1 €

Profit before depreciation/tax allowance Depreciation/tax allowance Profit after depreciation/tax allowance Tax rate (%) Actual (cash) tax charge Total reported tax charge Deferred tax charge/(gain) Effective tax rate (before deferred tax) (%)

Taxation

Accounting

Taxation

Accounting

1,000 (400) 600

1,000 (250) 750

1,000 (100) 900

1,000 (250) 750

30 180

30 270

180 225 45 24

Effective tax rate (after deferred tax) (%)

270 225 (45) 36

30

30

In year 1 the difference in tax charges relates to the additional tax capital allowances charges (€150*30% = €45) whereas in year 2 the difference is due to the smaller tax capital allowances. Deferred tax tries to ‘smooth’ these timing differences out: in year 1 a deferred tax liability would be made for €45 to increase the actual tax charge up to the expected amount of €225. This reflects a liability on balance sheet as the current favourable tax allowances upfront will be offset by more tax being payable in the future. In year 2 this deferred tax liability is reversed as the timing difference reverses resulting in a reduction in the actual tax charge from €270 to €225. Accounting for deferred tax means that the reported tax charge reflects the tax expected to be payable (albeit not maybe immediately) based on accounting profits. In the above example, without providing for deferred tax, the effective tax rates for years 1 and 2 are 24% (€180/€750) and 36% (€270/€750) respectively. Providing for deferred tax brings these to 30% for both years (€225/€750).

2.3.4.7

What tax losses are, how they are recovered

Tax loss carry forward is the current net taxable loss that can be used to reduce taxable income (and therefore taxes payable) in future years. Companies recognise a deferred tax asset when it expects to realise a future tax benefit from the loss carry forward. If the company believes that, more likely than not, future taxable income will be insufficient to allow realising the full tax benefit, it may decide to offset the gross deferred tax asset by the so-called valuation allowance. The resulting net deferred tax asset on the balance sheet reflects the management’s estimate of the benefit to be realised from the total amount of net operating losses available.

2.3.4.8

Deferred taxes and valuation

Historical operating losses can be a source of value if companies can use these losses to offset future or sometimes past taxable income. Below we set an example in order to understand this better In its 2007 Annual Report, ArcelorMittal discloses the total amount of estimated tax losses carry forwards of US$7,179 million, compared with US$9,019 million as per year end 2006. This amount includes US$2,478 million of losses with set expiry dates whereas the remaining tax loss carry forwards are indefinite. The company measures total deferred tax assets for tax loss carry forwards of US$2,373 million (33% tax rate times the US$7,179 million tax losses). However it only recognises US$1,659 million as deferred tax assets leaving US$714 million as unrecognised deferred tax assets. Example: US$ million

2006 2007 Source:

Gross amount

Total deferred tax assets

Recognised deferred tax assets

Unrecognised deferred tax assets

9,019 7,179

3,079 2,373

2,234 1,659

845 717

ArcelorMittal (annual report 2007)


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The valuation allowance is based on the company’s current view of the level of taxable income of the different entities where the tax losses reside. If the likelihood of the company being able to realise the tax loss carry forward improves, valuation allowance is reversed to reflect the improved likelihood. This reversal increases the total amount of tax losses available to offset future taxable income. In interpreting the amount of recognised deferred tax assets for the purpose of valuation, we recommend using the net number of US$1,659 million for ArcelorMittal instead of the US$2,373 million of gross deferred tax assets. For the purposes of calculating the EV, the value of the deferred tax asset is typically treated separately and added to the EV as a non-core asset. The practical problem is estimating the proper value for the deferred tax asset related to tax loss carry forwards. It theoretically requires estimating the present value of the cash tax benefits as using the book value would overestimate the value as it does not take into account the timing of the cash benefits. Although company disclosure should help in assessing the timing of the tax benefits, it remains a challenging exercise. In addition, it requires estimating the discount rate where opinions vary. Although some people argue that the risk free rate should be used as the cash payment from the government should be seen as risk free, it is accepted that the cost of equity is generally the appropriate discount rate for cash tax benefits, because companies must generate profits after interest cost in order to benefit from tax loss carry forwards. A similar methodology is used when evaluating a company from a transaction point of view. A company that offers buyers significant tax savings later should be worth more than an identical business which does not. Key issues to keep an eye out for are whether these deferred taxes are transferable to the new owners and extent to which ownership changes may affect the realisation of tax deferrals.

2.4

Pro forma adjustments for acquisitions, disposals and other corporate transactions

To the extent that transactions have either taken place since publication of the most recent balance sheet or current or prospective year figures do not include a full year’s impact of the transaction, we need to make certain adjustments to reflect this. Adjustment to balance sheet The balance sheet of the acquirer needs to be adjusted to reflect the assets being acquired and the financing for the transaction. If the transaction has not yet completed it may not be possible to do a pro forma calculation line by line across the balance sheet. In this scenario, EV should simply be adjusted to reflect either the debt taken on or the shares issued to finance the transaction (to the extent not already captured). In the event of a disposal, the EV needs to be adjusted to reflect the proceeds received. Adjustment to the P&L The P&L items need to be adjusted for the acquired/disposed entity. Pro forma full year contribution calculations are the most appropriate way to do this in the transaction year. Ensure that the forecasts you are using have been published subsequent to the date of any such transaction so that they reflect it.

2.5

Some additional consideration for multiples based valuations

Company with abnormally high debt for its sector (we can adjust the process appropriately for abnormally low debt)

Assume a normal level of debt, and adjust interest, taxes and earnings appropriately. Obtain a notional value on this basis and then make an appropriate deduction for the additional debt, including an adjustment for additional debt, including an adjustment for additional risk/operational gearing.

Conglomerate or multi-business group

If the P/E of the different subsidiaries are likely to be very different from each other, it may be best to allocate debt (e.g. on the basis of capital employed) attributable to each of these and value the resultant “post interest” earnings by reference to the appropriate multiples, rather than valuing each subsidiary on a debt free basis and then making an overall deduction for debt.


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2.6

Data sources

2.6.1

Historic financials

Historic financials should be from the latest annual report (full financial section) or quarterly reports. Balance Sheet information can be found in the financial section of latest report, annual or interim report. The same can be obtained from the company website or Stock exchange website (SEC, LSE, etc). Check out www.sec.gov for US companies or www.londonstockexchange.com for UK listed companies. Alternatively, the investor relations section of company websites often include recent filings and can often be the fastest way to access the data. Using analyst research for balance sheet and historic data can often be problematic due to inaccurate or incomplete analysis—company reports should ALWAYS be used.

2.6.2

Forecasts

UBS research For financial forecasts UBS research forecasts can be used and these are available on Research web. For European trading companies, you can request the analyst research model and you can also find most of them on ras (type ras in your browser) and click on Launch Model Viewer (link can be found toward the bottom right of the web page). You should benchmark the UBS research forecasts to consensus estimates (see below) to understand whether our analysts are bullish or bearish relative to the other analysts covering the stock in question. Datastream/Factset (consensus estimates) IBES estimates (a survey of all contributing analysts who cover the stock) can be sourced from DataStream whereas both IBES and Reuters consensus estimates can be pulled from FactSet. More info on both of these databases can be found in the WorkSmarter handbook. Creating consensus estimates Consensus estimates can also be created manually by building a spreadsheet comparing the forecasts of the credible brokers. This can be more reliable than IBES which often includes forecasts from less well-known research houses and/or forecasts which are out of date. Be careful, in case brokers report financials using different reporting methodologies/accounting treatments, so in this case the numbers are not directly comparable and your consensus will not be meaningful.

2.7

How to check efficiently

 Sanity check the output. If a number seems out of line, check it  Compare the multiples at different levels of the balance sheet/P&L against one another. Anomalies should be investigated  Evolution of multiples over the forecast period is a key part of the analysis—check that it makes sense. Usually the multiple should be decreasing over time as the company grows (will not work for companies which are shrinking or undergoing corporate change)  Compare your results with Equity Research or FactSet front company page—make sure you know where any differences comes from  Check with Bloomberg, FactSet, DataStream, other databases and try and reconcile the difference (if any)  Check the output ratios of comps on a rough estimate from Bloomberg or other sources to cross-check data and check if they are in ‘ball park’ (Bloomberg Command: FA11 can be useful)  Check your multiples with sector/market multiples


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2.8

Common errors

 Most UK Companies share prices are quoted in pence and not pounds so be careful when calculating the equity value  Be careful with the units—sometimes balance sheet/notes to the accounts give the information in ‘THOUSANDS’—please divide the figure by 1,000 to get the figures in ‘Millions’ (we input all figures in millions for our company valuation model) – Japanese companies: I/B/E/S estimates given in JP Yen are generally in BILLIONS, please double check and input them accordingly – No. of shares outstanding figures from Datastream are in THOUSANDS  Odd figures in Estimates: e.g. EBIT greater than EBITDA which is not possible. Do not use old figures without double checking the source e.g. the comps file  EV being less than Market cap—might be the case (if cash > debt) but double-check  Consistency between denominator and numerator—calculation of EV should be comparable with the profit measures used in the multiples. For example, if EV includes adjustment for pension liabilities, then EBIT(DA) should also be adjusted  Currency adjustments (some companies have share prices in one currency and report in another)  Calendarisation—ensure you have sufficient forecasts to allow calendarisation of the furthest year out  Classes of shares—include all classes of shares. Use the MSH function on Bloomberg  Options—to be included to get the fully diluted number of shares adjustment based on the Treasury method, assuming shares outstanding are increased by the total shares underlying options net of the number of shares that can be bought back using the proceeds from the options being exercised  Exceptionals—should be excluded from all comparable company analysis  Buyback and share issuance—implied change in NOSH needs to be reflected  Buyback—implied reduction in NOSH needs to be reflected

2.9

Tips for success

 Source and tag all back up to enable auditing  Insert comments in Excel to explain where adjustments made  Use reliable forecasts and if using forecasts from a specific broker, determine where they stand relative to consensus  No formulae hidden in cells. Where additional analysis is required, create a new tab and link  Clean numbers—all P&L items should be adjusted for exceptional items  At the net income level, exceptionals need to be POST TAX (using the marginal tax rate)  Pro forma—P&L items need to be pro forma for transactions


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SECTION 3

Precedent transaction analysis 3

SECTION 3: Precedent transaction analysis

41


Precedent transaction analysis 3.1

Introduction

Precedent transaction analysis is a methodology which compares the multiples implied by selected M&A transactions involving companies displaying similar characteristics to the company under consideration in order to derive an implied transaction value for that company. This analysis is useful as it attempts to quantify the difference between a trading and transaction valuation—often referred to as a control premium.

3.2

Why do we use precedent multiples?

Precedent multiples represent an index of recent market prices paid by other acquirers and accepted by other sellers. The multiples are “real” in the sense that past transactions were successfully completed at certain prices. The mathematical methodology is very similar to the comparable company analysis in Section 2 with the key distinction that precedent transaction multiples are often based on historic or LTM figures while comparable company analysis is forward-looking. The output is also different due to the premium that was paid to gain control of the target company. As a result, precedent transaction multiples tend to be higher than comparable company multiples.

3.3

Premium for control

This represents the theoretical difference between trading and transaction valuations of the equity of the business. It can reflect a combination of:  The fact that the owner of an entire business can manage the assets as it wishes and obtain direct access to the cash flows, whereas a buyer of a minority interest has to rely on the board/management for the cash flow it will obtain (via dividends)  Because of the above, a strategic buyer of a business is able to extract synergies by combining the target business with its own and this has a clear value to the buyer’s shareholders. (How much of the value of these synergies is given to the vendor as part of the purchase price will be a function of the parties’ relative negotiating positions)  Factors that are often not quantifiable in the short term (e.g. the special value to an acquirer obtaining a strategic foothold in a new market), or “defensive” factors such as maintaining market position or eliminating over-capacity in the buyer’s industry  The amount needed to overcome inertia amongst shareholders and to induce them to sell The quantum of the control premium will vary depending on the circumstances of the transaction.  The applicable range of premia to trading multiples should be corroborated by checking precedent transactions. A rough rule of thumb might be that transaction values are 20–50% higher than trading values but they can be much higher or lower so please note: this is only a rule of thumb and needs rigorous testing by comparison both with previous control premia paid in public takeovers (over unaffected share prices) and precedent transaction multiples  Control premia can be significantly affected by economic circumstances (e.g. if a target company is perceived to be trading at a high multiple or is subject to takeover speculation, a buyer is likely to be wary about paying a high premium over the trading values in a transaction)  It is not necessarily the case that there will always be a premium for control over the trading value. An absence of free capital markets, or regulations restricting types of potential acquirers of companies, may all contribute to lower takeover values and control premia. Indeed, in some cases there may be no premium for control over the trading value, or the transaction value may even be lower than the trading value  Some trophy companies may command transaction prices that are particularly high. This is also valid for assets (e.g. hotels that are bought for “pleasure of ownership and not economic rationale”)


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Control premium percentages should be applied to equity values rather than enterprise values. This is because they are derived from observations of the takeover prices of real companies, which usually have at least an element of debt in their capital structure. Another way of looking at the situation is to bear in mind that control is actually exercised by the holders of voting equity rather than the holders of debt, and hence the control premium should only be applied to the value of the formers’ holding.

3.4

Choosing transactions

A database of completed precedent transactions is retained and updated by each sector team—this should always be used as the starting point. Always submit any newly created precedent transactions analyses for inclusion in the database of the relevant sector team. When choosing transactions, the aim is to find deals which have similar businesses and financial characteristics to the transaction being considered. As with the comparable company analysis, financial/operational benchmarking is helpful. In general, it is advisable to consider the following when selecting precedent transactions:  Transactions in the same industry as the target business  Transactions in the relevant geography (e.g. North West Europe, South America)  Transaction background (e.g. strategic vs. financial buyer, domestic vs. cross-border, full auction vs. negotiated deal, underlying market conditions)  Transaction rationale and financial profile of the assets acquired: scale, growth, synergies, diversification  Timing: the more recent the data, the more relevant the benchmark, particularly in cyclical industries  Size of the deal: transactions that are similar in size to the company that is being evaluated are generally more relevant

3.5

Key metrics

Precedent transaction analysis is normally based on historical, not forward looking, data as this is most readily available in the majority of situations. Usually done on an LTM basis, i.e. the last twelve months financials prior to the transaction are used (historical data only)—which means the twelve months prior to the latest quarterly or interim earnings statement, or annual results. However, at the time of the acquisition, the value was, in all likelihood, determined by reference to future profitability and so, whenever this data is available (most commonly where a public company has been acquired and equity research from the time of the acquisition is available) we should show implied forward multiples too. Bear in mind that the forecasts of the buyer and the seller might not be the same. For example, by forecasting a lower EBITDA the seller can claim to have sold for a higher multiple and vice versa for the buyer. Prices paid as a multiple of net earnings and/or operating profit (EBIT or EBITDA) are typically the most useful for a broad range of industrial companies, although as with comparable company analysis, other sector specific multiples should be considered as appropriate. Sector-specific operational multiples (e.g. average room rate, occupancy rate etc) are often used, in particular for transactions involving private companies when financial information is limited.

3.5.1.1

Premium analysis

Premium analysis is usually computed for public transactions to illustrate the price paid relative to the prevailing share price at the time of the deal. The key is to use an “unaffected share price” prior to market rumours, announcement of a possible offer or strategic review. For the most accurate analysis, you need to research the exact date when the rumours surfaced and calculate the premium based on the previous day’s closing share price. This is occasionally impractical (e.g. if analysing a large number of transactions quickly) and so a 1 month or 3 month premium can be used as a proxy. Other common metrics considered are as follows:  Percentage of 1-day trading price, 1-week trading price and 1-month trading price  Percentage of 1-month VWAP price, 3-month VWAP price and 6-month VWAP price  Other points include as percentage of 52 week high and low, broker price targets etc.


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3.5.1.2

Synergies

Synergies are the financial benefits that a company expects to realise from the integration of two businesses. There are four main sources of synergies:  Cost synergies: result from efficiencies created through improved operating practices and greater economies of scale, e.g. consolidated purchasing, SG&A reductions  Revenue synergies: result from ability to generate more revenues through combination of infrastructure or distribution network. Usually very difficult to quantify  Capex synergies: lower investment required per unit of sales  Financial synergies: potentially lower cost of debt due to increased earnings power Cost synergies are normally the simplest to quantify—they are usually announced for most transactions and typically can be found in the press releases/investor presentations. It is key to consider the multiples on a post-synergy basis to demonstrate how the acquiring company may have justified the acquisition price. It is also important to benchmark the level of synergies across transactions (as a percentage of sales or costs) as this can often account for variations.

3.6

Adjustments

Please see section 2 on comparable companies which shows how to factor in various EV adjustments. Consistency is important with all adjustments to ensure that one has a meaningful set of data.

3.7

Link to UBS model

There is a simple precedent model which is already set up and easy to use. The model can be found at: http://nldn1633pap:8257/mandakm/European%20Standard%20Models/Forms/AllItems.htm

3.8

Drawbacks of methodology

 Past transactions are rarely directly comparable either due to company specific factors or the fact that acquisitions occur at different points in the cycle  It is very difficult to obtain full information regarding expected performance of the company and the actual business plan the buyer used at the time of the acquisition  If based on historic financial information for target companies, it will not reflect expected future performance of targets  Public data on past transactions can be incomplete, non-existent or misleading – data in news stories can be misleading and should be cross-checked where possible  Premia paid driven by the circumstances surrounding each deal – nature (e.g. contested, hostile or friendly) – financial buyer vs. strategic buyer – consolidation of sector, scarcity of assets

3.9

Data sources

Finding information on M&A deals can be challenging; as a result it is always a good idea to start with transaction announcement documents from the acquirer and/or the seller. Information on deals involving private companies is often very limited. It is recommended to consult the appropriate sector teams for specific sources.


44


+  Transaction announcement / document

Company

Reliability

 Investor presentations

sources

 Latest annual report and interim report of the target  Dedicated databases: SDC, Dealogic

Third party

 Broker notes issued at the time of the deal

sources

 Press, mergermarket

-

Confidential information (e.g. info memo, UBS models, documents sent by clients) should not be used for sourcing financial information.

3.10


 If a number seems out of line—double check inputs – challenge the financials—the result is only as good as the inputs, so make sure you believe the raw data is accurate  Cross check with company presentation and research notes published at the time of transaction  Cross check with trading comps – multiples tend to be higher reflecting control premia paid – understand why multiple is lower (scale, existing stake, timing, level of financial distress etc)  Pro forma financials for recent acquisitions/disposals

3.11

Common errors

 Options should be calculated based on offer price and not current share price  Accepting the company’s presentation of numbers without checking the notes  Control premia should be applied to equity values only  Watch out for revised synergies figures after deal has closed which can help explain the price paid  Any special dividend paid to the target shareholders should be included in the enterprise value of the deal  Make sure you are using enterprise value and not market value (particularly for private deals)  Watch out for stake acquired and adjust appropriately

3.12

Tips for success

 Always ask the industry/sector team for information before you begin  Important to understand each transaction selected and key drivers for price paid  Do not forget to calendarise data to get LTM financials


45


Transaction multiples—illustrative output LTM enterprise multiples

LTM equity multiples

LTM margins

Equity

Enterprise

EV/sales

EV/EBIT

EV/EBITDA

P/E

P/NAV

EBIT

EBITDA

Target

value (€m)

value (€m)

(x)

(x)

(x)

(x)

(x)

(%)

(%)

15-May-07

HeidelbergCement Hanson

11,641.1

13,264.1

2.20

17.2

12.1

20.1

2.9

12.8

18.2

20-Feb-07

Vulcan Materials

Florida Rock

3,539.8

3,502.1

3.50

14.5

11.7

22.2

3.7

24.2

30.0

02-Mar-06

Hanson

Civil & Marine

362.1

362.1

2.48

na

9.6

na

na

0.0

26.0

21-Mar-03

CRH

SE Johnson

208.7

208.7

0.81

12.2

7.9

12.2

na

6.6

10.3

Median

2.34

14.5

10.6

20.1

3.3

9.7

22.1

Mean

2.25

14.6

10.3

18.2

3.3

10.9

21.1

Date announced Acquirer

Premia paid and synergies analysis—illustrative output Premia paid

LTM

1 day prior (%)

1 month prior (%)

Announced synergies

Synergies as % of target sales

Adj. EV/EBITDA (x)

4.1

33.0

199.9

3.3

10.2

44.9

45.4

38.0

3.8

10.3

Date announced

Acquirer

Target

15-May-07

HeidelbergCement

Hanson

20-Feb-07

Vulcan Materials

Florida Rock

2-Mar-06

Hanson

Civil & Marine

na

na

4.4

3.0

8.6

21-Mar-03

CRH

SE Johnson

na

na

0.0

na

7.9

Median

3.3

9.4

Mean

3.4

9.3

Source:

Where relevant, add columns with operating metrics

Publicly available information


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SECTION 4

Discounted cash flow 4


Discounted cash flow 4.1

Introduction to DCF concepts

4.1.1

What does DCF value represent?

The DCF analysis estimates the net present value of projected cash flows available to the providers of capital to the company being valued. It is a more sophisticated approach than relative multiple valuation, aimed at capturing the intrinsic value of the underlying business. It is particularly suitable for valuations involving:  Predictable cash flows (e.g. utilities, infrastructure projects)  A business with simple operational characteristics (e.g. hotels)  Assets with finite lives (e.g. mines, oil and gas properties, royalty streams)  Projects that will not produce revenues for some time (e.g. construction projects)  Situations where detailed financial information is available for modelling so that we can prepare accurate projections of turnover, operating costs and capital expenditures  An investment which is difficult to value in other ways (e.g. a business with operating losses, a joint venture or a “bolt-on” acquisition where cost savings are an important source of value) A DCF analysis is only as good as the cash flow forecasts on which it is based. If we only have 3 years of public data for example, a DCF can only ever be a crude cross-check. However, if we have a good set of financial forecasts, DCF will become much more important as a valuation tool, particularly if the company fits into one of the categories above. In addition, DCF analysis is a good communication tool as it allows us to understand and model the key drivers that will affect value.

4.1.2

Discounting projections and terminal value

There are two parts to a DCF valuation: the projected cash flows and the terminal value. The terminal value represents the value at the point in time at which the explicit projection period ends, and its derivation is covered in greater detail below. The cash flows for each year and the terminal value should be discounted back to the valuation date using the following formula: Present value = Cash flow / (1+Discount rate)t Where t is the time period in years of the cash flow you are discounting.

SECTION 4: Discounted cash flow

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4.1.3

Defining what to discount

The discount rate and cash flows that should be used are dependent upon the type of DCF valuation you are seeking to undertake. Different DCF approaches can be used as valuation tools. These different methods are essentially equivalent and should result in the same value for equity. When performing a DCF analysis, it is important to consider what is being valued (the enterprise or the equity), and to use cash flows and discount rates which reflect these (i.e. for equity value you look at dividends and the cost of equity, for enterprise value you look at all cash flows and a weighted average cost of debt and equity to reflect all sources of capital). Discounted cash flow valuation

PV of equity cash flows

Dividend discount model

Adjusted present value

PV of enterprise cash flows

Discounted enterprise FCF

Enterprise cash flows  Discounted enterprise free cash flows: the most common DCF technique, based on free cash flows (see below). Discount rate is the weighted average cost of capital (see below). Provides an estimated enterprise value that must be adjusted to identify the implied equity value Equity cash flows  Dividend discount model (“DDM”): a direct equity valuation. Forecast dividends are discounted by the cost of equity. Dividends can be forecasted directly or generated by forecasting earnings and the payout ratio  Adjusted present value (“APV”): modified version of DDM. Focuses on all cash flows that can potentially be distributed to equity holders discounted at the cost of equity – APV calculates the net present value of cash flows assuming 100% equity financing and adds up the present value of benefits/drawbacks of financing (e.g. tax shield) – in cases where the level of gearing changes substantially over time (e.g. if an entity cannot be re-levered at the present time, or construction projects that can sustain very different debt profiles early on), it may be more appropriate to use a discounted equity free cash flow model that calculates cash flows available to equity holders using a detailed schedule deducting the amortisation of existing debt and related service costs from free cash flows and discounting by the cost of equity, thus capturing the change in the debt profile over time Equity cash flow DCF methodologies are discussed further in section 6. The rest of this section focuses on DCF analysis based on enterprise cash flows although the mathematical framework is identical.

4.1.4

Real vs. nominal

It should be noted that the present value of a business should be the same whether real or nominal cash flows are used. The discount rate should be calculated on the same basis in which the cash flows are presented (i.e. real cash flows—use a real discount rate). In practice, nominal values are used in the vast majority of cases. This reduces the need for additional assumptions regarding projected inflation rates.


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4.2

Free cash flow

4.2.1

Definition

A business’ free cash flow represents the cash returns available for distribution to all providers of capital (i.e. debt and equity holders). Free cash flows are calculated as the net cash flow from a business, after capital expenditure, changes in working capital and notional cash tax (but before interest): Less: Add: Less: Less:

EBIT Notional taxes/cash taxes 1 Earnings before interest, after tax Depreciation & amortisation Investment in working capital Capital expenditure Unlevered Free Cash Flow

Alternatively, Add: Add: Less: Less:

Net income 2 Deferred taxes & other non-cash charges (e.g. depreciation, amortisation and deferred taxes) 3 After-tax interest expense Investment in working capital Capital expenditure Unlevered Free Cash Flow

Notes: 1 Notional tax/cash tax is the total tax charge less interest relief at the marginal tax rate. Alternatively you can apply the effective tax rate to taxable income (roughly EBIT less tax losses carried forwards) to reflect the tax charge as if there were no debt 2 Net income before preferred dividends, equity income and minority interest 3 Goodwill amortisation is only deductible for tax purposes under limited circumstances in certain countries

As you can see from the above, tax on EBIT is adjusted for in the free cash flow calculations. It is important that this reflects to the fullest extent possible the actual tax charge on earnings, including the appropriate deductibility of amortisation and depreciation. This is discussed in more detail below. Conventionally, a DCF valuation is undertaken pre-synergies. This theoretically values the whole company, as if it were controlled, and so there is no need to add a control premium. In order to assess the total theoretical value that an acquirer might extract from the business, it may also be appropriate to prepare a DCF including synergies. A purchaser would not be prepared to pay this higher value, as it would be paying away all its synergies, but might be prepared to pay a value incorporating, say, half the synergies assuming the transaction meets a predefined return within an acceptable timeframe.

4.2.2

How to develop cash flow projections

4.2.2.1

Turnover

Turnover should be broken down and modelled at an appropriate level of detail unless the mix is expected to remain stable (e.g. by country, product group, channel of distribution). In general, turnover can be projected by applying the assumed inflation rate and real growth rates, or volumes and unit prices. Research reports, client forecasts and industry surveys should be consulted to develop or confirm projections. The relationships between turnover, market growth and market share should be considered carefully and, if possible, modelled explicitly. It is critical to understand the basis for turnover and margin projections and to assess their reasonableness. Inflation rate assumptions in the market/turnover forecasts must also be checked for consistency with the inflation rate assumptions in the DCF model and discount rate estimation (or make adjustments as appropriate). It is particularly important that the cash flow projections be expressed in (or converted to) the same currency for which the discount rate has been calculated. For example, if you are using a US$ risk free rate as the basis for the WACC, the forecasts must be converted into US$ at appropriate rates (remember that the exchange rate captures the inflation differential between currencies). Generally, it is recommended to use the currency in which company’s cash flows are denominated. SECTION 4: Discounted cash flow

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4.2.2.2

Operating expenses

Projected operating margins should be compared against historic and competitor margins; we have to consider whether the projected margins are reasonable for the market in question. Operating expenses should be broken out by category if possible; determine whether each item is fixed or variable. Depreciation should be considered separately. In many businesses, COGS (cost of goods sold) and SG&A (selling, general and administrative) expenses can be separated easily. Minority interest, provisions, deferred taxes and other non-cash items should be excluded. Corporate overheads should be included.

4.2.2.3

Depreciation and amortisation

When unavailable, depreciation can be estimated from balance sheet data as follows: Plant and equipment (beginning of period) + ½ capital expenditures Average asset life Future values of plant and equipment on balance sheet can be projected by deducting depreciation and asset disposals and adding capital expenditures on plant and equipment. It should be noted that as the business’ markets mature and growth opportunities become more scarce, depreciation and capital expenditure should converge to a 1:1 relationship, reflecting the fact that capital expenditure is being spent to maintain, as opposed to expand, capacity. Over the long term, a common rule of thumb is for capex to be equal to depreciation over the course of the cycle in order to maintain returns. This effectively provides for a constant capital stock. Clearly this will be true in aggregate for a mature industry, but care should be taken to examine the relative prospects of the business being valued within that industry.

4.2.2.4

Cash taxes (notional)

Notional cash taxes are calculated by assuming no interest can be estimated from the P&L by taking the existing tax charge and adding back the notional tax on interest expense at the marginal tax rate. Notional cash taxes can also be calculated as a percentage of EBIT unless the company’s effective cash tax rate differs substantially from the marginal tax rate, but it should be noted that an adjustment should be made for amortisation in jurisdictions where it is not tax deductible (i.e. in most jurisdictions). Amortisation is likely to be particularly significant in US company financial statements, where goodwill has been incurred and is being written off. Taxes should be reviewed carefully if the assumed rate is different from the statutory rate. When modelling cash flows in detail, consider carefully the effects of capital expenditures on taxes—there may be tax credits or tax shelter through accelerated depreciation. At the end of the projection period, make a generous allowance for capital expenditure required to sustain the asset base, particularly if, in the terminal year, capex is below depreciation.

4.2.2.5

Investment in working capital

Can be estimated roughly as a percentage of sales. However, a more detailed, yet still simple, approach separates working capital into its components and calculates their turnover against sales or COGS, usually expressed in days, and calculated as follows: Stock days = Stock / Cost of Goods Sold x 365 Debtor days = Debtors / Sales x 365 Creditor days = Creditors / Cost of Goods Sold x 365


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4.2.2.6

Capital expenditures

Sustaining capital expenditures (i.e. regular replacement of plant and equipment) should be considered as well as specific planned capital expenditures for growth. We should look at long-term average ratios of capital expenditures to sales and capital expenditures as a percentage of fixed assets for the target and competitors. Consider factors which can create specific capital expenditure requirements, for example capacity limits, new technology and environmental compliance.

4.2.2.7

Asset disposals

There may be certain assets that can be sold, either immediately or in the future; e.g. investments, property, excess capacity.

4.2.3

Dealing with affiliate income, minority interests, other income and financial income

Equity income from associates can be problematic. Only dividend income is received—which is likely to be less than the investing company’s share of profits, and the company’s pro-rata share of capital expenditure and debt will not be included in the annual report or prospectus. If associates represent a large proportion of income on value, they should be valued separately and excluded from the DCF analysis. Minority interests should be valued separately as appropriate and deducted from the enterprise value when estimating equity value if they have been added back to net income in calculating free cash flow. Other income and financial income should be included in the firm’s cash flows to the extent that these are core business activities. If this is not the case, or if there is significant variability in these items, they should be excluded from the free cash flows and valued separately.

4.2.4

How to deal with deferred taxes and long-term accruals

Deferred taxes occur for a number of reasons, as explained in Section 2.3.4. For most companies (except for those with very significant or irregular capital expenditure programmes) the deferred tax component of the profit and loss account tax charge is normally relatively small and in practice, subject to a one year deferral in payment, taxes provided in the P&L are often a reasonable estimate of notional cash taxes for DCF valuation purposes. If deferred taxes are large, it will normally be necessary to adjust the P&L tax charge to add back the deferred tax element. All of this is relevant only to “bottom-up” estimates of free cash flows. Accumulated tax losses or tax credits are often valued separately rather than adjusting the projected cash flows. The value of the tax loss or credit then becomes an adjustment to the enterprise value. This approach may not work if the losses or credits are not expected to be recoverable over an extended period. Accruals reflect the difference in timing between when a cost is incurred and the related cash payment is made. These need to be carefully analysed to determine whether this timing difference can be assumed to persist, and if so, the cash flows should be adjusted to ensure the cash payment is properly reflected in free cash flows (assuming they are suitably material).

4.2.5

What to do with loss making or very fast growing subsidiaries and where DCF valuation may be inappropriate

DCF valuations are only as reliable as the data on which they are based. In the case of loss-making or fast-growing subsidiaries where there is a lesser degree of confidence regarding likely future performance additional analysis should be undertaken. Loss making companies which are not likely to achieve profitability in the future should be considered as if they are being wound up; their cash flows excluded from the rest of the business and be valued on the basis of their liquidation value (realisable proceeds net of closure and sale costs). For companies making temporary losses, consider valuing them on the basis of their net assets, with an appropriate adjustment. Alternatively, they may be valued on the basis of a normalised operating margin (based on the industry/sector) to derive a theoretical profitability level, based on turnover/assets. Then amounts for risk and uncertainty should be deducted in achieving those theoretical profitability levels (very subjective) and costs incurred in getting to that stage including losses in the intervening period.


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Fast growing subsidiaries should be valued independently of the rest of the business if possible in order to allow analysis and sensitivity of the growth profile of that subsidiary. This should be benchmarked against other growing companies (past and present) in that sector, and sense-checked in terms of costs of achieving growth and winning market share.

4.2.6

How long to forecast?

In principle, cash flows should be projected until they are expected to stabilise (i.e. grow reasonably in line with inflation or GDP, on normal margins). In practice, a 10-year projection period is common. Projecting for a minimum of five years is recommended. Even if there is a lack of detailed cash flow projections beyond two or three years, reasonable forecasts for the rest of the projection period, based on general growth and margin assumptions, are Iikely to be less subject to error than the terminal value itself. Terminal value estimates are subject to wide variation, depending on the perpetual growth rate assumption for future cash flows; the free cash flows themselves are somewhat less difficult to forecast. Shortening the projection period causes most of the value in the DCF valuation to be in the terminal value. One approach to DCF modelling involves making detailed projections for, say, five years and then projecting free cash flow using a simple growth rate assumption for the next 10 to 15 years; this minimises the effect of errors in estimating the terminal value while making explicit the general nature of forecasts beyond the first few years. Long projection periods are appropriate in special cases. Examples include:  Mines and other finite-life assets, for which cash flow projections should cover the life of the asset (i.e. no terminal value); and  Large projects for which there will be negative cash flows for several years (e.g. Eurotunnel) In these cases, a projection period longer than 10 years would be appropriate. Only certain balance sheet items need to be projected in most cases:  Working capital movements;  Asset disposals; and  Capital expenditures Projecting a balance sheet or P&L statement is not necessary to establish an enterprise value using the DCF method. Only cash flow matters. However, it may be useful to develop balance sheet and P&L projections in order to put the cash flow forecasts into context and to ensure sensible assumptions have been made on capital structure and returns going forward.

4.2.7

How to create sensible assumptions for free cash flows

4.2.7.1

Forecasting cyclical companies

It is important when forecasting cash flows for a cyclical company to include at least one complete cycle. This avoids results that are not representative of the long term value of the company that are caused by only using cash flows during a peak or trough in the cycle. Particular care should be exercised when projecting the terminal value cash flow. This should be representative of average cash flows across the entire cycle to ensure there is no bias one way or the other.

4.2.7.2

Forecasting in different currencies

If a business has only a small proportion of its business in different currencies, it is customary to assume that the cash flows from this business are converted to the valuation currency at a fixed rate. In situations where currency exposures are more significant, it is advisable to separately value the cash flows of the business that are generated in the different currency to allow sensitivities to be run. These cash flows should then be converted at the expected FX rate for each year, from a credible source (e.g. UBS, Economist Intelligence Unit, Global Insight, etc), cross-checked against forward rates.


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4.3

Terminal value

4.3.1

Definitions

Terminal value is an estimate of the value of business at the end of the projection period, which is in turn expected to be the present value of the future cash flows from that point. Conceptually, the firm is being valued on the last day of the last year of the projection period. As with the cashflows during the projection period, the terminal value needs to be discounted back to the valuation date.

4.3.2

How to calculate the value terminal value

There are three common ways to calculate terminal value:  By capitalising free cash flow (as a growing perpetuity);  By applying a multiple; and  By capitalising free cash flow in a formula that explicitly considers the return on newly invested capital from that point onwards in the projection period For the first and last methods, it is necessary to project cash flows for the year after the projection period because the formulas used are for the value of perpetuity.

4.3.2.1

Perpetual growth

The perpetual growth (or Gordon Growth) method calculates terminal value by growing the year t cash flow by a chosen growth rate (often 2%, but which shouldn’t exceed the inflation rate in the relevant country as this implies a continuously growing business in perpetuity). The value of this growth to infinity as at year t, is: FCFt 1 WACC  g

Where “FCFt+1“ is the cash flow in year t+1 and “g” is the perpetual growth rate. This should be discounted back t years to year zero. It is important to show a sensitivity table with different assumptions for WACC and g, given their significant impact on the terminal value, and hence overall value.

4.3.2.2

Multiple

This method assumes that the business trades in the public market or is sold at the end of the projection period. It is often used as a cross-check to the other terminal value methods. For example, it is helpful to know what EV/EBITDA multiple is implied by certain perpetuity assumptions and then to cross-reference this against comparable company benchmarks to check that it is reasonable. When using multiples it is imperative you apply the right one i.e. a current year sales multiple times year 10 sales will give the value at year 10, as will a one year forward multiple times year 11 sales. A current year multiple times year 11 sales gives the value at year 11. Terminal Value = Operating statistic x Multiple If free cash flows are being capitalised, we need to be sure that adequate long-term capex is being provided. Where the operating statistic used can be sales, EBITDA, EBIT, net income, or another measure as appropriate for the industry. We also need to bear in mind that, by the terminal value date, many of the special attributes of a good business may well have been averaged down by competition implying a lower multiple than might be used today.


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4.3.2.3

Value driver

This technique produces the same result as the perpetual growth method; it simply expresses the perpetual growth method in terms of the value drivers: ROCE and growth: Terminal value

=

NOPLATt 1  (1  g / ROCE) WACC  g

Where  NOPLATt+1 = the normalised level of net operating profit less adjusted tax (NOPLAT) in the first year after the explicit forecast period (see section 4.3.8 for detailed calculation of NOPLAT)  g = the expected growth rate in NOPLAT perpetuity  ROCE = the expected rate of return on net new investment This formula is identical to the Gordon growth formula above in the case where ROCE is equal to WACC (practically speaking when the return on new investments only equals the WACC), which could feasibly be the case in mature, competitive markets where opportunities for value-creating investments are no longer available. Hence the Gordon growth formula is used in most cases. If you wish to assume that a company remains able to make incremental investments at above its cost of capital in perpetuity, the above value driver formula can be used. This would be the case where a company is assumed to have a natural advantage over its competition that will not be eroded over time.

4.3.3

Understanding the relationship between growth and investment in the terminal year including the relationship between capital expenditure and depreciation

In a steady state, the capex of a business would be equal to depreciation. At this level, the amount of capex spent is equal to the fall in useful value of its assets, i.e. capacity neither expands nor contracts but is only replaced. If a business expands, it will need to grow its fixed asset base in order to provide capacity for expansion. In this case, the business will spend capex in excess of the cost of maintenance and replacement of existing capacity, hence capex will be greater than depreciation. Vice versa, if a business is contracting, its capex will be lower than its depreciation. In calculating a terminal value, we need to assume that the business has reached a steady state. Therefore we typically assume that capex and depreciation are equal (or at least very close). There will usually be a trend over time to reach this level.

4.3.4

Preparing and checking the steady state cash flow

In calculating the steady state cash flow, you should ensure that any abnormal results are normalised (by using an average over time or simply reversing any identifiable anomalies). This should be done on a line-by-line basis, and the result sense-checked against historic and industry-average growth rates and margins. As per the above, you should ensure that the ratio of capex to depreciation does not imply strong growth or contraction in the business either.

4.3.5

Preparing a steady state year for a cyclical company

The steady state year for a cyclical company should be reflective of the state of the business across an entire business cycle in order to prevent bias. In this respect, growth rates and margins for the terminal year should be based on average levels. Over the cycle historic analysis is often useful to corroborate the assumptions used.


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4.3.6

Sanity checking the amount of value embedded in the terminal value? How much is too much?

The amount of value embedded in the terminal value will be a result of a number of factors, including:  Length of the explicit projection period (longer period will lower proportion of value in terminal value); and  Growth rate in projection period (higher rates will raise proportion of value in terminal value) As such, it is not possible to be precise about the proportion of value in the terminal value, except to say that for a normal business assumed to operate in perpetuity it is likely to be 50–70% depending on the projection period. If it is higher than this, you should extend the projection period and explicitly model a longer time period to try to capture a higher proportion of the projections explicitly and thus improve accuracy.

4.3.7

Understand how to back calculate the implied long-term growth rate if you use an EBITDA multiple for the terminal value

By rearranging the Gordon growth formula, it is possible to derive the implied long term growth rate. This is useful to sanity check the EBITDA multiple which is being used to ensure it appropriately reflects the future prospects of the business at the end of the forecast period. The formula is as follows: Implied growth rate = WACC – (Steady state cash flow/Terminal value (multiple-based))

4.3.8

Example terminal value calculation

Assume that we are valuing a business with the following cash flows in the first year after the projection period (steady state cash flows): (£m)

Turnover Cost of goods sold Gross profit SGA and overheads Operating profit Share of associates EBIT Notional cash taxes (150 x .33) NOPLAT Depreciation & amortisation Capex Investment in NWC FCF Additional capital expenditure to “normalise” FCF Normalised FCF

1,000 (600) 400 (275) 125 25 150 (50) 100 60 (12) (4) 144 (48) 1 96

Note: 1 This adjustment assumes capex is equal to depreciation. The correct figure will depend on the circumstances of the business being modelled


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With a WACC of 10%, an assumed FCF growth rate of 2% and an assumed NOPLAT growth rate of 7%, the terminal value (“TV”) would be as follows under the three methods: 1. Perpetual growth: TV = = =

FCF WACC  g 96 0.10  0.02 1,200

2. From EBIT multiple (say 7x): TV

=

EBIT multiple

=

150 X 7

=

1,050

3. From NOPLAT (assuming r = WACC): TV

=

= =

4.3.9

NOPLAT  (1  g / r) WACC  g

100  (1  0.02 / 0.10) 0.10  0.02 1,000

Link to UBS model

There are both standard long form and short form DCF model templates, which will allow you to link in financial data to automatically calculate and sensitise DCF values. Whilst these are very useful tools, their use and outputs should be considered in the context of the discussion above to ensure that the most logical forecasts and methodology are used. The models can be found at: http://nldn1633pap:8257/mandakm/European%20Standard%20Models/Forms/AllItems.htm

4.4

The discount rate—Weighted Average Cost of Capital (WACC)

4.4.1

Definition

The WACC is a measure of the weighted average after tax cost of all sources of capital to an entity. It can also be thought of as the effective blended rate of return which an entity must pay to capital providers. It is important to remember that in a typical valuation, the WACC is supposed to represent the appropriate long term cost of capital.

4.4.2

Estimating WACC under Capital Asset Pricing Model (CAPM)

Overleaf is the standard page setting out the WACC calculation under CAPM, which is contained within the standard DCF model.


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WACC analysis SUMMARY OF WEIGHTED AVERAGE COST OF CAPITAL CALCULATION—CAPITAL ASSET PRICING MODEL

Market risk premium (%) ¹ 5.50 Cost

Equity risk premium (%) 5.53

of Levered company beta ² 1.01

equity

Levered company cost of equity (%) 9.77 Risk free rate (%) 4.24

3

WACC (%) 8.93 Levered company cost of debt (%) 5.74

Cost

Assumed long-term financing structure 85%

Levered debt premium 150bp

After tax cost of debt (%) 4.13 15%

4

of debt Marginal tax rate (%) 28.0 Notes: 1 Source: UBS Equity Research market risk premium derived from “forward looking” calculation using UBS forecasts across the equity market and spot prices 2 Source: observed levered Beta (Barra - local) relevered based on assumed long term financing structure 3 10-year government benchmark bond yield (Source: Bloomberg, Datastream) 4 Company credit margin at chosen financing structure

The calculations behind this page are set out below: WACC

= =

Weighted cost of debt + weighted cost of equity

D D E

 (Cost of debt"Kd" ) (1- T) 

E DE

 (Cost of equity "Ke")

Where  D = Debt component of capital (at market value)  E = Equity component of capital (at market value)  t = Marginal tax rate

Kd (i.e. net of tax relief)

= (R+m ) x (1– t)

Ke

= R + (p x ß)

Where  R = Risk free rate  m = Interest margin (i.e. the debt risk premium)  p = Equity risk premium  ß = Beta for the assumed long-term gearing


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The risk-free rate (R) can be taken as the yield on the applicable 10-year government bonds. It is important to take a 10 year bond as this captures longer-term WACC. The “debt risk premium” (m) is the premium over the yield on long-term government bonds demanded by the market on the company’s debt. It varies widely according to the credit rating of a company, or underlying credit strength. DCM or GSF may be able to give an indication of the likely premium for individual companies. Alternatively check the yield on recent long term (5 years +) financings of the company in question. You should verify that the all-in cost of debt is correct (i.e. the consistent risk free rate and margin are used). The “equity risk premium” (p) refers to the premium demanded by equity investors on shares that have an “average” degree of market related risk and an “average” level of gearing. For equities on major stock exchanges, it is likely to fall between 4 and 8%. Beta (ß) reflects the sensitivity of the stock to movements in the market. Betas are dependent upon the gearing of a company, and when obtained from Barra, Datastream, Bloomberg and most other sources are “geared betas” which reflect the actual level of gearing for the company concerned (i.e. reflects actual measured co-variance between movement in the stock and the relevant index). Within normal gearing ranges, beta can be adjusted to reflect assumed gearing levels different from the actual gearing level using the following formula: ß geared =

ß ungeared x 1 + (

D

x (1 – t))

E

Betas and equity risk premium data are normally available only for major stock markets. It may still be possible to use this data when the target business is in a different country, although the equity risk premium might be higher for a developing economy or an emerging stock market than for, say, the NYSE or London Stock Exchange (see 4.4.5.2). Consistency of assumptions concerning interest rates, inflation rates, tax rates and the cost of capital is important. The following points should be considered:  The risk-free rate should normally be 2 to 6% above the assumed general long-term rate of inflation  The currency used for projections should be the same as the currency on which WACC is based  The assumptions about capital structure (i.e. proportions of debt and equity) and tax rates should be reviewed carefully if the company will pay little or no tax under those assumptions  If management provide a discount rate, the underlying assumptions should be checked. Is it after-tax? Is it a return on equity or a return on capital? For what currency is it calculated? Is it a hurdle rate?  An after-tax discount rate should be used with after-tax cash flows  Turnover and costs are generally projected as nominal values (i.e. they include inflation). There are some situations in which it is acceptable to discount real cash flows using a “real” discount rate, but using nominal figures (i.e. which include inflation) is usually more accurate, reduces the possibility of confusion and is often simpler  The cost of preference shares is defined as the yield to maturity (based on the net dividend) on the company’s preference shares, with no deduction for corporate tax

4.4.2.1

Is your WACC fully weighted?

When calculating the WACC using the above formula, it is important to ensure that all debt and equity instruments are included. The weightings can then be adjusted accordingly, based on the market value of these securities. Using the book values will not accurately reflect the current capital structure of the company due to the fact that they are based on historic cost. In instances where no market value is available, book values may, however, be the best approximation available. Due to the fact that interest payments are deductible in most jurisdictions (although not all), you should ensure that the WACC reflects the after tax, or effective, cost to the company. Further information regarding the tax rate you should use is set out overleaf. Preference shares should be included in the WACC calculation and in the capital structure weightings if they represent a significant part of the capital structure. Their effective cost should be calculated as the yield to maturity of the outstanding preference shares (potentially based on issuance cost if market values are not available).


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The cost of common equity can be calculated based on the CAPM as calculated above, which can be crosschecked by calculating the implied cost of equity from a dividend discount model (see below). There may be circumstances where it makes sense to use a different WACC in different years, for example, if a tax regime is expected to change.

4.4.3

Which tax rate to use?

4.4.3.1

Taxation in different countries

We should bear in mind the way tax is actually levied by tax authorities. If a UK company buys a US company, it may finance this in part with US$ debt. The debt may be denominated in dollars, but it may be located in the UK (where it will attract relief at UK tax rates against UK profits) or in a US sub-holding company (where it will attract relief at US tax rates). Given all the other simplifying assumptions and simplifications in DCF modelling, it is probably not worth worrying about the implication of this, and we should instead use the marginal tax rate in the target jurisdiction to tax the cash flows. However, we should be aware that, if tax rates differ by a very large amount, this can cause inaccuracies in the context of “value to the purchaser.” Indeed, in some cases, overseas companies may be held in such a way that tax relief is obtained twice (once in the target’s and once in the owner’s jurisdiction). It is possible to deal with such issues in the DCF modelling, and reference should be made to tax treatment in any fairness opinions.

4.4.3.2

Investor vs. Corporate taxes

People sometimes question how the WACC should take account of the differences between corporate and investor tax rates. This question is complicated by:  The dividend payment system in the country in question;  The fact that some investors (e.g. pension funds) are tax exempt; and/or  Different tax rates amongst tax paying investors It is usual practise to ignore the above differences in the WACC calculation, and to allow tax relief at the corporate tax rate for debt, and no tax relief for equity funding. This makes sense if one is looking at the DCF process from the perspective of the acquiring company. After all, it gets tax relief on servicing costs for its borrowings, and does not get any tax relief on servicing costs for its equity (dividends). Other arguments in favour of ignoring the taxes at the shareholder level are:  The part of the WACC calculation that relates to the returns demanded by investors, in order to invest in equity rather than debt, is based on historical data, and is what it is—an average  The measured risk premium is generally computed as the pre-investor tax differential between the risk-free rate and the overall return on equities  The measured risk premium includes the impact on the cost of capital of investor taxes and therefore it would be double counting to apply the effect of the tax again  It is impossible for a public company to choose who will invest in it, e.g. to try to sell its equity only to tax-exempt pension funds or to top-tax rate paying individuals  The cash flows being discounted are after notional corporate taxes but before investor level taxes; therefore the discount rate should also reflect only corporate level taxes

4.4.4

Equity risk premium

The equity risk premium (“p”)—i.e. the difference in returns expected by investors under the CAPM theory from investing in equities, relative to the risk-free rate, has been estimated in several studies. These estimates range from c. 4.0–8.5%. Some have used Treasury bill yields as the risk-free rate; others have used long-term bond yields. For our purposes, we regard long rates as a better measure of the risk-free rate than short rates, since DCF valuations are based on long-term projections. Furthermore, forward-looking measures are strongly preferred due to their more accurate picture of current expectations.


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UBS Equity Research calculates a measure of the forward-looking risk premium, which attempts to capture investor expectations. This implied equity risk premium is derived from a discounted cash flow model, which equates discounted future streams of earnings (cash flows) to prevailing market valuations and is primarily used to assess risk appetite. The equilibrating factor is the discount rate, which is the sum of the risk-free rate and the equity risk premium. Subtracting the long-term bond yield from the discount rate yields the implied equity risk premium. This methodology has drawbacks arising from the fact that consensus forecasts are often incomplete and/or date quickly, particularly in volatile markets, potentially giving rise to anomalous results. As the wide range of estimates suggests, “p” is difficult to estimate, since it is in theory a measure of the Ievel of required—rather than actual—equity returns. Because required returns from equities cannot be easily measured, "p" is often estimated by considering actual stock market returns over a very long period of time, relative to either short-term or long-term government bond yields. Equity returns can be measured either as a geometric mean (i.e. the compound average return over the period) or as an arithmetic mean of the annual returns. There are arguments for both measurement approaches. Similarly, there are arguments both for using short-term and for using long-term rates as the risk-free rate in this calculation; for our purposes, long-term rates are preferable since we are attempting to measure the cost of long-term capital, and as such will be the same as the rate used in calculating the cost of equity.

4.4.5

Beta

Betas are calculated using the following formula: Beta (Stock) = Covariance (Expected stock return, Expected market return) / Standard deviation (Expected market return) Forward looking betas are estimated by Barra, but in the absence of reliable data on expected returns, historic data may be used. This can be downloaded into Excel from information services such as Datastream, and calculated using standard Excel formulae. The betas acquired from most public sources reflect the specific debt/(debt—equity) ratio at the time of measurement. For comparability purposes (e.g. in WACC calculations), we may wish to make use of a beta with a different capital structure. Note that for companies that have some level of debt, levered betas are higher than unlevered betas because leverage amplifies the ups and downs of returns for shareholders for any given level of business risk. Business risk with no leverage is measured by the unlevered beta or asset beta. The equation overleaf sets out how to adjust the beta for leverage:


61


Example: 25 =

D0 =

original debt component of capital (at market value)

75 =

E0 =

original equity component of capital (at market value)

33% =

t=

1.1 =

ß geared =

marginal tax rate the measured, geared volatility of the particular share ß geared

ß ungeared = 1 + (

D

x (1 – t))

E 1.1

= 1 + (

25

x (1 – 33%))

75 =

0.90

This is in line with the idea that lower gearing yields a lower beta (because gearing compounds volatility). Then, assuming the desired gearing was: 40 =

Dt =

“target” debt component of capital (at market value)

60 =

Et =

“target” equity component of capital (at market value)

ß geared = =

ß ungeared x 1 + ( 0.90 x 1 + (

40

D

x (1 – t))

E x (1 – 33%))

60 =

4.4.6

1.30

Capital structure

Given that debt is typically less risky than equity it is usually a cheaper source of financing, particularly when you take into account the tax shield on interest. However, it is not the case that the optimal financing structure is to maximise the debt component as increasing the debt burden increases the financial pressure on the company with a lower ability to service debt and higher volatility in equity returns. As a result, the cost of both debt and equity increase as debt accounts for a greater portion of the capital structure. In practice, the lowest weighted average cost of capital tends to be the point at which a company’s credit rating is just above the investment grade boundary. However, companies often target different capital structures as a result of the need to preserve a very high credit rating (e.g. banks) or a suitability for high leverage (e.g. infrastructure).

4.4.7

WACC reasonability

Changes in the WACC can have a very significant effect on the valuation. It is therefore very important that you check the data used to calculate the WACC, and furthermore, also ensure that it is reasonable from a logical perspective. Factors we should bear in mind in considering the WACC are:  How much debt and equity (at market value) does the company use to finance itself? An all equity financed company should have a higher WACC, because of the absence of tax relief  Are we using a US or UK (or other) risk-free rate?  Are we using a “pure” WACC or one that includes a hurdle rate or one that has been loaded for risk?


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4.4.8

WACC versus purchaser hurdle rate

A DCF with a “normal” WACC calculation produces a theoretical or absolute value for the business. This does not necessarily reflect the purchaser’s hurdle rate of required return (which includes the profit potential required). Thus, a WACC of 13% may produce a DCF value of 100. However, the purchaser may only be prepared to buy the business for 80. This might represent a discount rate of 18%, which is the buyer’s hurdle rate or required IRR.

4.4.9

Link to UBS model

Both the short and long form DCF models contain a template to calculate the WACC in a format that can be used in presentations, and (as per the above link), are available at: http://nldn1633pap:8257/mandakm/European%20Standard%20Models/Forms/AllItems.htm

4.4.10

Dividend discount model as an alternative to CAPM

In addition to CAPM a number of other models exist to calculate the required return on equity. These have been proven to increase the accuracy (reduce the standard deviation) of predictions in the real world, but the effect is relatively small, and by introducing additional complexity the potential for errors in calculation grows. As such, CAPM is generally used in the financial services industry as a relatively simple but accurate model. Of the remaining methods of estimation, a dividend discount model is most commonly used as a cross-check for CAPM. Further information on this is included in section 6. To calculate the cost of equity from a dividend discount model, you will need to model the expected future dividends of the business. Then, taking the current share price of the company, you can calculate the IRR that is implied by this price and the future cash flows. This IRR is the implied cost of equity. This method does however rely on dividend estimates being in line with market expectations and as a result can produce inaccurate results.

4.5

How to discount

4.5.1

Understanding the financial maths for discounting

Discounting is performed via rearranging the formula used to calculate future values given a set rate of return (as you would use to calculate your own bank interest), which is: FVt= PV x (1+r) t

Where r is the WACC and t is the time period of the cash flow being discounted (i.e. year 1, year 2 etc) Rearranging, the formula to discount a future value is: PV = FVt / (1+r) t

4.5.2

Impact of seasonality

Where cash flows are assumed to fall on average in the middle of a year (as is the case with most companies with steady sales), but reported at the end of a year, the time factor (“t”) for the first year’s cash flow should reflect this fact, i.e. the first year will be discounted by: PV = FV / (1+r) 0.5 All future years’ cash flows will also be considered to fall mid-year, so the timing factors will be 1.5, 2.5, 3.5 and so on. Where a business is highly seasonal (e.g. garden furniture that is mostly sold in spring), the time factor should be adjusted. For instance if we assume cash flows are received on average at the end of March, the discount factors would be 0.25, 1.25, 2.25, etc.


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4.5.3

Discounting to a specific deal date

If we are discounting to a June valuation date, we assume the cash flows fall on average at the end of September and financials are reported annually, we need to adjust for these timing factors.  The buyer will not get the benefit of any cash flows that have occurred prior to June, so these should be excluded entirely  The time factor for the first year and subsequent years will need to reflect the fact that we are only three months (or 25% of a year) away from receiving the first cash flow (i.e. June to September), so would be 0.25, increasing by one for each year thereafter based on the entire reported cash flow for each subsequent year

4.6

Additional things that you need to know for a DCF

4.6.1

DCF when a purchaser is buying a dissimilar business

Consider a utility (low beta) buying a large housebuilder (high beta). Whose WACC input (debt margin, gearing, beta) should we use? It is sometimes tempting to use those of the utility. This would help establish a higher value for the housebuilder, because the WACC discount rate would be lower. What would actually happen, however, is that some of the value in the utility would therefore be transferred into the housebuilder. In other words, the acquisition would reduce the value of the utility’s other businesses. It seems also wrong to evaluate the housebuilder by reference to the average WACC inputs of the enlarged group. This is because one would again be flattering the value of the target, while ignoring the loss of value of the purchaser. The position is analogous to what happens with P/E ratios. If a large company has a P/E of 20x, it can probably issue shares to buy a small lower quality business with a P/E of 10x without upsetting its own P/E. The technical increase in EPS might even result in the price of the enlarged group’s shares going up (because the market might still rate the enlarged business on a multiple of 20x). If, however, the two businesses were of roughly equal size, the P/E of the enlarged business would probably trend to the average of 15x. If we value the target at a multiple higher than 10x, there will be value transfer from acquirer to target shareholders as the equity market will not value the enlarged business more highly simply by virtue of the acquirer paying a high price. By analogy, the correct way of doing DCF valuations of target businesses is normally by reference to  The target’s debt margin (over the risk-free rate);  The target’s gearing assuming a “normal” capital structure for its sector (this has to be done by reference to market, not book values); and  The target’s beta Management may feel they can afford to pay more (or less) because of hurdle rate requirements, technical, strategic or other unsystematic risk-type reasons (to the extent not built into the cash flows) but that should be a separate evaluation. If we “pollute” the DCF valuation by including attributes in the WACC calculation (such as gearing, cost of capital etc) particular to the purchaser, we are probably mixing up the concepts of “theoretical” or “absolute” value and value to a particular purchaser. This is not to say, however, that we should ignore the attributes of the purchaser. For example, the target company and sector may typically operate on a debt/equity ratio (at market values) of 50 % while the purchaser may, for reasons of temperament, only be prepared to operate at a lower gearing level, e.g. 20 %. This would push up the WACC the buyer applies (because there is no tax shelter on the higher equity ingredient of the buyer’s financing)—this is in effect a voluntary additional hurdle imposed by the buyer, limiting the buyer’s willingness to pay high prices. It is probably best, however, to make this point explicit, rather than implicit, by summarising the results of the valuation as: Initial DCF value Less: amount to take into account purchaser’s preferred gearing Value to purchaser

100 (10) 90 SECTION 4: Discounted cash flow

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4.6.2

Adjustments from enterprise value to calculate equity value

When undertaking a DCF using the WACC and free cash flows, you will arrive at an answer that values the entire business, or the enterprise value. As with comparable company and precedents analysis, if you then wish to derive an equity value you will need to adjust for certain items (e.g. net debt, pensions etc). This should be undertaken in an identical fashion to that explained in Section 2.2.

4.6.3

Understanding where to incorporate the value of financial investments and loss making/very fast growing subsidiaries

As described in section 4.2.5, it is sometimes appropriate for these items to be removed from the core cash flows used in the DCF and valued separately. If this is the case, it is important to add these value items to the enterprise value derived for the core operations to ensure any additional realisable value is recognised.

4.6.4

Multiple scenarios/sensitivity analyses

As is evident from the model outputs shown below, sensitivity analyses are one of the key outputs from a DCF model. Given the high dependence the overall value has on the value of the WACC and terminal growth/exit multiples, it is essential to ensure that the impacts of changes in these items are properly identified. Additionally it is useful to incorporate, at a minimum, sensitivities for the future growth and margins of a business in the projected period to demonstrate the effects of increased or lessened competition. The overall level of sensitivity analysis you perform should be dependent upon the predictability of the forecasts and the availability of information. Clearly, you would undertake significantly more sensitivities for a cyclical consumer goods company than a utility with regulated prices and predictable demand.

4.6.5

Difference in value between terminal value methodologies

It is common for there to be differences between the valuations derived by the perpetual growth and multiple-based DCF valuations. As shown in Section 4.3.8 above, under certain circumstances these should be equivalent. Differences between these valuations can occur for a number of reasons, most commonly due to the use of a multiple that does not adequately effect the expected reduction in value over time as competitive advantages that currently exist disappear (thus reducing the future growth of the business and hence its multiple). You should ensure that you are able to explain the differences between the results of both methodologies ahead of presenting the results of a DCF and in particular to cross-reference (i.e. understand the terminal multiple implied by a particular PGR and vice versa).

4.6.6

Using a reverse DCF to imply market assumptions

Reverse DCF analysis is a useful tool to impute the long term growth rate and/or WACC that the equity market currently applies to a listed company. It is undertaken by calculating the terminal value assumptions implied by the current market capitalisation of the company. 10.50

10.25

WACC (%)

10.00

9.75

9.50

9.25

9.00 1.5

1.6

1.7

1.8

1.9

2

2.1

2.2

2.3

2.4

2.5

Perpetual growth rate (%) Value @ 50p

Value @ 45p


65


4.6.7

Reconciliation with results of other valuation methods

DCF valuations reflect the fundamentals of a company. It is rare, however, for a company to trade at its DCF value. This is in part due to subjectivity in developing long term projections due to imperfect information, but is also due to the fact that there are often risks associated with businesses that are not wholly accounted for in the WACC and cash flows (e.g., probability of realising synergies, impact of potential management changes etc). As a result, the implied discount rate for a company given to it by the market may be higher than that strictly implied by its DCF. You should ensure that you are able to provide suitable reasons for any differences between methodologies before presenting your results (e.g. company’s projections are higher than the market expects etc).

4.6.8

Difficult situations

4.6.8.1

International investments and country risk

Given that exchange rates take into account interest rate differentials, purchasers considering an offshore acquisition need to factor this in when selecting which FX and WACC to use when evaluating such a transaction. There are two possible approaches to this issue. The first approach, and most common in practice, is to discount the foreign currency cash flow using the relevant offshore discount rate and then convert the resulting valuation into local currency at the spot exchange rate. An alternative is to convert foreign currency future cash flows into local currency at the forward rates in the market and discount the resulting local currency cashflows with a local currency WACC. The forward FX rate will reflect the interest rate differential between the two currencies and reach a comparable result to the above.

4.6.8.2

Developing markets

The risk of investing in the market in question is captured using local measures for the following:  Risk free rate;  Equity risk premium; and  Debt risk premium (unless the DCF valuation is for acquisition purposes in which case it can make more sense to add the acquirer’s credit spread to the local risk free rate) As a result, the discount rate for an emerging market WACC can be very high as seen in the below example: Indonesian subsidiary as at May 2009 Rate Source

US risk free rate Country risk premium

2.7% 10 year US treasury (Datastream) 7.2% Difference between 10Yr US$ denominated Indonesian and US Govt Bonds (Datastream)

Risk free rate

9.9%

Market risk premium Levered beta

5.8% Deutsche Bank Research report 0.60 Average unlevered beta of peers from Barra, adjusted for leverage

Cost of equity Parent cost of debt Country risk premium

13.4% 7.4% 250bps above 10 yr US treasuries (DCM) 7.2% Difference between 10Yr US$ denominated Indonesian and US Govt Bonds (Datastream)

Pre-tax cost of debt

14.6%

Marginal tax rate

28.0% KPMG Tax Rate Survey 2008

Post-tax cost of debt

10.5%

Debt/(debt + equity) WACC

30%

Assumed long term leverage

11.2%


66


There is some debate around whether to include an additional country equity risk premium in the cost of equity. As in the example above, it can be argued that this is already captured in the risk free rate and that there is no fundamental reason why an investor in emerging market equities requires a greater spread over the relevant risk free rate than an investor in, say, Western Europe. If local data is not available, it is possible to add a country risk premium on top of an established (e.g. UK/US) risk free rate and market risk premium for a benchmark country. Estimates for this are relatively scarce, but estimates from Aswath Damodaran, a recognised finance professor are often used (see: http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/ctryprem.html), as are Bloomberg estimates (type “CRP”). In the event that a country risk premium is not available either, you should estimate the equity risk premium by benchmarking against other countries for which data is available based on economic characteristics.

4.7


The most significant challenge in undertaking DCF analysis is the requirement to have long term financial forecasts. Whilst in many cases companies diligently forecast their financials over an extended time period, many companies prefer to only forecast in the required level of detail for a relatively short time period. This necessitates the use of a number of assumptions in order to perform a DCF. Additionally, you should bear in mind that the forecasts used may have been prepared for a different purpose (e.g. to set challenging budgets for managers), and therefore may be skewed. DCFs are also very sensitive to the WACC, perpetual growth and exit multiple assumptions used. As a result, any errors in these numbers are greatly magnified in the final valuation, requiring great care to be taken. The CAPM is an equilibrium-based model that assumes that all investors are value maximisers, who look for the optimal trade-off between risks and returns. They are price takers in an environment of perfect information where the markets are perfectly efficient and all participants can borrow and lend as much as they like at the same rate in order to hold identically composed portfolios of the most attractive combination of assets in the market. Clearly this case is never observed in reality in the presence of funding constraints, imperfect availability of information and differing investment strategies and outlooks. Despite this the CAPM has been proven to be reasonably accurate in practice in academic studies for relatively liquid markets (e.g. major worldwide stock exchanges), and remains the most widely used method for predicting asset prices.

4.8

Data sources

4.8.1

Market risk premia

The most commonly used source of market risk premia is UBS Equity research, a link to which can be found on the Global Equity Strategy page (http://clientportal.swissbank.com/portal/index.htm?page=eqrschstratsectorstrategy). Alternatively, the historical implied premia can be taken from Bloomberg (type “ERP”).

4.8.2

Betas

Barra betas are commonly used. The latest Barra betas are continuously updated and can be found on the UBS shared drive, under: \\ldnroot\data\IBD\APPLICATIONS\APPS\Barra\. Barra betas are the preferred source for betas as they are based on forward looking information from Barra’s equity model and are unlevered. Alternatively, betas are available from Bloomberg under the security description for equity instruments, or by typing BETA. Two types are available—the raw beta, based on historical prices, not adjusted for dividends, etc, or the adjusted beta, calculated as (0.67 x raw beta) + (0.33 x 1). This calculation is intended to give an estimation of future expected beta. Bloomberg betas are levered betas and hence should be unlevered based on current leverage and relevered using the assumed long term capital structure. Betas are also available from Datastream (data type: BETA), based on historic stock price data over the previous 2.5 years and adjusted for outlying data. These are levered betas and hence should also be adjusted as per the above. Consider reviewing the R2 values for your betas. Low R2 values indicate little correlation and hence near meaningless beta results. These are available on the Beta screen in Bloomberg, or can be calculated in Excel if using a manual regression of historic market and share price data.


67


4.9


Whilst important to check all aspects of any valuation, the key aspects of a DCF should be checked in detail, being:  Financial profile—are the long term projections realistic?  Terminal year—are capex and depreciation in line, is the growth and margin reflective of the long term?  Beta—is this reflective of long-term beta for the industry?  WACC—have comparable companies been used for benchmarking, and are the risk free rates and market premia sensible?  Do the multiple and perpetual growth methods produce similar outcomes? If not, why not?

4.10

Common errors

 Not adjusting the terminal year cash flow appropriately  Incorrectly calculating the discount factor due to wrong timing (i.e. year end vs. mid year)  Over-optimism in forecasts  Terminal multiple—based on current multiple with no erosion to valuation over time  Cost of Equity—use of unadjusted betas where significant differences in capital structure or markets exist  Incorrect input of financial data from operating models  Incorrect source for risk free rate or market risk premia (cross-check sources against each other for accuracy)

4.11

Tips for success

 Sense check the output—don’t assume you have finished once you have completed the inputs  Always reconcile the different results (from different TV methodologies) to each other and other methodologies—be prepared to reconcile any differences  Challenge the financials—the result is only as good as the inputs, so make sure you believe the raw data is accurate and appropriate for the business  Present appropriate sensitivities—e.g. provide profitability sensitivities for unpredictable businesses  Source every assumption clearly and check multiple sources  If the company is covered by UBS Research, request the valuation model to sense check the output

4.12

Example of UBS model

The following pages show a selection of outputs from the standard UBS DCF model, which has been set up to provide presentations-ready print-outs. Please note in particular the sensitivities page presented. You will be able to see the significant impact that only a small change in the key WACC, perpetual growth rate or exit multiple assumptions has on the overall valuation. This page also reconciles the resulting valuations to EBITDA multiples, allowing the results to be sense checked against other valuation methods.


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Free cash flows—Base case Free cash flows

Stub '09E 2009E -3.4 mths

(March y/e GBPm) EBIT Pre-tax net EBIT synergies Effective cash tax rate (%) – notional tax on EBIT NOPLAT

+ Depreciation and intangible amortisation – Capex (including acquisition of intangibles) – Increase/(decrease) in net working capital – Increase/(decrease) in other LT assets +/– Net adjustments Unlevered Free cash flow

2010E

2011E

2012E

2013E

2014E

2015E

2016E

2017E

2018E

392 0 28% (110) 282

(113) 0 28% 0 (113)

411 0 28% (115) 296

451 0 28% (126) 324

491 0 28% (138) 354

511 0 28% (143) 368

529 0 28% (148) 381

545 0 28% (152) 392

561 0 28% (157) 404

578 0 28% (162) 416

595 0 28% (167) 429

119 (214) (11) (10) 0

(34) 61 3 3 0

123 (182) (7) (8) 0

128 (162) (7) (6) 0

132 (148) (7) (4) 0

136 (148) (7) (2) 0

140 (158) (6) (2) 0

143 (156) (5) (2) 0

147 (160) (5) (2) 0

150 (158) (6) (2) 0

154 (162) (6) (2) 0

167

(79)

223

277

327

347

355

372

384

400

413

50% (0.1)

50% 0.2

50% 1.2

50% 2.2

50% 3.2

50% 4.2

50% 5.2

50% 6.2

50% 7.2

50% 8.2

101.2% (80)

98.2% 219

90.2% 249

82.8% 271

76.0% 264

69.7% 247

64.0% 238

58.8% 226

53.9% 216

49.5% 205

Cash flow weighting Years to discount Discount factor PV of FCF Sum of PV of FCFs

2,054



4

Terminal value—Base case DCF VALUATION (GBPm) Terminal value Terminal value as % of EV

NORMALISATION ADJUSTMENTS TO YEAR 10 CASH FLOW Perpetual EBITDA growth multiple 6,111 5,993 59.6% 59.1%

Implied EBITDA multiple (x) Implied perpetual growth rate (%)

8.2x 2.0%

8.0x 1.9%

Present value: Years 1-10 Free cash flows Terminal value Enterprise value

2,054 3,027 5,081

2,054 2,968 5,023

0 0 (500) 0 0 4,581 15.27

0 0 (500) 0 0 4,523 15.08

53%

51% 8.9% 2.0% 8.0x

Enterprise value to equity value bridge Associates Net non-core assets Net (debt)/cash Minority interest Pension deficit Equity value

Equity value per share (GBP) Upside/(downside) to current (%)

ENTERPRISE VALUE COMPONENTS—PERPETUAL GROWTH PV of Yrs 1-10 Cash Flow 40.4% Terminal Value 59.6% Terminal Value 60%

Normalised Adj. 2018E 0 595 24.0% 0 (167) 0 429 0 154 0 (162) 105.0% 0 (6) 0 0 0 416

TV (Yr 11) 607 (170) 437 157 (165) (6) 0 423

IMPLIED ENTRY AND EXIT MULTIPLES

KEY ASSUMPTIONS WACC (%) Perpetual growth rate (%) Exit EBITDA multiple (based on 2018E EBITDA) (x)

As stated (March y/e GBPm) 2018E EBIT 595 margin (%) 24.0% – notional tax on EBIT (167) NOPLAT 429 + Depreciation and intangible amortisation 154 – Capex (incl. acquisition of intangibles) (162) as % of depreciation (%) 105.0% – Increase/(decrease) in net working capital (6) +/– Net adjustments 0 Free cash flow 416

PV of Yrs 1-10 Cash Flows 40%

Perpetual EBITDA growth multiple EV/EBITDA (x) 2009E 2010E

9.9x 9.5x

9.8x 9.4x

EV/EBIT (x) 2009E 2010E

13.0x 12.4x

12.8x 12.2x

Implied exit multiples (x) 2018E EBITDA 2018E EBIT

8.2x 10.3x

8.0x 10.1x

ENTERPRISE VALUE COMPONENTS—EBITDA MULTIPLE PV of Yrs 1 40.9% 59.1% Terminal V Terminal Value 59%

PV of Yrs 1-10 Cash Flows 41%



5


69


Perpetual growth rate sensitivities—Base case & WACC of 8.9% ENTERPRISE VALUE (GBPm)

IMPLIED SHARE PRICE (GBP)

5,081.0 7.9 8.4 8.9 9.4 9.9

1.0 5,370 4,998 4,673 4,387 4,134

Perpetual growth rate (%) 1.5 2.0 2.5 5,639 5,953 6,325 5,223 5,483 5,787 4,863 5,081 5,332 4,549 4,733 4,944 4,273 4,430 4,608

3.0 6,772 6,147 5,626 5,187 4,812

WACC (%)

WACC (%)

SENSITIVITY TO PERPETUAL GROWTH RATE AND WACC

5,081.0 7.9 8.4 8.9 9.4 9.9

1.0 16.23 14.99 13.91 12.96 12.11

Perpetual growth rate (%) 1.5 2.0 2.5 17.13 18.18 19.42 15.74 16.61 17.62 14.54 15.27 16.11 13.50 14.11 14.81 12.58 13.10 13.69

3.0 20.91 18.82 17.09 15.62 14.37

5,081.0 7.9 8.4 8.9 9.4 9.9

(2.0) 14.74 13.50 12.44 11.52 10.72

Change in Sales growth (%) (1.0) 0.0 1.0 16.39 18.18 20.11 15.00 16.61 18.35 13.80 15.27 16.86 12.77 14.11 15.56 11.87 13.10 14.43

2.0 22.19 20.24 18.57 17.13 15.87

5,081.0 7.9 8.4 8.9 9.4 9.9

(2.0) 16.43 15.00 13.77 12.72 11.79

Change in EBITDA margin (%) (1.0) 0.0 1.0 17.30 18.18 19.05 15.80 16.61 17.42 14.52 15.27 16.02 13.41 14.11 14.81 12.45 13.10 13.75

2.0 19.92 18.22 16.77 15.51 14.41

5,081.0 7.9 8.4 8.9 9.4 9.9

Change in NWC as % of sales (%) (5.0) (2.5) 0.0 2.5 18.29 18.23 18.18 18.12 16.71 16.66 16.61 16.56 15.36 15.31 15.27 15.23 14.19 14.15 14.11 14.07 13.17 13.13 13.10 13.07

5.0 18.06 16.51 15.18 14.04 13.03

5,081.0 7.9 8.4 8.9 9.4 9.9

Change in Capex as % of sales (%) (1.0) (0.5) 0.0 0.5 18.64 18.41 18.18 17.95 17.06 16.84 16.61 16.38 15.71 15.49 15.27 15.05 14.55 14.33 14.11 13.89 13.53 13.31 13.10 12.89

1.0 17.72 16.16 14.83 13.68 12.67

5,081.0 7.9 8.4 8.9 9.4 9.9

(2.0) 4,922 4,551 4,233 3,957 3,716

Change in Sales growth (%) (1.0) 0.0 1.0 5,417 5,953 6,532 4,999 5,483 6,006 4,641 5,081 5,557 4,331 4,733 5,169 4,060 4,430 4,830

2.0 7,157 6,571 6,070 5,638 5,261

WACC (%)

WACC (%)

SENSITIVITY TO SALES GROWTH RATE AND WACC

5,081.0 7.9 8.4 8.9 9.4 9.9

(2.0) 5,429 4,999 4,632 4,315 4,037

Change in EBITDA margin (%) (1.0) 0.0 1.0 5,691 5,953 6,215 5,241 5,483 5,725 4,857 5,081 5,305 4,524 4,733 4,943 4,234 4,430 4,626

2.0 6,477 5,966 5,530 5,152 4,823

WACC (%)

WACC (%)

SENSITIVITY TO EBITDA MARGIN AND WACC

5,081.0 7.9 8.4 8.9 9.4 9.9

Change in NWC as % of sales (%) (5.0) (2.5) 0.0 2.5 5,987 5,970 5,953 5,936 5,512 5,498 5,483 5,468 5,107 5,094 5,081 5,068 4,756 4,745 4,733 4,722 4,450 4,440 4,430 4,420

5.0 5,919 5,453 5,055 4,711 4,410

WACC (%)

WACC (%)

SENSITIVITY TO NET WORKING CAPITAL AND WACC

5,081.0 7.9 8.4 8.9 9.4 9.9

Change in Capex as % of sales (%) (1.0) (0.5) 0.0 0.5 6,091 6,022 5,953 5,884 5,618 5,551 5,483 5,415 5,214 5,147 5,081 5,015 4,864 4,799 4,733 4,668 4,558 4,494 4,430 4,366

1.0 5,815 5,348 4,948 4,603 4,302

WACC (%)

WACC (%)

SENSITIVITY TO CAPEX AND WACC



6

Perpetual growth rate sensitivities—Base case ENTERPRISE VALUE SENSITIVITY — 2.0% perpetual growth rate, 8.9% WACC 5,081

Base case - DCF valuation

Sales growth (+/- 1%)

5,557

4,641

EBITDA margin (+/- 1%)

5,305

4,857

WACC (+/- 0.5%)

4,733

Perpetual growth rate (+/- 0.5%)

4,863 (0)

1,000

2,000

3,000

4,000

5,483

5,332

5,000

6,000

Enterprise value (GBPm)

IMPLIED SHARE PRICE SENSITIVITY — 2.0% perpetual growth rate, 8.9% WACC Base case - DCF valuation

15.27

Sales growth (+/- 1%)

13.80

14.52

EBITDA margin (+/- 1%)

16.02

14.11

WACC (+/- 0.5%)

14.54

Perpetual growth rate (+/- 0.5%) 0.00

16.86

2.00

4.00

6.00

8.00

10.00

12.00

14.00

16.61

16.11

16.00

18.00

20.00

Share price (GBP)



8


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WACC analysis SUMMARY OF WEIGHTED AVERAGE COST OF CAPITAL CALCULATION—CAPITAL ASSET PRICING MODEL

Market risk premium (%) ¹ 5.50 Cost

Equity risk premium (%) 5.53

of Levered company beta ² 1.01

equity

Levered company cost of equity (%) 9.77 Risk free rate (%) 4.24

3

WACC (%) 8.93 Levered company cost of debt (%) 5.74

Cost

Assumed long-term financing structure 85%

Levered debt premium 150bp

After tax cost of debt (%) 4.13 15%

4

of debt Marginal tax rate (%) 28.0 Notes: 1 Source: UBS Equity Research market risk premium derived from “forward looking” calculation using UBS forecasts across the equity market and spot prices 2 Source: observed levered Beta (Barra - local) relevered based on assumed long term financing structure 3 10-year government benchmark bond yield (Source: Bloomberg, Datastream) 4 Company credit margin at chosen financing structure

Beta analysis Beta methodology

Company data 1.0

Equity Currency (LCm)1 Company Corleone GBP 3,000 [Company 1] [GBP] 1,000 [Company 2] [GBP] 1,000 [Company 3] [GBP] 1,000 [Company 4] [GBP] 1,000 [Company 5] [GBP] 1,000 [Company 6] [GBP] 1,000 [Company 7] [GBP] 1,000 Mean (excluding Corleone) Median (excluding Corleone) Corleone (selected unlevered Beta)

Marginal Debt tax rate (LCm) (%) 500 2 28.0 500 30.0 500 30.0 500 30.0 500 30.0 500 30.0 500 30.0 500 30.0

Capital structure Levered beta D/E D/(D+E) Barra - local Bloomberg Datastream (%) (%) predicted (x) (x) (x) 16.7 14.3 1.00 2.00 3.00 50.0 33.3 1.00 2.00 3.00 50.0 33.3 1.00 2.00 3.00 50.0 33.3 1.00 2.00 3.00 50.0 33.3 1.00 2.00 3.00 50.0 33.3 1.00 2.00 3.00 50.0 33.3 1.00 2.00 3.00 50.0 33.3 1.00 2.00 3.00 50.0 33.3 1.00 2.00 3.00 50.0 33.3 1.00 2.00 3.00

Source Selected (x) (x) Barra - local 1.00 Barra - local 1.00 Barra - local 1.00 Barra - local 1.00 Barra - local 1.00 Barra - local 1.00 Barra - local 1.00 Barra - local 1.00 1.00 1.00

Unlevd. beta (x) 0.89 0.74 0.74 0.74 0.74 0.74 0.74 0.74 0.74 0.74 0.89

WACC—SENSITIVITY ANALYSIS Capital structure D/E D/(D+E) (%) (%)

Relevered beta (x)

Cost of equity (%)

Cost of debt Pre-tax (%)

Post-tax (%)

Cost of capital (%)

17.6

15.0

1.01

9.77

5.74

4.13

8.93

0.0 10.0 20.0 30.0 40.0 50.0 60.0 70.0 80.0 90.0 100.0

0.0 9.1 16.7 23.1 28.6 33.3 37.5 41.2 44.4 47.4 50.0

0.89 0.96 1.02 1.09 1.15 1.21 1.28 1.34 1.41 1.47 1.54

9.15 9.50 9.86 10.21 10.56 10.92 11.27 11.62 11.98 12.33 12.68

5.74 5.74 5.74 5.74 5.74 5.74 5.74 5.74 5.74 5.74 5.74

4.13 4.13 4.13 4.13 4.13 4.13 4.13 4.13 4.13 4.13 4.13

9.15 9.01 8.90 8.81 8.73 8.65 8.59 8.54 8.49 8.45 8.41

Notes: 1 Market cap as of [•] 2 Latest reported net debt as of [•]



17


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SECTION 5

Leveraged buy-out (LBO) 5


Leveraged buy-out (LBO) 5.1

Overview

5.1.1

What is a LBO

A leveraged buy-out (LBO) is the acquisition of a target company by a financial investor (typically led by a private equity firm, “financial sponsor” or “sponsor”), which may include the target’s own management. The investor group acquires control of the target, financing its acquisition with a minimal amount of equity capital. Hence the primary financing source is typically debt capital. The assets of the acquired company are used as collateral for the debt.

5.1.2

What does a LBO valuation represent?

A LBO valuation represents the maximum price which a financial investor could pay for an asset, whilst achieving an adequate return (usually assumed to be approximately 20–30% per annum, the range being determined by the nature of the asset and market conditions). It is highly dependent upon the assumed capital structure of the target company post acquisition as well as long term valuation trends. In competitive auctions, it is often used to determine the expected realisable value for a financial investor that any strategic bidder will have to exceed in order to win. It should be noted that a stand-alone LBO will not reflect strategic sale value because it excludes synergies available to an industrial acquirer and is measured on a financial return criteria rather than capturing any strategic value premium. Generally, given that a LBO valuation would not normally include synergies as the target remains a stand-alone entity, and would involve quite high required returns for the providers of equity (albeit levered), one would expect the resulting valuation to be lower than a DCF valuation for the business.

5.1.3

Role of leverage

The goal of a LBO is to use the future cash flows of the target to finance the acquisition. The greater the borrowing power of the target, the less equity the investor group requires to make the acquisition. The actual cash outlay of the equity investors is thereby minimised—and the potential return on that equity investment increased—the power of leverage. In a typical LBO, equity comprises between 30% and 40% of the enterprise value, although there are instances when it is significantly higher, for example if debt is less readily available and lenders become more credit risk averse or the asset has strong growth characteristics. The total amount of equity required depends upon the acquisition price, the debt capacity of the target, and the lenders’ requirement for a minimum equity cushion. According to S&P the average sponsor equity contributions reached their lowest levels since the mid-90s between 2005–2007 standing at 34%. The debt holders receive a fixed return, the interest paid on the debt. The equity holders get the excess capital as profit. The objective of a private equity firm is typically to exit the investment after three to five years realising, on average, an internal rate of return of 20–30% or a money multiple of 2–3x, although it will vary case to case depending on risk.

5.1.4

Identifying LBO candidates

It should be noted that not all businesses are suitable for a LBO—if they were, there would be no publicly traded companies! For a company to be a potential target for a LBO there are some key factors which private equity firms look for:  Steady and predictable cash flow: The strength and stability of cash flows is crucial in determining the debt capacity of the business. Excessive requirements for capital expenditure will reduce debt capacity as this will reduce cash flow available to service and retire acquisition debt. “Cash is king, the rest is just journal entries” is a key concept  Strong, defensible market position: LBO entities typically have a strong or leading position in their market which increases the reliability of their cash flow. Obviously, it also helps to have a steady growth trajectory, since growth in profitability will accelerate the repayment of the debt

SECTION 5: Leveraged buy-out (LBO)

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 Minimal future capital requirements: The priority of a company that has been acquired through a LBO is the payment of interest and principal payments on the new debt. All other things being equal, companies with lower maintenance capital expenditure requirements can dedicate more cash to servicing their debt  Divestible assets: Unrelated or potentially non-core divisions can greatly enhance the attractiveness of a target company, since they may be sold to raise funds for repayment of debt if required  Strong, incentivised management team: Good management is often thought of as the single most important factor in any LBO. A motivated and competent management group is needed to run the company after the buy-out. In most cases, the best choice is for existing management to take an equity interest in the company. However, new management is sometimes brought in by investors. The LBO structure typically provides strong incentives/rewards for successful management teams which is a key differentiator versus traditional strategic bidders  Viable exit strategy: The private equity firm should have a strategy for exiting the business within an appropriate timeframe, either by selling the business to a strategic buyer or by selling equity to the public through an initial public offering. Over the past years, secondary buy-outs (i.e. a sale to another financial investor) have been offered as viable exit strategies, however these do rely on the availability of debt  Potential for restructuring: Significant value in a LBO can often be created through restructuring the operations of the business (i.e. cost cutting, process efficiencies). Often divisions of large corporates have never had a true focus on the efficiency of operations and this represents a significant opportunity to create value for the equity investors in a LBO  Technology: State-of-the-art technology helps ensure maximum efficiency and profitability. The nature and requirements of the technology platform should be considered, particularly in relation to capital expenditure requirements  Skeletons: Any litigation problems, environmental concerns or other unresolved contingent liabilities can be “deal-breakers” since these problems can make financing difficult to attain given the risk implied

5.2

LBO returns

A LBO valuation is defined by whether or not a private equity firm can achieve a targeted level of return. Assumptions regarding business performance, the exit strategy, and the period between the acquisition and the exit are critical to determining an appropriate capital structure and potential returns to equity investors. The sponsors will generally look to create value through either some/all of the following mechanisms:  An increase in the underlying operating and financial performance of the asset acquired, both on the revenue and cost side  Repayment of debt through cash flow generated while owning the asset  Exit multiple expansion Financial buyers, such as private equity, venture capital and mezzanine capital providers, often have required rates of return for each investment based on the expectations of their investors. These returns are generated primarily through the sale of the company—usually “exiting” three to five years from the date of the initial investment—at which time the firm's investors generate their returns from the proceeds of the sale. In general, the greater the debt (and less equity) a financial buyer can structure into a transaction, the higher its ultimate returns. As such, the amount a financial buyer is willing to pay for a company is not only dependent on the company's projected performance, but also constrained by the capital structure that the buyer can impose.

5.3

Understanding the components of return

5.3.1

Entry and Exit Multiples

A LBO capitalises a company with a significant amount of debt (fixed in value) and with the balance in equity (variable in value). Assuming a fixed or increasing enterprise value for the business, as the debt is paid down, so the portion of the value attributable to the equity increases even if the multiple does not change. If the initial amount of equity is relatively small then the proportionate increase in value, and therefore the return, can be significant. The equity holders also benefit from the tax relief generated by interest payments.


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The interplay between the fixed and variable financing ("leverage") and its effects can be illustrated with an example. EBITDA EBITDA multiple Enterprise value Debt outstanding Equity value

yr 1 (m)

yr 5 (m)

CAGR (%)

100 6x 600 (300) 300

150 6x 900 (150) 750

10.7 10.7 25.7

Though the percentage growth in firm value is relatively modest (under 11%), the investors in the equity would have achieved 26% per annum return on their investment. Of course, the effects of leverage can work equally dramatically in the opposite direction if the firm value decreases even modestly. The impact is accentuated if the fall in value stems from a fall in earnings as the debt will be paid off less rapidly. As a rule of thumb, many assume that entry multiple = exit multiple. However, financial investors are increasingly factoring in market, sector and company specific factors when determining assumptions and further analysis should be undertaken to support exit multiple assumptions (i.e. trading of multiples through the cycle).

5.3.2

Debt Paydown

The paydown of debt also significantly increases the returns to the equity provider, as cash flows from the target company are used to pay down this debt. Occasionally divestments of parts of the business can be used to enhance this, particularly if such a sale can be undertaken at a value enhancing multiple.

5.3.3

Profit Growth

Potential buyers look at the operating performance of the target company and rely on management’s ability to improve the business (a combination of increasing revenue and decreasing cost) in order to enhance profitability. Even if the exit multiple is unchanged, moderate profit growth can lead to very significant equity returns even before any debt paydown.

5.3.4

Bolt on acquisitions

In addition to organic growth, businesses may also deliver value through the acquisition of new businesses. Similar to industrial acquirers, these acquisitions might offer the opportunity to deliver synergies or enhanced growth. Typically, acquisitions will be funded through a combination of debt (some financing structures have specific facilities set aside for acquisitions) and equity. Financial investors typically run LBO analyses to consider whether any acquisition is accretive or dilutive. Where a large number of acquisitions are available at implied multiples (post synergies) below the in-price for the original asset, substantial value can be realised. This might justify a higher price for the “seed” business as the in-price will be reduced over time by acquiring new bolt-on acquisitions at lower prices. Alternatively, bolt-on acquisitions may change the investment case thereby opening up new exit alternatives or enhancing the exit multiple.

5.4

Required returns

Driving most leveraged buy-outs is the ability for equity investors to generate attractive returns. In LBOs, returns are measured in terms of Internal Rate of Return (“IRR”) or CAGR achieved on the original equity invested. Generally, investors will expect a return of approximately 20–30% per annum though it can vary according to market conditions. Returns can be generated in a wide variety of ways, but most commonly they are realised through the eventual sale or initial public offering of the target asset. Investors are increasingly targeting returns based on a money multiple. The multiple of money is simply calculated as the cash returned to the investors following exit divided by the cash initially deployed by them. Typically, investors seek minimum returns of 2x over a three-year period. In recent times, expectations have moved to 3x albeit over a period in excess of five years.


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5.5

Management participation and impact on institutional returns

Institutional equity typically takes the form of redeemable preference shares or subordinated loan notes plus ordinary shares. Such a mix is designed to provide a non-cash running yield on the investment, to take advantage of tax relief on interest (on the preference shares/loan notes) to the fullest extent and to allow a tranching of the equity between the equity investors and management. Practically speaking, the full tranche of institutional investment is referred to as "equity" as it is fully subordinated to other forms of debt with no cash dividends received and forms a package, all the returns of which go to the equity investors. Management equity is normally a small part of the overall equity tranche and, provided institutional equity returns are acceptable, it can be assumed that management returns are at least as good. In practice, there are many ways of incentivising management including giving it a “kicker” in the form of warrants, similar to that given to mezzanine finance (in some cases), and/or a formula which gives them more of the equity the better the value achieved for equity holders, or the faster debt is reduced. This enhanced equity is often referred to as “sweet equity” in Europe and “sweat equity” in the US. Alternatively, management may be given the opportunity to purchase its equity entitlement at a discount to the institutional price.

5.6

Typical LBO structure and components of financing

5.6.1

Financing sources

LBOs are typically structured using three sources or “tranches” of finance Type of finance 1

2

3

Description

Provider

Senior debt

Generally secured on the assets of the business and ranking ahead of all other claims on the business in the event of a liquidation (exceptions apply)

Banks, institutional buyers, CLOs

Subordinated debt (high yield bonds or mezzanine debt)

Subordinate to the senior debt but ranking ahead of other claims on the business.

Institutional bond investors, mezzanine funds, banks

Equity

Ordinary shares or preference shares or subordinated loan stock

LBO funds, venture capitalists, management groups etc


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5.6.2

General example of an LBO structure

Below is an example of a typical LBO structure, in a transaction that utilises the high yield bond and/or mezzanine market. In this diagram the bank debt resides at Bidco and benefits from Targetco and subsidiaries guarantees. In many instances however, the bank debt is eventually pushed down to the Targetco and subsidiaries. This means that debt pushed down to i.e. the Targetco must be serviced before cash can be up streamed (through a dividend) to Bidco.

Management

Private equity 3 Equity/ shareholder loan

3 Equity

3 New Co (equity)

Banks

1 Senior debt

Bid Co

2 Bond Co/Mezz Co

Mezzanine & high yield debt

Bids for target

Existing debt (normally refinanced)

Guarantees & security over assets

Target Co

Subsidiaries


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5.6.3 Type

Typical features of financing Description

Usual covenants

Senior debt (first lien)

 Ordinary floating rate bank debt ranking senior to all other  Financial covenants financing obligations (leverage, interest cover, capex limits)  Often includes combinations of amortising and bullet debt (payments in kind or “PIK”) with varying maturities,  Restrictions on typically 5 to 9 years acquisitions and disposals, raising of  Secured for LBOs additional finance, payment of dividends, change of control and negative pledge Second Lien  Debt that ranks below the rights of other, more senior  Closely replicate senior debts issued against the same collateral debt covenants  Second lien lenders can be part of the same security agreement and vote as secured lenders equal to that of first lien  Usually bullet payments with longer maturities Mezzanine debt  Subordinated to other senior secured claims  Closely replicate senior debt covenants  Usually bullet repayment with longer maturity than senior debt  Return can incorporate equity type instruments, e.g. equity warrants High yield debt  Larger amounts than mezzanine achievable, minimum size  Limited covenants but typically US$200 million including restrictions on raising new debt,  Non-investment grade traded capital market instruments acquisitions and  Typically 7 to 12 years maturities with bullet repayment payment of dividends  Usually fixed interest rates Bridge finance  Short-term financing to allow rapid deal completion,  Closely replicate senior refinanced by capital markets instruments (e.g. high debt covenants yield debt)  Often structured so as to convert into mezzanine finance with increasing margins and warrants if a refinancing in the capital markets does not occur Vendor loan note  Financing provided by vendor, to capture further upside or  na increase headline price  Fully subordinated (structurally/contractually) and hence considered as equity by the debt providers  The loan can be secured by the shares (an equity loan) or through a debenture  Form part of the money that private equity funds plough into such structures, alongside normal equity  Typically with rolled-up interest PIK Notes  No interest payment until company is sold or refinanced  na  With rolled-up interest Pure equity  Pure equity is a form of financing which gives ownership in  na the company  Direct participation of company’s equity


78


5.6.4

Key debt ratios

There are five key ratios which measure debt capacity in a LBO transaction and although each of these can be used individually to give an indication of leverage, they should not be used exclusively to determine the optimum debt levels. Indeed, the debt capacity of a LBO transaction is often constrained by one of the five drivers hitting its “limit” before the others. These drivers all have pre-defined limits; however, these limits are ultimately market driven (as the debt typically needs to be sold down or syndicated to market participants) and can vary dramatically between transactions:  EBITDA Debt Leverage (debt cover) Total net debt EBITDA

The multiple of total net debt to EBITDA is often used as the key determinant of debt capacity, indeed this ratio is often put forward as a benchmark indicator. However, as stated above, it should not be used to the exclusion of the other drivers. The total debt to EBITDA ratio uses EBITDA as a proxy for cash flow and shows the number of years of such cash flow that would be required to repay all debt. Total net debt would normally exclude trapped cash which is either required for operations or “trapped” in a foreign jurisdiction.  Free Cash Flow Total net debt FCF (post interest)

The ability of a company to repay debt out of free cash flow (after interest) is critical. Most LBO transactions are structured with an element of amortising senior debt which is repaid over a given number of years from cash flow. Limited free cash flow results in limited senior debt capacity.  Interest coverage EBITDA Cash interest

A basic measure of a firm’s ability to meet its cash interest obligations.  Fixed Charge Coverage (also called DSCR, Debt Service Coverage Ratio) Cash flow available for debt service Cash interest plus scheduled repayment

A more comprehensive measure of a firm’s ability to meet its fixed-charge obligations. Although banks normally only consider cash interest, they might also look at the coverage including PIK interest.  Equity Gearing Equity Debt + Equity

The amount of equity required in a transaction is governed both by debt capacity but also by the extent to which the industry and development story of the company is determined to be “equity risk”.


79


5.6.5

Financing restrictions on LBOs

Acquirers are normally restricted in what they can and cannot do with their LBO company primarily in order to ensure that sufficient cash is available to service the debt. It is normal to agree a repayment schedule for senior debt which is usually straight line amortisation over the period of the loan. Other typical restrictions might include:  Dividends restricted or prohibited until interest cover reaches an acceptable level, typically 2.5 times covered  Material acquisitions and disposals can only be made with the permission of the lenders  Limitation on capital expenditure  No new borrowings  Mandatory cash flow sleep, i.e. 75% of FCF has to be used to pre-pay debt

5.7

LBO Modelling

5.7.1

Modelling a LBO

Determining the LBO value and structure requires balancing a number of variables in order to meet several different targets for providers of different forms of finance. As a consequence, without developing an mathematical model, the process of satisfying all these requirements and deriving a value is extremely difficult. The principal targets of minimum returns, fixed charge cover and debt repayment are set out above.


80


5.7.2

Suggested starting points

In order to simplify the iterative process to an extent, some suggestions for a starting point are set out below: 1

Model the cash flows of the business for a forecast period of 10 years. The key components for cash flows are Revenue, EBITDA, Depreciation, Capex and Change in Net working capital. A guide to building up projections is set out in Section 4. In addition, we should consider whether there are any ways of generating further cash such as reducing working capital requirements or capital expenditure (although take account of any impact this may have on growth) and model these into the business You should also consider disposals of surplus assets. However, little reliance should be put on disposals in order to make the financing ”work“ as there is often significant execution risk around disposals. The projections should generally be for the business on a stand alone basis and this may necessitate adjustment of the numbers available to reflect the costs of provision of certain central functions

2

When modelling a LBO, the base interest rate for senior debt tranches should be taken as the blended rate between the three-year swap rate and the three-months LIBOR rate in the currency of borrowing to reflect the cost of interest rate hedging (normally LBOs are required to fix at least 50% of their variable borrowing cost to reduce risk). If the debt is to be multi-currency, then a weighted average rate should be estimated given the relative proportions of the regional revenues or assumed currencies through which the borrowing take place In addition to the base rate, the interest rate margins applicable to senior debt vary according to tenor, amortisation schedule, market conditions and deal structure. In general, a shorter term amortising tranche (Term Loan A) will have lower margins than a longer bullet repayment tranche (Term Loan B and C). The price of senior debt, as with other debt tranches, is ultimately market driven as LBO debt is usually syndicated. As such, the GSF team should always be consulted in determining appropriate margins and the overall level of debt Purely for illustrative purposes, a seven year amortising tranche may price at a margin of approximately 325 basis points above the base rate while an eight year bullet repayment tranche may price at around 400 basis points above base rate

3

In practice, capital structures vary significantly according to the nature of the business and market conditions. Normal European structures would have Term Loan A, B and C as well as a Mezzanine tranche. Previously, there have been second lien and high yield tranches in some deals as well. In 2007-2008, many deals were executed without a Term Loan C For example, a buy-out in March 2008 of a European based telecoms company with an EV of €2,000m and EBITDA of €200m could have had approximately 5.0x total debt as of the transaction. The capital structure might have looked as follows: Amount (€m)

(%)

EBITDA (x) 1

Margin (bps) 2

Tenor (yr)

250 275

12.5 13.8

1.3 1.4

325 400

7 8

Term Loan C Total senior debt Mezzanine Total debt Total equity

275 800 200 1,000 1,000

13.8 40.0 10.0 50.0 50.0

1.4 4.0 1.0 5.0 5.0

425

9

1050 3

10

Total

2,000

100.0

10.0

Facility type

Term Loan A Term Loan B

Notes: 1 Based on Pro forma LTM EBITDA of €200m 2 Margin over base rate of X%. Base rate assumed to be a blend of 3 year Euribor and 3 year Euro swap rate as of [date] 3 Mezzanine price includes an element of cash margin at 500bps and PIK at 550bps 4 EV assumed to be 10x LTM EBITDA. EV assumed debt free and cash free at the date of acquisition


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4

Based on a typical scenario, assume an exit in year 3 at an EBITDA multiple equivalent to the multiple at which the business is assumed to be purchased. However, as referenced earlier, more sophisticated assumptions are normally required

5

The iterative process now begins. The first step would be to check if fixed charge cover, leverage (i.e. the gross and net debt/EBITDA ratio), debt repayment and investor returns are adequate. If they are, then a higher total valuation may be possible. If not then an iterative process begins of flexing the proportions of debt, equity and total value so as to reach a position when all investors' requirements are satisfied. If they cannot be, then the total value may need to be reduced

6

The outcome of a LBO will be sensitive to a number of assumptions, in particular the rate of growth of the business, the exit multiple and the year of exit. The modeller should sensitize the assumptions. Basic sensitivity tables have been incorporated into the standard LBO model

5.7.3

Flexing effects

A matrix setting out the impact of INCREASING certain variables whilst keeping all others constant is set out below to aid the flexing process: Variable being increased

Fixed charge cover

Return for debt holders

Returns for equity

Debt repayment period

Interest rate Proportion of equity

Down Up

Up No effect

Down Down

Up Down

Growth rate of EBITDA Entry multiple Exit multiple

Up No effect ² No effect

No effect 1 No effect No effect

Up Down Up

Down No effect ² No effect

Notes: 1 A material improvement of the credit could positively impact the secondary trading value of the debt 2 If because of a lower entry EV the debt/equity ratio decreases, the fixed charge cover will be up and debt repayment period down

Given these multiple effects, it is normal to show a range of sensitivities when presenting LBO valuation outputs, typical tables may be as follows


82


A

yr 3 IRR Purchase EV (£m)

120.0

125.0

130.0

135.0

10.1

10.5

31.4

37.1

Entry LTM EBITDA (x)

9.3

9.7 Offer premium (%)

20.0

25.7

Exit LTM EBITDA (x)

Offer price (£)

B

7.5 8.0 8.5 9.0 9.5 10.0 10.5

1.20

1.26

1.31

1.37

26.7 29.6 32.3 34.7 37.0 39.1 41.1

21.3 24.1 26.7 29.0 31.2 33.2 35.1

17.1 19.8 22.3 24.5 26.6 28.6 30.4

13.6 16.3 18.7 20.9 22.9 24.8 26.6

Entry EV to achieve target IRR after 3 years

Exit LTM EBITDA (x)

Target IRR (%)

5.8

7.5 8.0 8.5 9.0 9.5 10.0 10.5

15.0

20.0

25.0

30.0

137.8 142.0 146.1 150.2 154.3 158.5 162.6

131.3 134.6 137.9 141.2 144.5 147.8 151.1

126.3 129.0 131.6 134.3 137.0 139.6 142.3

122.4 124.6 126.8 128.9 131.1 133.3 135.4


As with DCF valuations, LBO valuations rely upon future projections of the business and therefore if reliable sources of information are not available, these projections can become highly subjective and therefore raise the potential for inaccurate results. LBO valuations represent the value to a financial investor, and as such, and in common with other valuation methodologies, they do not represent what an investor would actually pay for a business. In particular, whilst target investment returns are generally accepted to be around 20–30% per annum, this will vary between investors, particularly if they feel that there is more or less risk in a particular investment. A LBO valuation depends upon the performance of the business until exit. Therefore, if an investor is a specialist in a particular sector, they may take a different view on the future projections of a business, which an independent standalone LBO will not capture. Similarly, financial investors often use their relationships with financing institutions to secure preferential terms or larger quantums of debt. This can lead to asymmetry in the market, and therefore the valuation may not be representative of the terms which are practically available to all potential investors. As described above, not all companies are ideal LBO candidates. This valuation methodology is only relevant where a LBO could actually be realised, and therefore for businesses with unpredictable cash flows or other unattractive attributes to a financial investor, a LBO valuation becomes irrelevant. As can be seen from the example output tables above, LBO valuations are very sensitive to the exit multiple. It is essential that a considered view is taken on the most likely exit multiple to ensure that the valuation remains accurate.


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5.9

Data sources

5.9.1

LIBOR and swap rates

The best sources for up to date, accurate LIBOR and swap rates are the live information sources: Bloomberg (codes: BTMM/BBAM and IRSM/WS) or Reuters (code: LIBOR). Alternatively, DataStream can be used (codes: LDNIBON for LIBOR, EUEONIA for EURIBOR).

5.9.2

Debt margins and acceptable leverage levels

It is best to contact the GSF team for margins on leveraged debt. These are constantly evolving with market conditions, and can differ significantly from issuer to issuer. A detailed view is therefore required, even for basic valuations. Similarly, the appropriate level of acceptable debt metrics varies with market conditions. The GSF team will be able to provide an up-to-date view.

5.10


A thorough check of the entire model is even more important for LBOs than other valuation methods due to the fact that any LBO model will inherently be circular, and therefore it can be substantially harder to identify any errors. There are however some quick checks which you can do to ensure that the outputs are sensible to start with:  Balance sheet—does it balance?  Financial profile—are the long term projections realistic?  Entry and exit multiples—are they reasonable? What level would you expect the exit multiple to be compared to entry?  IRR—is it reasonable given entry and exit assumptions? An IRR for a regular company over 100% is always wrong. Period  Debt levels—is the entry debt/EBITDA in line with precedent transactions? Are the debt tranches paid off by their maturity? Are the debt metrics throughout the projection period within market limits?  Equity—the amount of equity in the structure should be high enough to meet minimum requirements by debt providers, but not too high in value to be out of reach of target investors  Use of cash—is cash in excess of that required being used to pay down the debt tranches in order of seniority? If not, where is the cash going?

5.11

Common errors

 Inaccurate financial projections  Using wrong LIBOR or swap rates for the currency debt is issued in, or sourcing incorrectly  Not checking latest market views for leverage and margins with the GSF team, or getting updated views when required (particularly in volatile markets)  Inaccurate exit multiple assumptions and inappropriate sensitivities  Modelling errors—particularly given circularity in models  Incorrectly reflecting mid-year acquisitions—not accurately calculating an appropriate rump year (only cash from acquisition date to year end should be included, as this is the only cash available to the acquirer to pay down debt). Also ensuring the XIRR function is used to take count of acquisition date where the time period between entry and exit in years is not a whole number  Incorrect cash sweep—ensuring cash only pays down debt when it is available after the repayment of interest and more senior debt tranches (always stress-test the model to ensure this works, particularly if adding new tranches to a standard model)  Management equity—is it properly reflected in the sponsor returns (i.e. impact of dilution)


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5.12

Tips for success

 Sense-check the output—don’t assume you have finished once you have completed the inputs  Challenge the financials—the result is only as good as the inputs, so make sure you believe the raw data is accurate and appropriate for the business  Challenge the appropriateness of leverage multiples—ensure you provide the GSF team with detailed views of the relative merits of the target compared to peers to enable them to come to the best view in the current market  Present appropriate sensitivities—include additional sensitivities to standard exit multiple and IRR tables tailored to uncertain areas (e.g. different financial cases, earnings growth sensitivities, etc)  Source every assumption clearly and check multiple sources

5.13

Example of UBS model

Below are a number of outputs from a standard UBS LBO model used for valuation. Please note that this model is currently being redesigned and the new will be available soon. As such, be sure to check within your team for the latest version. The LBO model for valuations is separate from the standard GSF model, which is used for NBCC and GSFCC purposes, where UBS is required to provide a firm view of available debt financing, or commit its own capital. This model is far more detailed, and provides outputs tailored to the approvals process.  The below overview page highlights some of the key assumptions required for a LBO valuation – the assumed purchase price, sources and uses of funds, margins on debt products together with the benchmark rate and, importantly, the exit multiple.

Corleone LBO Analysis: Summary (Capital Structure I) IRR ANALYSIS

OFFER AT 25% PREMIUM Current share price (GBP) Offer price (GBP) No of shares (m) Equity value (GBPm)

SOURCES OF FUNDS Term loan A Term loan B Term loan C Second lien Total senior debt Mezzanine High yield PIK Total subordinated debt TOTAL DEBT Loan note Ordinary equity TOTAL EQUITY

TOTAL SOURCES

RCF available (undrawn)

6.00 7.50 300 2,250

Sales EBITDA EBITA EBIT

LTM ¹ 1.4x 5.4x 6.7x 7.2x

2009E 1.4x 5.4x 6.7x 7.3x

2011E 1.3x 4.9x 6.0x 6.5x

0.4x

5.00%

7.26%

Debt Capital split split (%) (%) 25% 9% 25% 9% 25% 9% 0% 0% 75% 27% 25% 9% 0% 0% 0% 0% 25% 9% 100% 36% 32% 32% 64% 100% OK

LTM ¹ 1,766 na 468 na 26.5 350 19.8

2009E 1,781 5.5 466 (2.8) 26.2 347 19.5

2010E 1,870 5.0 493 5.7 26.4 369 19.7

2011E 1,959 4.8 519 5.3 26.5 391 20.0

2012E 2,047 4.5 544 4.8 26.6 412 20.1

2013E 2,129 4.0 566 4.0 26.6 429 20.2

nm nm nm

836 (40) 796.5

704 (83) 621.1

534 (133) 401.5

339 (187) 152.9

332 (440) (108.3)

(GBPm) 234 234 234 0 702 234 0 0 234 936 825 825 1,649 2,586 200

LTM Interest EBITDA Margin rate (x) (%) (%) 0.5x 5.00% 7.26% 0.5x 5.50% 7.76% 0.5x 6.00% 8.26% 0.0x 5.00% 7.26% 1.5x 0.5x 3.74% 6.00% 0.0x 7.74% 10.00% 0.0x 10.74% 13.00% 0.5x 2.0x 5.06% 7.32%

2010E 1.4x 5.1x 6.3x 6.9x

SUMMARY FINANCIALS (GBPm) Sales % growth EBITDA % growth % margin EBIT % margin Total debt Cash Net debt

Exit LTM EBITDA (x) 5.0x 5.5x 6.0x 6.5x

SPONSOR IRR 2011E 2012E 2013E 8% 11% 12% 15% 15% 15% 20% 18% 17% 26% 22% 19%

MANAGEMENT IRR 2011E 2012E 2013E 12% 16% 17% 25% 24% 22% 37% 31% 27% 47% 37% 31%

USES OF FUNDS Consideration for Corleone's equity Purchase of stock options Refinancing of existing net debt Pension deficit Minority interest Transaction fees (including financing fees)

TOTAL USES

(GBPm) 2,250 35 250 0 0 51

Split (%) 87% 1% 10% 0% 0% 2%

2,586

100%

2012E 0.4x 0.6x 1.0x 1.3x 1.0x 0.7x 12.2x 8.9x 9.9x 9.2x 1.2x

2013E 0.1x 0.1x 0.6x 0.8x 0.6x 0.3x 19.1x 14.1x 15.5x 14.5x 1.2x

CREDIT RATIOS (x) Senior debt / EBITDA Senior debt / (EBITDA-Capex) Cash pay debt / EBITDA Cash pay debt / (EBITDA-Capex) Total debt / EBITDA Net debt / EBITDA EBITDA / Cash interest (EBITDA - Capex) / Cash interest EBITA / Cash interest EBIT / Cash interest Fixed charge cover

LTM ¹ 1.5x 3.3x 2.0x 4.4x 2.0x 2.0x 6.8x 3.1x 5.1x 5.1x na

2009E 1.5x 2.7x 2.0x 3.7x 2.0x 2.0x 6.7x 3.6x 5.4x 5.0x 1.2x

2010E 1.2x 1.9x 1.7x 2.7x 1.7x 1.6x 7.6x 4.8x 6.1x 5.7x 1.2x

2011E 0.8x 1.2x 1.4x 2.0x 1.4x 1.2x 9.2x 6.3x 7.4x 6.9x 1.2x

Note: (1) LTM based on 12 months to 31 Jan 09



12


85


 A LBO critically relies on the ability of a company to generate cash to service its debt. In the example below, cash flows in excess of servicing fixed charges are relatively modest in the stub year. Thereafter, significant cash becomes available to pay down some of the outstanding debt

LBO—Income statement & cash flow statement (Capital Structure I) INCOME STATEMENT (March y/e GBPm)

LTM ¹

2009E

Stub 09

2010E

2011E

2012E

2013E

2014E

2015E

2016E

2017E

2018E

Sales growth (%)

1,766 na

1,781 5.5

288 na

1,870 5.0

1,959 4.8

2,047 4.5

2,129 4.0

2,203 3.5

2,269 3.0

2,337 3.0

2,408 3.0

2,480 3.0

EBITDA growth (%) margin (%)

468 na 26.5

466 (2.8) 26.2

75 na 26.2

493 5.7 26.4

519 5.3 26.5

544 4.8 26.6

566 4.0 26.6

584 3.2 26.5

597 2.3 26.3

611 2.3 26.1

625 2.3 25.9

639 2.3 25.8

Depreciation Intangibles amortisation Amortisation of acquisition goodwill EBIT margin (%)

(88) (30) 0 350 19.8

(89) (30) 0 347 19.5

(14) (5) 0 56 19.5

(93) (30) 0 369 19.7

(98) (30) 0 391 20.0

(102) (30) 0 412 20.1

(106) (30) 0 429 20.2

(110) (30) 0 443 20.1

(113) (30) 0 453 20.0

(117) (30) 0 464 19.8

(120) (30) 0 474 19.7

(124) (30) 0 485 19.5

Pre-tax net EBIT synergies

0

0

0

0

0

0

0

0

0

0

Adjustments (net)

0

0

0

0

0

0

0

0

0

0

Net interest PBT

(27) 29

(165) 205

(165) 226

(162) 250

(157) 273

(156) 288

(161) 292

(169) 295

(177) 297

(187) 298

Tax PAT

(13) 16

(86) 118

(96) 131

(105) 144

(115) 157

(123) 164

(128) 164

(133) 162

(138) 159

(143) 155

CASH FLOW STATEMENT LTM ¹

2009E

Stub 09

2010E

2011E

2012E

2013E

2014E

2015E

2016E

2017E

2018E

468

466

-9 -9 (257) 194 41.4

-8 (10) (214) 234 50.2

75 0 (1) (2) (35) 38 50.2

493 0 (7) (8) (182) 296 60.1

519 0 (7) (6) (162) 343 66.2

544 0 (7) (4) (148) 385 70.9

566 0 (7) (2) (148) 409 72.3

584 0 (6) (2) (158) 417 71.5

597 0 (5) (2) (156) 433 72.6

611 0 (5) (2) (160) 444 72.7

625 0 (6) (2) (158) 459 73.4

639 0 (6) (2) (162) 469 73.5

Tax charge Other cash flows Cash flow before debt service

(13) 0 25

(86) 0 210

(96) 0 248

(105) 0 280

(115) 0 294

(123) 0 294

(128) 0 305

(133) 0 311

(138) 0 320

(143) 0 326

Target fixed charge cover Cash interest expense Cash flow available for debt repayment

(4) (11) 10

(35) (65) 110

(41) (57) 150

(47) (45) 189

(49) (30) 215

(49) (21) 224

(51) (21) 233

(52) (22) 236

(53) (24) 243

(54) (25) 246

(March y/e GBPm) EBITDA Pre-tax net EBIT synergies Δ Net working capital Δ other operating LT assets/(liabilities) Capital expenditure Free cash flow cash conversion (%)

Note: (1) LTM based on 12 months to 31 Jan 09



13

 It is essential that the use of excess cash is properly modelled. Below is an extract from the debt schedule, from which the sequential order in which the debt tranches are paid down is evident

Outstanding debt balances (Capital Structure I) (March y/e GBPm)

Stub 09

2010E

2011E

2012E

2013E

2014E

2015E

2016E

2017E

2018E

200 0 0 0 0 200 (0) 10

200 0 0 0 0 200 (1) 110

200 0 0 0 0 200 (1) 150

200 0 0 0 0 200 (1) 189

200 0 0 0 0 200 (1) 215

200 0 0 0 0 200 (1) 224

200 0 0 0 0 200 (1) 233

200 0 0 0 0 200 (1) 236

200 0 0 0 0 200 (1) 243

200 0 0 0 0 200 (1) 246

234 0 (10) 224 (3) 0

224 0 (110) 115 (12) 0

115 0 (115) 0 (4) 35

0 0 0 0 0 189

0 0 0 0 0 215

0 0 0 0 0 224

0 0 0 0 0 233

0 0 0 0 0 236

0 0 0 0 0 243

0 0 0 0 0 246

234 0 0 234 (3) 0

234 0 0 234 (18) 0

234 0 (35) 199 (17) 0

199 0 (189) 10 (8) 0

10 0 (10) 0 (0) 205

0 0 0 0 0 224

0 0 0 0 0 233

0 0 0 0 0 236

0 0 0 0 0 243

0 0 0 0 0 246

234 0 0 234 (3) 0

234 0 0 234 (19) 0

234 0 0 234 (19) 0

234 0 0 234 (19) 0

234 0 (205) 29 (11) 0

29 0 (29) 0 (1) 195

0 0 0 0 0 233

0 0 0 0 0 236

0 0 0 0 0 243

0 0 0 0 0 246

0 0 0 0 0 0

0 0 0 0 0 0

0 0 0 0 0 0

0 0 0 0 0 0

0 0 0 0 0 0

0 0 0 0 0 195

0 0 0 0 0 233

0 0 0 0 0 236

0 0 0 0 0 243

0 0 0 0 0 246

RCF RCF available RCF, BoP Drawdown/(repayment) RCF, EoP Average drawn RCF Average undrawn RCF Interest on RCF Cash flow available post repayment of RCF

0 0.5% 7.3%

Term Loan A Term loan A, BoP Recap Repayment Term loan A, EoP Interest on Term loan A Cash flow available post repayment of Term loan A

234 7.3%

Term Loan B Term loan B, BoP Recap Repayment Term loan B, EoP Interest on Term loan B Cash flow available post repayment of Term loan B

234 7.8%

Term Loan C Term loan C, BoP Recap Repayment Term loan C, EoP Interest on Term loan C Cash flow available post repayment of Term loan C

234 8.3%

Second Lien Second Lien, BoP Recap Repayment Second Lien, EoP Interest on Second Lien Cash flow available post repayment of Second Lien

0 7.3%


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 Below is the key valuation output for the LBO. IRRs on the equity investment are calculated based upon set exit years and exit multiples. This table should also be accompanied in any presentation by the sensitivity tables outlined above (see section 5.7.3) EQUITY SPLIT AT EXIT Financial sponsor Management Mezzanine provider

EXIT COSTS

(%) 90% 10% 0%

(GBPm)

Cost of pensions Other Total

0 0 0

FINANCIAL SPONSOR RETURNS

2010E

2011E

2012E

2013E

LTM Exit EBITDA multiple (GBPm) (x) 493 5.0x 493 5.5x 493 6.0x 493 6.5x 493 7.0x 519 5.0x 519 5.5x 519 6.0x 519 6.5x 519 7.0x 544 5.0x 544 5.5x 544 6.0x 544 6.5x 544 7.0x 566 5.0x 566 5.5x 566 6.0x 566 6.5x 566 7.0x

EV (GBPm) 2,464 2,710 2,956 3,203 3,449 2,594 2,853 3,113 3,372 3,631 2,720 2,992 3,264 3,535 3,807 2,828 3,111 3,394 3,677 3,960

Net debt (GBPm) 796 796 796 796 796 621 621 621 621 621 401 401 401 401 401 153 153 153 153 153

Loan note (GBPm) 922 922 922 922 922 1,014 1,014 1,014 1,014 1,014 1,115 1,115 1,115 1,115 1,115 1,227 1,227 1,227 1,227 1,227

Equity value (GBPm) 745 992 1,238 1,485 1,731 959 1,218 1,478 1,737 1,996 1,203 1,475 1,747 2,019 2,291 1,449 1,731 2,014 2,297 2,580

Money IRR multiple (%) (x) 1% 1.0x 13% 1.2x 25% 1.3x 36% 1.4x 48% 1.6x 8% 1.2x 15% 1.3x 20% 1.5x 26% 1.6x 31% 1.8x 11% 1.4x 15% 1.6x 18% 1.7x 22% 1.9x 25% 2.0x 12% 1.6x 15% 1.8x 17% 1.9x 19% 2.1x 22% 2.3x

Inv. Cost (GBPm)

Year 1 2009E

Year 2 2010E

Year 3 2011E

Year 4 2012E

Year 5 2013E

Jan 09

Mar 09

Mar 10

Mar 11

Mar 12

Mar 13

(1,574) (1,574) (1,574) (1,574) (1,574) (1,574) (1,574) (1,574) (1,574) (1,574) (1,574) (1,574) (1,574) (1,574) (1,574) (1,574) (1,574) (1,574) (1,574) (1,574)

---------------------

1,593 1,814 2,036 2,258 2,480 ----------------

1,877 2,110 2,344 2,577 2,811 -----------

2,198 2,443 2,687 2,932 3,177 ------

2,531 2,785 3,040 3,294 3,549

Note: 1. Assumes offer price of GBP7.50, EV purchase price of GBP2,586m, and an entry leverage of 2.0x LTM EBITDA


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SECTION 6

Alternative valuation methods 6


Alternative valuation methods 6.1

Sum of the parts analysis (SOTP)

6.1.1

Definition

The sum-of-the-part (“SoTP”) methodology values a company by applying different valuation techniques to its separate units. The sum of these values makes up the total enterprise value (“EV”) of the company.

6.1.2

Application

 This methodology is used to value holding companies or conglomerates where the constituent businesses require different valuation techniques. It is well-suited to valuations involving restructuring and where a client is considering a strategic review or sale of one of its businesses. It is quite common for UBS or other equity research to include a SOTP valuation in their reports  The individual businesses can be valued on a (1) trading, (2) break-up or (3) fundamental basis – (1 & 3) a group conducting a full de-merger of its businesses in two separately quoted entities – (2 & 3) a group selling one of its subsidiaries to a trade buyer – (1, 2 & 3) an acquirer disposing unwanted parts of its recently acquired target via a combination of flotation and a trade sale  Helps to understand whether the company is more valuable as a whole or in parts  Helps to identify value-driving business units  Care needs to be taken to account for synergies and dissynergies

6.1.3

Trading sum-of-the-parts

The trading sum-of-the-parts is the total value of the company as if each part of the business was separately listed. It is typically undertaken by comparing the financial metrics of the different divisions with the appropriate set of comparable companies and thereby implying a valuation for each part of the business. When undertaking a trading SOTP valuation, certain additional factors need to be considered as follows:

6.1.3.1

Conglomerate discount

A conglomerate is a group of different businesses whose operations are not integrated with each other A holding company is a company whose single raison d’être is to hold shares in other companies (usually the company does not produce goods or services itself) The conglomerate/holding company discount is the discount to underlying net asset value (“NAV”) at which conglomerates are valued  Discount tends to increase in weaker market conditions and reduce in a stronger environment  Discounts are volatile over time and vary significantly between companies Conglomerates and conglomeracy come into and out of fashion at different times and in different countries.

6.1.3.1.1

Understanding the conglomerate discount

Investors can spread their risk by investing in a conglomerate (the ultimate passive conglomerate is the stock market index). A holding company with significant stakes in unlisted companies can represent the only way to invest in these assets (“scarcity value”). The market typically applies a conglomerate discount to companies which hold assets which are not necessarily synergistic. As a result, a SOTP valuation (done on a trading value basis) often produces a higher value than that attributable by the stock market to the group as a whole  Individual parts will be valued higher as there usually is an investor who would value it highest per se  One or two badly run business segments can be enough to create negative investor sentiment for the entire company  Financial and intangible resources (e.g. ability of central management) can add value to the parts

SECTION 6: Alternative valuation methods

89


Key factors to influence level of holding/conglomerate discount:  Active management of the underlying portfolio should produce higher returns, thus lower discount  A higher level of ownership of subsidiaries should lower the discount (as the parent company can exert a greater degree of control) as there will be less dividend/cash flow leakage  Level of overhead costs at the parent company level  Latent tax liability (if subsidiaries are sold)  Multi-layered holding companies are generally penalised as the discount is multiplied through the control chain

6.1.3.2

Corporate costs

Some companies allocate head office costs by division but others do not. In the former case, these costs are captured in your valuation of the different parts of the business but in the latter case, these need to be valued separately. This can be done in a variety of ways but typically they are either capitalised at the multiple implied by the group SOTP or on a perpetual growth basis, using the group WACC and a nominal growth rate which is typically 2.0–3.0%.

6.1.3.3

Excess cash and debt

Excess cash or debt should be valued at 1x

6.1.4

Break-up and fundamental valuation

The break-up or fundamental value is the total value of the company if operations are sold separately. As such this is a transaction valuation. It tends to be more complex than a trading SOTP analysis as the latter is typically a question of finding the appropriate peer set for each division while the former needs to take into account the practicalities of a break-up.

6.1.4.1

Break-up costs

 Are there any overheads that will be eliminated (e.g. head office costs)? – will the pieces need to repurchase some of these services (e.g. IT)?  Is there a loss of financial economies of scale? – losing lower borrowing or higher deposit rates – losing group tax relief/tax management  Have break-up costs been calculated and deducted in present value terms? – related tax costs (capital gains tax for selling a subsidiary), redundancy costs and other associated costs  The costs of separating the individual businesses in practice can be prohibitive if there is a high degree of integration between them. Typically it will be difficult to quantify many of these elements, particularly from an “outside-in” perspective so when presenting this type of analysis it is important to highlight assumptions made and where further work is required to understand the true value that can be created via a break-up.

6.1.4.2

Post break-up adjustments

 Following the break-up, management charges and other services provided by the corporate centre will no longer be borne by the subsidiaries (assuming some of this had been financed by them before)  The purchase price of inputs and sales price of output need to reflect the lack of transfer pricing going forward


90


6.1.4.3

Legal considerations

 Are there change-of-control clauses or other arrangements that may be triggered through a break-up (e.g. pre-emption rights of a partner in a partly owned subsidiary once it leaves the group's control)?  Are there debt covenants (e.g. on low-coupon debt of the parent) that might be triggered on a change of control, resulting in a loss of value? – the nature of lenders' covenants will reflect the borrower's general standing and creditworthiness and this may be affected by splitting up the group into smaller components

6.1.4.4

Listing of shares

If the break-up valuation assumes that the company will list the shares of one of its subsidiaries, the new issue price will have to be discounted (relative to the theoretical trading value) in order to attract investors to participate in the offer. This is commonly referred to as the “IPO discount”. Therefore a simple reference to multiples of comparable companies may not tell the full story.


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6.1.5

Worked example

Remember to include the corporate function and eliminations. This example is a depicting a trading, not a break-up valuation. In the latter case, we need to account for break-up costs and tax considerations.

6.1.5.1

Calculations

(€m)

Methodology

Multiple (x) Low-high

Reference

Share held (%)

Value Low-high

Listed portfolio Subsidiary 1

Market cap

na

2,526

68.3

1,725

Subsidiary 2

Market cap

na

1,236

43.4

536

Non-listed portfolio Subsidiary 3

P/E

Subsidiary 4

P/TBV

Subsidiary 5

EV/EBITDA less net debt¹

8–10

10

88.0

70–88

1.0–1.5

600

95.3

572–858

5–7

254

63.7

809–1,133 3,713–4,340

Operating units Corporate function

P/E

8

(8)

Net debt

P/BV

1

(150)

(64) (150)

Total

3,499–4,126

Note: 1 Assumed net debt at the subsidiary is zero

Sum-of-the-parts valuation 4,500 1,133 4,000

809

3,500

(€m)

4,126 3,713 3,499

( 64 )

858

( 150 )

3,123

572

3,000 2,500 2,000

4,340

536

88 70

1,725

1,500 1,000 500 Sub 1

Sub 2

Sub 3

Sub 4

Sub 5

Operating Corporate units

Source:

Debt

Total

Market cap

UBS Investment Bank


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6.1.6

OpCo-PropCo valuation

This is a specific type of SOTP valuation which looks at the value of splitting a business with real estate assets into two separate companies – an Operating Company (OpCo) and Property Company (PropCo). The theoretical advantage of this is that the PropCo can sustain more leverage than the OpCo (due to the stable, long-term rental income), and thus for a financial investor it may be possible to increase overall returns. The PropCo is typically valued on the basis of a market real estate yield, which will in turn depend on the sector which the asset is related to and the strength of the underlying OpCo. This yield is then applied to the rents the OpCo pays to the PropCo to derive an implied value of the PropCo. The OpCo is then separately valued using standard methodologies.

6.1.7


There are a number of complexities which can undermine a SOTP valuation:  Obtaining financial details and forecasts for each business unit can be difficult  Cash flow projections can be complex and interdependent on different units  Allocation of corporate function and elimination of double-counting between units are usually estimates at best  Valuations can vary over a wide range  Particularly in the case of a break-up SOTP, it is a theoretical valuation unless there is a real prospect of selling the company on a piecemeal basis

6.1.8


Error

Comments

Check against respective methods used to value the parts

 The SOTP approach uses any of the techniques described earlier to value the separate businesses of the company. Therefore the same cross-checks are to be done on the individual pieces as the respective technique allows for

Consistency

 Ensure the values for all parts are either EVs or equity values

Trading vs. break-up valuation

 No break-up costs are to be assumed in a trading valuation – double-check the post break-up adjustments otherwise

Excess cash/debt

 Do no forget to add the value if applicable as a separate item – valued at 1x

6.2

Economic Value Added (EVA)

6.2.1

Definition and applicability

Economic Value Added (“EVA”) was developed by Stern Stewart in 1991. EVA is a measure of the surplus value created by an investment or a portfolio of investments/assets. EVA has become a popular measure of corporate performance, valuing businesses and equity investments. The EVA concept is very simple whereby to create value for shareholders, returns on capital should exceed the relevant cost of capital. To illustrate, take a company, Castle plc which has capital of €100 million (shareholders’ equity and debt) and whose post-tax cost of capital is 15% (equity underwriting costs and interest on debt). Castle plc will only add value once it has generated a post-tax return on capital (typically measured as taxed EBIT) exceeding €15 million a year. If the company generates €25 million, the EVA will be €10 million for that year.


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6.2.2

Alternative uses of EVA concept

Uses

Comments

1. As part of an internal management reporting system

 Powerful internal management tool for divisional performance evaluation and management remuneration

2. As a measure of performance

 EVA sets a minimum acceptable performance level to the rate of return/cash generated in the long run

 Focuses management on the factors which add value e.g. (profitability, efficient use and re-allocation of capital)

 If a division or investment cannot achieve the hurdle rate—then, according to EVA theory, a company would be better off closing or selling this operation. All positive EVA projects should be undertaken, subject to having enough capital to undertake these. In the event capital is constrained, those with the highest proportional EVA to capital should be undertaken first  Focus on: – positive versus negative EVA – annual change in EVA – EVA impact of strategic decisions 3. As a valuation technique

6.2.3

 Economic value = Capital employed + present value of forecast EVA  Mathematically equivalent to a DCF valuation – should give the same answer if calculated in a consistent manner

EVA as a valuation technique

EVA is usually calculated from an enterprise perspective (i.e. based on all capital rather than just equity) and therefore based upon normal operating profit less adjusted taxes (“NOPLAT”). EVA is defined as a measure of profit (NOPLAT) less a charge which represents the economic cost of the capital employed in generating that profit. EVA = NOPLAT – Opening Capital employed x WACC OR EVA = Capital employed x (ROCE – WACC)  NOPLAT = Normal operating profit less adjusted taxes. Essentially EBIT adjusted to exclude income from non-core assets and remove any implied interest cost in respect of unfunded pensions less tax related to this core EBIT  Capital employed = the total capital utilised in the generation of operating profit (essentially shareholders funds plus net debt and the value of other sources of finance). This should capture shareholders' funds plus minority interests, net debt, unfunded pension provisions and any other source of finance less the value of non-core assets  WACC = Weighted average cost of capital. This should capture the average post tax cost of all sources of finance weighted according to market values  ROCE = A post tax rate of return on invested capital = NOPLAT / Capital employed (either average or opening capital is used)


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6.2.4

Worked example

EVA valuation Assumptions

WACC Terminal growth (g) Return on new investments (ROCE) Tax rate

10.0% 6.0% 20.0% 25%

% D&A of Sales % Capex of D&A % of change in WC

Capital employed Opening balance D&A Capex Change in WC Closing balance

EBIT Tax NOPLAT (A) Opening capital * WACC (B) EVA (A-B) NPV of EVA Sum of NPV of EVA (C)

6.0% 120.0% 7.5% 1

2

3

4

5

TV

1,000

1,020

1,040

1,063

1,088

1,109

(60) 72 8

(66) 79 8

(73) 87 8

(80) 96 9

(83) 100 4

1020

1040

1063

1088

1109

1

2

3

4

5

TV

250 (63) 188

275 (69) 206

303 (76) 227

333 (83) 250

346 (87) 260

367 (92) 275

(100)

(102)

(104)

(106)

(109)

(111)

88 80 449

104 86

123 92

143 98

151 94

164

Value of Economic Profit (1st year of Perpetuity) (D) EVA TV / WACC = 164 / 10% Incremental value beyond 1st year of Perpetuity created (destroyed) by additional growth (E) NOPLAT TV x (g / ROCE ) x (ROCE – WACC) / (WACC x (WACC – g)) = 275 x (6% / 20%) x (20% – 10%) / (10% x (10% – 6%))

1,643

Terminal Value (D + E)

3,706

NPV of Terminal value (F) Terminal value / (1+WACC)^(1 / terminal year) = 3706 / (1+ 10%)^(1/5)

2,301

Invested capital at beginning of forecast PV during explicit forecast period (C) PV of Terminal value (F)

449 2,301

Total EV

3,751

2,063

1,000


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6.2.5

Drawbacks of Methodology

 EVA is often unreliable as a performance measure – the difficulty of identifying a realistic measure of capital employed – differences in accounting policies

6.2.6


Error

Comments

Change opening capital employed…

 In a correct EVA valuation changing opening capital employed should not affect the valuation – if the valuation changes then the model is wrong!  All the accounting adjustments made in calculating EVA are irrelevant and do not affect value – higher capital employed is offset by lower annual EVA – capital employed does not feature in a DCF valuation and EVA is mathematically equivalent to DCF – capital employed is a ‘sunk cost’ and therefore irrelevant—only the incremental return on new investment matters

Check against a DCF valuation…

 “Mathematically” an EVA valuation is equivalent to a DCF valuation (although this may not be the case if you use a value driver approach from TV rather than a multiple or perpetuity growth rate) – if the values differ it is probably a problem with the EVA model!  Ensure the change of capital employed each year equals NOPLAT–FCF  Work on the basis of year end cash flows and use opening capital not average capital in calculating EVA  Ensure that if a terminal value is used for EVA that a true steady state has been reached

Terminal values in EVA…

 A constant terminal growth of cash flows does not imply the same constant terminal growth of the EVA!  The growth rate you use to estimate after-tax operating income in future periods should be estimated from fundamentals when doing discounted cash flow valuation. – Set growth rate = Reinvestment rate x Return on capital – if the above relationship does not hold, different values will obtained from the DCF and EVA valuations

6.2.7

Adjusted Present Value

Adjusted Present Value (“APV”) is a business valuation method which calculates the value of the company as if it was unlevered (i.e. financed 100% with equity) and then adds the value of the tax shield generated by the debt in the capital structure APV = PV of all-equity financed project + PV of financing effect The APV valuation method is considered effective in situations which have a changing capital structure of the company over time (as opposed to DCF valuation which assumes a long-term, constant capital structure). A key advantage of the APV approach is the flexibility it gives. Essentially it allows the separation of the effects of debt into different components and allows the use of different discount rates for each component. APV and the standard DCF approaches should give the identical result if the capital structure remains stable. APV analyses financing effects separately and then adds their value to that of the business. APV allows the manager to more easily identify the sources of value in a project, providing a better understanding of the project.


96


6.2.8

APV as a valuation technique

The difference with a standard DCF model is that the APV model separates the value of operations into two components: 1. The value of operations as if the company was entirely equity financed: – calculate the non-levered annual FCF and Terminal value as usually done for DCF models – calculate the non-levered cost of equity (Ku) Ku = risk-free rate + (non-levered beta x equity risk-premium) Non-levered beta = βu = [βe x E + βd x D x (1-t)] / [E + D x (1-t)] – where βu = non-levered beta; βe = Levered beta; βd = beta of debt; E = Market Value of Equity; D = Market Value of Debt; t= tax Rate – discount the non-levered annual FCF and terminal values using Ku – this results in the NPV assuming the business were financed entirely by equity 2. The value of the tax benefits associated with debt financing: – calculate the interest tax shield by multiplying the annual interest expenses with the marginal tax rate on a year-by-year basis Interest tax shield = interest expenses x marginal tax rate – calculate Terminal value of interest tax shields (based on long term capital structure assumptions) Terminal value = interest tax shieldN+1 / (cost of debt – perpetual growth rate) – discount the tax savings at the estimated cost of debt. The cost of debt should be pre-tax

6.2.9

Worked example

Assumptions

Tax rate Cost of debt Cost of equity

35.0% 6.0% 12.4%

Debt ratio (D/V)

40%

Long-term growth forecast

3.0%


97


1. Calculation of Base case PV 1

2

3

4

5

6

TV

EBIT

20.9

22.4

23.9

25.1

25.9

26.7

27.5

Tax

(7.3)

(7.8)

(8.4)

(8.8)

(9.1)

(9.3)

(9.6)

D&A

6.6

7.1

7.6

7.9

8.2

8.4

8.7

Capex

(8.8)

(9.4)

(10.1)

(10.6)

(10.9)

(11.2)

(11.6)

Change in NWC

(1.0)

(0.8)

(0.8)

(0.6)

(0.4)

(0.4)

(0.4)

FCF

10.4

11.4

12.2

13.1

13.7

14.1

14.5

9.5

9.5

9.2

9.0

8.6

8.0

NPV of FCF Terminal Value

242.2

NPV of TV

144.4

Base case PV

191.6

Calculation of TV

FCFTV / (WACC – long term growth forecast) = 14.5 / (9% -3%)

242.2

NPV of Terminal value Terminal value / (1+WACC)^(1 / terminal year) = 242.2 / (1+ 9.84%)^(1/6)

144.4

2. Calculate PV interest tax shields 1

2

3

4

5

6

Debt

50.0

49.0

48.0

47.0

46.0

45.0

Interest

3.06

3.00

2.94

2.88

2.82

2.76

Interest tax shield

1.07

1.05

1.03

1.01

0.99

0.97

PV Interest tax shields

5.0

3. Total APV Base Case PV PV Interest tax shields

191.6 5.0

Total APV

196.7

6.2.10

Drawbacks of Methodology

 More complicated than WACC approach and easily misapplied – information for analysis is not always readily available  WACC adjusts the discount rate to account for financial enhancements – thus, the value created by financing side effects remains obscure  Difficulty of estimating probabilities of default and the cost of bankruptcy, which is usually ignored. This means that enterprise value from APV method is usually overstated, particularly at high leveraged companies  Need to estimate long term debt structure (when you assume zero debt once existing debt is repaid)


98


6.3

Dividend discount model (DDM)

In certain sectors the conventional valuation methodologies cannot be applied due to the nature of the company’s business model. Banks and insurance companies for example need to meet capital requirements that are set by particular regulatory bodies. Only when a certain portion of the net income is put to increase the capital or a minimum capital position is reached, can dividends be paid out. This cash flow is discounted as a normal DCF to arrive at the equity value of the company. Use only the cost of equity for your calculations. Subtracting debt would not make sense in this case, as debt is more like working capital for a bank, not so much a pure financing instrument as for companies in other sectors. Banks make money on the margin between the interest payments they pay (to entities the bank owes money to) and interest they receive (from those who owe money to the bank).

6.4

Appraisal Value (AV)

Calculating Appraisal Value is the key methodology to value life insurance companies. It is ultimately a DCF, made easier with the use of Embedded Value (EV) and Value of New Business (VNB). Appraisal Value = EV + Goodwill The aim of an EV is to recognise the profit as it is earned over the life of the insurance policy (i.e.: when it is earned, not when it is released to shareholders). EV is the value of the product sold, estimated at time of sale and booked in P&L. The future profits are discounted at a risk discount rate, typically calculated as risk free rate plus a risk premium and often different for different products. The goodwill can be calculated as a multiple of the VNB, usually in the order of 4–8 times. Do not mistake this goodwill with the accounting term—this is the terminology used for the franchise value in life insurance. For an in-depth calculation of AV, please refer to the UBS Valuation Guide Book, Life and Pensions Insurers, prepared by FIG.

6.5

Special cases

6.5.1

Loss-making companies

In this case valuation based on multiples and precedents is not valid. Consider valuing by reference to underlying net assets. Consider also assuming a "normalised" operating margin based on the industry/sector, work out a theoretical profitability level, based on turnover/assets, and value the business. Then deduct amounts for risk, uncertainty, in achieving those theoretical profitability levels (very subjective) and costs incurred in getting to that stage including losses in the intervening period. (Turnover multiples can be used as a shortcut in following this approach, particularly in sectors where there are other loss-making quoted companies). Most companies that make a positive EBIT should be capable of being recapitalised with more equity and less debt, even if they are presently making a pre-tax loss. We would value the EBIT (using multiples or DCF) and then produce enterprise value. This may show that the debt is actually bigger than the enterprise value.

6.5.2

Liquidation value

This represents the value remaining once all the assets have been sold and the liabilities settled. We have to bear in mind the incidence of redundancies, stock clearance and other transaction costs and taxes on disposals within the Company during the liquidation process. When, as in liquidation, there is a forced sale element, it is always possible that assets will not be sold for valuation hoped for, or even book values. In particular, there may be losses on stocks and certain types of fixed assets (e.g. plant).


99


APPENDIX A

Comps & Precedents adjustments 7.


Comps & Precedents adjustments A.1.

Adjustments

It is difficult to make a list of all possible EV adjustments. In practice, adjustments will be decided within each team. Focus should be on adjustments that are likely to have a material impact on the enterprise value calculation. The key is being consistent with all adjustments.

A.1.1.

Information sources

Sources of information Category

Information needed?

Market data

Latest closing share price Latest number of shares Market value of debt

Datastream, Bloomberg Bloomberg, Datastream, Company reports Bloomberg

P&L — historical

Full financial section of latest annual report

Company website, http://www.sec.gov/edgar.shtml (for US companies)

Balance sheet

Full financial section of latest report (annual/interim)

Company website, http://www.sec.gov/edgar.shtml (for US companies)

P&L forecasts

UBS Research forecasts

Researchweb, analyst models (for European companies only!) The Markets or Thomson Research

Other broker notes Other

A.1.2.

Any significant news or corporate events?

Where to find it?

Company website, Factiva, Bloomberg and Reuters

Classes of shares Comments

Principle

 Include all classes of shares – there should be a price for each class

Impact on NOSH

 Equity value = (“A” shares x “A” price) + (“B” shares x “B” price)

A.1.2.1.

Options Comments

Principle

 Only include “in the money” options in number of shares outstanding – typically all options vest on “change of control” event  Treasury method is the most common – proceeds from conversion of options are used to buy back shares at offer price  In theory, “out of the money” options will also have value and should be included in equity value – in practice this value is not available from public documents and requires specialist option valuation

Impact on NOSH

 Use “outstanding” options and average strike price – calculate by each class if available  Net new shares = options − (options × strike price ÷ offer price)

APPENDIX A: Comps & Precedents adjustments

101


A.1.2.2.

Convertibles Comments

Principle

 “In the money” when the conversion price < offer price – increases diluted NOSH – adjust Net income for the interest expense (post tax) – convertible bond should be EXCLUDED from the net debt  “Out of the money” when the conversion price > offer price – convertible bond should be INCLUDED in the net debt – use aggregate amount of the debt and option components

Impact on NOSH

 New shares issued = face value of convertibles ÷ conversion price

Impact on income

 The convertible interest charge (post tax) is added back to get the earnings figure as if the convertible did not exist

Impact on debt

 Either: “out of money” in which case treat convertible as part of net debt  Or: “in the money” in which case include as part of net debt as market value (and do not make the other adjustments above)

A.1.2.3.

Pensions Comments

Principle

 Pension liabilities are effectively long-term debt used to fund employee compensation and as a result have an impact on EV  Pension deficit (post tax) needs to be added to the EV – = (value of plan assets) – (value of plan liabilities)  Other pension employment benefits (OPEBs) is not usually funded – OPEBs deficit treated as debt equivalent in EV on a post tax basis  Normally pension expense treated as operating item and included in EBIT – in reality, only service is truly the operating item

Impact on EV

 Adjusted EV = EV + pension deficit + OPEBs – include pension deficit and OPEBs on a post tax basis

Impact on EBIT(DA)

 Adjusted EBIT(DA) = EBIT(DA) + pension expense – service cost – in some companies, this adjustment has already been made in the accounts therefore no need to “clean out”

A.1.2.4.

Operating leases Comments

Principle

 Add back the equivalent liability of a capital lease  8x lease expense used a rule of thumb – however depends on industry – NPV method sometimes used as a better cross-check

Impact on EV

 Adjusted EV = EV + equivalent liability of a capital lease

Impact on EBITDA

 EBITDAR = EBITDA + lease expense


102


A.1.2.5.

Investments and associates Comments

Principle

 In order to calculate the value of the “core business”, investments/associates should be stripped out and valued separately  The value of an investment/associate is reflected in the market cap of the company and therefore needs to be subtracted from the EV

Impact on EV

 There are several methodologies to value investments/associates – market value if listed – estimated market value (apply a multiple to earnings) – book value (last resort)  Most of the time, under IFRS, associates in the P&L are shown as a share of net income – Therefore an appropriate P/E multiple can be applied e.g. relevant peer group multiple

Impact on EBIT(DA)

 EBIT(DA) should also reflect the core business – i.e. exclude any earnings from associates/investments

A.1.2.6.

Exceptionals Comments

Principle

 All line items should be adjusted for exceptionals and exclude discontinued operations where relevant  Common exceptionals include: – restructuring charges – impairment of fixed and intangible assets – large loss/gain on disposals  Goodwill amortisation has disappeared (US GAAP + IFRS) – but replaced by impairment—to be treated as an exceptional

Impact on EBIT(DA)

 EBIT(DA) should be adjusted to reflect the operating nature of the business

Impact on net income

 Net income should be adjusted for exceptionals post tax – look for actual tax charge on exceptionals – otherwise apply the marginal tax rate


103


APPENDIX B

Glossary 8.

APPENDIX B: Glossary

104


Glossary Term

Meaning

Adjusted present value (“APV”)

A variant of the DCF used to calculate the net present value of a company or project assuming it were financed entirely by equity plus the net present value of the tax shield created by using debt in the capital structure Appraisal Value is the key methodology for the valuation of life insurance and pensions companies. It is an intrinsic valuation methodology similar to a DCF or DDM but made simpler by the use of Embedded Value (“EV”) and Value of New Business (“VNB”) A measure of the sensitivity of the stock to movements in the market Covariance (historical stock return, historical market return)/ Variance (historical market return)

Appraisal value (“AV”)

Beta

Break-up value Call Option

Break-up value is the total value of the company if its operations are sold separately, as such this is a transaction valuation Right, but not the obligation, to buy a security at a specified price

Capex

Capital expenditures

Capital Asset Pricing Model (“CAPM”)

Theoretical model used to estimate expected cost of equity based on correlation with the overall market

Capital lease

See Finance Lease

Compound annual growth rate (“CAGR”)

Equivalent annual growth for a given period CAGR (Year “n” value ÷ Year 1 value) ^ (1 / (n-1)) – 1

Conglomerate

Conglomerate is a group of different businesses whose operations are not integrated with each other Conglomerate/holding company discount is the discount to underlying net asset value (“NAV”) at which conglomerates are valued A liability for which its value depends on certain other values or events (e.g. Lawsuits)

Conglomerate/holding company discount Contingent liability Control premium

Incremental price required to obtain control

Conversion price

Price at which a convertible security converts

Convertible security

Security that is convertible into another security at a prestated price

Creditor days

Creditors/Cost of Goods Sold x 365

Debt risk premium

The premium over the yield on long-term government bonds demanded by the market on the company’s debt

Debtor days

Debtors/Sales x 365

Deferred tax

Deferred tax is an accounting item that effectively smoothes the difference between the tax charge expected in the accounts and what is actually payable

Defined benefit pension

A plan where the retirement benefits are defined by a company, who are obligated to meet payments at a set level, regardless of investment performance A plan providing an individual account for each participant, who will reveive benefits based solely on the amount contributed to the plan and the returns on assets in which the plan invests Present value of cashflow. Cashflow/(1+Discount rate)t

Defined contribution pension Discounted cash flow (“DCF”) Dividend discount model (“DDM”)

Valuation method to derive equity value by discounting future dividends


105


Term

Meaning

EBITA

Earnings before interest, tax and amortisation

EBITDA EBITDA Debt Leverage

Earnings before interest, tax, depreciation and amortisation Total net debt EBITDA

EBITDAR

Earnings before interest, tax, depreciation, amortisations and rents/leases

Economic value added (“EVA”)

Valuation methodology comparing the returns a company generates with cost of capital NOPLAT – opening capital employed x WACC OR Capital employed x (ROCE – WACC) Income tax expense/taxable income

Effective tax rate Enterprise value (“EV”)

Equity Gearing

Represents the total value of a business/enterprise to all providers of capital (debt, minorities, preference, equity) Equity value + net debt + minority interests + pension deficit + off-balance sheet items + other debt-like items Equity Debt + Equity

Equity risk premium

The premium demanded by equity investors on shares which have an “average” degree of market related risk and an “average” level of gearing

Equity value

Represents the value to the providers of equity, after net debt, minorities and preference shares have been deducted from enterprise value European Interbank Offer Rate Price at which an option holder may buy or sell a security

EURIBOR Exercise price Finance lease Fixed Charge Coverage

A finance or capital lease generally lasts for the life of the asset, with the present value of lease payments almost equivalent to the price of the asset Cash flow available for debt service Interest plus scheduled repayment

Free cash flow (“FCF”)

Cash flow available to service capital (cash flow from operations less capex)

Fundamental valuation

Reflects the net present value of the cash flows of the business

Holding company

Holding company is a company whose single raison d’être is to hold shares in other companies (usually the company does not produce goods or services itself)

Internal rate of return (“IRR”)

Equivalent annual return CAGR on an investment Corresponds to discount rate at which NPV=0

Lease

A lease is a contract between two parties: one party (lessee) has right to use an asset which is owned by another (lessor) for a fixed or indefinite period of time, whereby the lessee obtains exclusive possession of the property in return for paying the lessor a fixed or determinable payment. The lessor retains the legal ownership of the asset

Leveraged buy-out (“LBO”)

Purchase of a company through use of a high proportion of debt financing

LIBOR

London Interbank Offer Rate

Marginal tax rate

Statutory tax rate in specified jurisdiction

Minority interest

Third party ownership in a parent company’s subsidiary Cash exit value as a multiple of cash entry value of a given investment

Money multiple Net debt

Short-term + long-term interest-bearing liabilities—cash and cash equivalents (marketable securities)

Net present value (“NPV”)

See discounted cash flow


106


Term

Meaning

NOPLAT

Net operating profit less adjusted taxes (practically speaking, taxed EBIT adjusting for non-deductible items) Liability of a company which does not appear on its balance sheet

Off-balance sheet liability Operating lease

Option Perpetual growth

An operating lease is usually signed for a period considerably shorter than the useful life of the asset and the present value of lease payments are generally much lower than the actual price of the asset Right to buy or sell a security. See Call Option and Put Option Method for calculating terminal value based on a single future growth rate FCFt 1 WACC  g

Preference shares

Shares paying a fixed return. May be supplied with warrants attached

Put Option

Right, but not the obligation, to sell a security at a specified price

Return on capital employed (“ROCE”)

Return a business generates on its total capital ROCE = EBIT / (average shareholders funds + net debt)

Return on equity (“ROE”)

Return a business generates on its equity ROE = Net income / average shareholders funds

Return on invested capital (“ROIC”)

See return on capital employed

Stock days

Stock / Cost of Goods Sold x 365

Sum of the parts (“SOTP”)

Valuation method involving the separate valuation of different parts of a business to determine aggregate value

Synergies Terminal value

The financial benefits that a company expects to realise from the integration of two businesses An estimate of the value of business at the end of the projection period

Trading valuation

Reflects the theoretical value of one share as part of a listed entity

Transaction valuation

Reflects the value an acquirer can derive from controlling a company

Unaffected market value

Market capitalisation of a listed company implied by the closing price on the day prior to rumour or speculation of impending corporate transactions (e.g. takeover speculation)

Volume weighted average price (“VWAP”) Warrant

Average share price over a period where each day’s closing price is weighted by volume traded that day Entitlement to buy an amount of a security (usually common stock) at a specified price

Weighted average cost of capital (“WACC”)

Weighted cost of debt + weighted cost of equity = D E  (Cost of debt"Kd" ) (1  T)   (Cost of equity"Ke") D E D E


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APPENDIX C

Further reading 9.

APPENDIX C: Further reading

108


Further reading Valuation & Accounting  Damodaran on Valuation: Security Analysis for Investment and Corporate Finance  Equity Valuation: Models from Leading Investment Banks by Jan Viebig, Thorsten Poddig and Armin Varmaz  Applied Mergers And Acquisitions by Joseph R. Perella, Robert F. Bruner  Accounting For M & A, Equity, And Credit Analysts by James E. Morris  Valuation: Measuring And Managing The Value Of Companies by Tim Koller, Marc Goedhart & David Wessels  Security Analysis: Principles And Techniques by Benjamin Graham and David Dodd  Corporate Finance: Theory And Practice by Pierre Vernimmen and Pascal Quiry  Business Analysis And Valuation: Using Financial Statements by Krishna G. Palepu and Paul M. Healy  The Quest for Value by G. Bennett Stewart  Beyond Greed and Fear: Understanding Behavioral Finance and the Psychology of Investing by Hersh Shefrin

Business & Finance  The Smartest Guys in the Room—by Bethany McLean and Peter Elkind  When Genius Failed: The Rise and Fall of Long-Term Capital Management by Roger Lowenstein  Den of Thieves by James B. Stewart  Barbarians at the Gate: The Fall of RJR Nabisco by Bryan Burrough and John Helyar  All That Glitters: The Fall of Barings by John Gapper & Nicholas Denton  Disney War by James B. Stewart  The Warburgs: The Twentieth-Century Odyssey of a Remarkable Jewish Family by Ron Chernow  Stealing Time, Steve Case, Jerry Levin and the Collapse of AOL Time Warner by Alex Klein  Taken for a Ride: How Daimler Benz drove off with Chrysler by Bill Vlasic and Bradley A. Sterz.  Goldman Sachs: The Culture of Success by Lisa J. Endlich  Blue Blood and Mutiny: The Fight for the Soul of Morgan Stanley by Patricia Beard  The House of Morgan: An American Banking Dynasty and the Rise of Modern Finance by Ron Chernow

APPENDIX C: Further reading

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2009 Valuation Handbook a UBS Guide

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