Acquisition Valuation Techniques Valuation of Closely-held Firms (Version: January 2018) Week Overview This is the final topic for the class. We introduce two valuation techniques and discuss some...

Read file with directions. There are many attachments.


Acquisition Valuation Techniques Valuation of Closely-held Firms (Version: January 2018)    Week Overview This is the final topic for the class.  We introduce two valuation techniques and discuss some qualitative factors that affect the value of closely-held (non-traded) companies.  The reason that we are looking at closely-held/private/non-traded companies is that publicly-traded companies have a value already - their share price.  The premium that is offered over the share price in the acquisition of a public company depends on the synergies or value-added the bidder expects to capture from the acquisition.  That is usually very bidder/target specific.  So we will look at the more generic problem of estimating a value for a non-traded company, which is similar to estimating what its share price might be if it were traded.  The two valuation techniques we will discuss are the discounted cash flow method and the multiplies method.  This will be a brief introduction to an extremely complicated topic.    Learning Objectives · Consider how to value a business using the discounted cash flow (DCF) method. · Consider how to value a business using the multiples method. · Consider factors that will affect the value of a company away from the DCF or multiples value.    Readings All are optional. The Drake article provides an excellent description of computing the Free Cash Flows used in valuation. The UBS Warburg report does the same for multiples. The McKinsey article provides a great discussion of how to improve the multiples approach.  All except the Chaplinsky piece are posted in this unit for download. · Pamela Drake, What is free cash flow and how do I calculate it? · Susan Chaplinsky, Methods of Valuation for Mergers and Acquisitions, Darden Note, 2000  ( LINK HERE)           · Tim Leuhrman, What's It Worth? A General Manager's Guide to Valuation, Harvard Business Review, May 1997. · Peter Suozzo, et al, Valuation Multiples, A Primer, UBS Warbrug, November 2011. · Marc Goedhart, et al, The Right Role for Multiples in Valuation, McKinsey Quarterly, March 2005.    1. Company valuation using the discounted cash flow method Company valuation using the DCF method is very similar to computing a project's NPV.  You will recognize several of the concepts from NPV analysis applied here.  There is two big differences that I will spend some time on: · computing the appropriate cash flows · determining a terminal value as an infinite series.   Basic approach · Use free cash flows · Assume a perpetual growth rate and compute a terminal value for the company · Discount at the WACC to find the value of the enterprise · If applicable, subtract LT Debt to find Equity Value or compute FCFE (free cash flow available to equity holders)  A. Free Cash Flow Free Cash Flow (FCF) is the cash flow that is available to distribute to investors - both debt holders and shareholders - after all investments necessary for maintaining the company on its current growth trajectory have been made.  FCF could be distributed or re-invested to increase growth beyond the current growth rate. As in NPV analysis we do not include interest or financing costs in the cash flows we value. We are interested in how the operations of the company generate cash, not in how the company is financed. Including interest expense or other financing costs would distort our analysis away from the desired focus on operations. From the Drake reading, Equation 11, we will use this equation to compute the FCFF (Free Cash Flow for the Firm) FCFF = EBIT* ( 1-TaxRate) + Depreciation - Net Capital Expenditures - Net Change in Working Capital From this point I'll use the following abbreviated names for these items: · T = Tax Rate · DEP = Depreciation and other none cash charges such as amortization · CAPEX = Capital Expenditures = ∆Net Fixed Assets +DEP · ∆NWC = Change in Net Working Capital  Here is data that we will use to demonstrate the valuation process.  We have enough data to compute the FCFF for 2018. 2016 2017 2018 Net sales  8,700  9,600  10,000 Cost of sales  4,600  5,080  5,250 Gross profit  4,100  4,520  4,750 Selling, general and administrative expenses  2,950  3,180  3,300 Depreciation Expense  160  180  200 Interest Expense  90  100  100 Earning before tax  900  1,060  1,150 Tax expense  (30%)  270  318  345 Net income  630  742  805 Dividends paid 150 160 175 to Retained Earnings 480 582 630   ASSETS Dec. 31, 2017 Dec. 31, 2018 Cash and cash equivalents  220  340 Accounts receivable  580  620 Inventories  1,450  1,530 Total current assets  2,250  2,490 Property, plant, and equipment 3,850 4,240       less accumulated depreciation 1,300 1,500  Property, plant, and equipment, net  2,550 2,740 Total assets  4,800  5,230 LIABILITIES AND EQUITY Dec. 31, 2017 Dec. 31, 2018 Accounts payable  300  300 Current Portion LT Debt  200  200 Total current liabilties  500  500 LONG TERM DEBT (5%)  1,200  1,000 Total liabilities  2,200  2,000 Common stock  200  200 Retained earnings  2,400  3,030 Total liabilities and equity  4,800  5,230 EBIT (Earnings before Interest and Taxes) for 2017 is $1,250.  I added Interest Expense to Earnings before Tax, but you could also subtract SG&A Expense and Depreciation from Gross Profit. DEP is 200.   CAPEX is the change in the change in Property, Plant and Equipment or $390 = $4,240 - $3,850. You can also get CAPEX as Net PPE(2018) - Net PPE(2017) + DEP(2018) = $2,740 - $2,550 + $200 =  $390. Recall that net working capital is the difference between total current assets and total current liabilities. The ∆NWC is NWC(2018) - NWC(2017) = (2,490-500) - (2,250-500) = 1,990 - 1,750 = $240. We are only concerned with the change in NWC, not the total amount.  Recall that Working Capital circulates asInventory is sold and A/Receivables are collected cash is spun of that pays A/Payables.  Once we have some level of Working Capital it funds itself or replenishes itself at that level.  So the additional investment is the change in NWC or ∆NWC.  The tax rate is 30%, so our estimate of FCFF is: FCFF = EBIT*( 1-T) + DEP - CAPEX - ∆NWC FCFF = $1,250 *(1 -.3) + 200 - 390 - 240 = 875 + 200 - 390 - 240 = $445 This is the FCFF for 2018.  Because we didn't consider interest expense this is cash flow available to all sources of funds. To value the company we would discount this type of cash flow by the WACC. Using just one year of cash flow to value a company would be risky.  The year might have been atypical: profit margins might have been lower or higher than average, CAPEX might have been higher or lower than average, etc..  We would really like to have several years of data.  This is particularly important for companies that make large capital expenditures on plant and equipment.  Most capital-intensive companies make investments in lumps.  One year they make a big investment building a new plant, then capital expenditures are low for several years until sals growth requires an expansion of facilities or new equipment.  This is the idea behind  depreciation: it is a way to spread lumpy investments out over time.  B. Constructing Future Free Cash Flows & Terminal Value When we value a company or a unit of a company we would like to have several years of data.  We can use our pro forma financial statement skills to build future income statements and balance sheets, then compute the FCFF from those financial statements.  There will usually be a set of assumptions that will speed this process. For example, we might say that sales will grow 4% per year and all income statement items will be the same %-of-Sales as they were on the latest actual income statement.  We could make similar assumptions about some of the balance sheet items such as A/Receivable, Inventory, A/Payable and Cash.  We could develop a schedule for capital expenditures to support sales growth. We can do this for several years, but companies, in theory, last forever.  We cannot develop hundreds of years of pro forma statements.  Instead we assume that at some point the firm will be in a constant-growth state and then we can use the dividend growth formula to estimate its value from that point into perpetuity.                                                                                      Terminal Value Unlike the projects we evaluate with NPV analysis, which have an end point, a company has (in theory) an infinite life. We cannot estimate an infinite series of annual free cash flows, so instead we estimate some using pro formas then assume that beyond that point growth will be constant at some relatively low rate.  We know how to value an infinite series with a constant growth rate.  This is the dividend growth model from basic finance.  Remember that formula (sometimes called the Gordon Growth Model) is:     Suppose we have the following FCFF estimates for 2018 through 2022.  Further assume that beyond 2022 we expect FCFF to grow by 3% and that the appropriate discount rate is 15% for these cash flows.  That is, the WACC is 15% for this company.   YEAR 2018 2019  2020  2021  2022  FCFF  $445  $520  $600 $680  $710 PV(15%) $387 $393 $395 $389 $353 We find the value of the firm by discounting the FCFF in the table by 15%. We will assume that we are doing the PV calculation at the beginning of 2018 so the $445 cashflow is one year in the future, the $520 cash flow is 2 years in the future, and so on.  This is straight-forward present value calculation.  But what about all the years beyond 2022?  We find the value of those cash flows by applying the Dividend Growth Model to the 2022 FCFF of 710. In the formula for the dividend growth model shown above D is next period's dividend, which would correspond to the FCFF for 2023. We can find the 2023 FCFF by growing the 2022 FCFF by 3%, FCFF(2023) = $710 x 1.03=$731.3. Next, we divide by k-g (= 0.15 - 0.03 =0.12) to get a terminal value at the end of 2022.  The dividend growth formula computes the value of a share of stock today based on next period's dividend, so the analog for this example would be the PV of the infinite series of FCFF growing at 3% from 2023 and beyond, valued at the end of 2022 or beginning of 2023.  The terminal value is $731.3/0.12 = $6,094.17.  This is as of the end of 2022, so we have to adjust the 2022 cash flow to $710 + $6,094 = $6,804, which has a PV of $3,383 discounted at 15% for 5 years.  YEAR