Corporate Valuation is one of the most important aspects of Finance for a bank as it has the potential to generate huge sums of money for its Global Banking businesses.
One of the main aims of a company is to increase its shareholder value.
This can be done through various methods such as investment in various products or services, by cutting costs, or through improving its public perception (by no means an exhaustive list).
Being able to create value provides a positive outlook for the growth of a company, and hopefully ensures that shareholders retain their shares invested in the company.
Global Banking functions in Investment Banks who are looking to calculate the fair value of a company using existing and future factors can understandably find this difficult to calculate.
This is due to the fact that future expectations of a company’s growth are likely to differ significantly between valuing institutions.
Due to its difficulty, corporate valuations are highly subjective, and this is one of the reasons that Investment Banks must prepare detailed assessments and presentations to convince the corporations to allow them to carry out relevant activities using these analyses (e.g. Mergers, Acquisitions, and Leveraged Buy-Outs).
What are the Two Main Aims of Corporate Valuation?
Calculating Company Value
For a valuing firm, the main two questions they ask are: what is the fair value of the firm, and what is the potential amount that the company could be sold for?
There are three ways that are commonly used to value a company:
- Public Comparables Model: Using valuations from relative companies to make a valuation of the company in question,
- Acquisition Comparables Model: Estimating a relative value of the firm to previous transactions of similar companies,
- Discounted Cash Flow Model: Calculated by approximating future unleveraged cash flows and discounting them to a present day value.
Calculating Potential Synergy
To estimate the potential worth to a buyer (wishing to acquire or takeover the firm), there are two methods commonly used:
- Merger Consequences Model: Looking into what a firm potentially could pay based on their financial strength,
- Leveraged Buy-Out Model: An estimation of the purchasing power of a private equity firm funded with debt.
It is necessary to understand the aim of the buyer to select the correct analysis to use. A private equity firm will potentially require LBO analysis, while a company aiming to takeover another will require Merger Consequences analysis.
Outside of these two fundamental questions, the valuing institution must also assess whether the acquisition of the company is either friendly or hostile (hostile takeovers drive up the share price of the target company due to ‘toehold’ purchases).
Furthermore, the valuing institution will need to assess the stability of the market, as this also affects the ability to conduct comparable analysis.
Which Financial Performance Measurements are Used?
There are some key financial performance measurements which are assessed in each of the analyses which are imperative to answering the main valuing institution’s questions.
Value of Equity
Firstly, you first need to assess the value of equity, defined as the market capitalisation (volume of shares multiplied by the value of a share).
In practice, diluted shares are used in this valuation to include potential shares from convertible securities and options which are valued against the underlying shares.
In addition to the equity value, the net debt is calculated for the firm (the total value of debt minus cash and other equivalent liquid assets such as short-term marketable securities).
Net debt is used as in a takeover, the cash or equivalent assets can be used to pay off any outstanding debt as they have a 100% recovery rate.
Both of these measures are totalled to create the Enterprise Value of a firm.
Earnings Before Interest and Tax (EBIT)
A valuing institution will then want to assess the EBIT of a company (Earnings before Interest and Tax).
This measure is the next logical step to valuing a company as it directly affects the Enterprise Value, and is an indicator of the profitability of the day-to-day operations of the firm regardless of the split between debt and equity.
Earnings Before Interest, Tax, Amortisation and Depreciation (EBITDA)
Additionally, the EBITDA (Earnings before Interest, Tax, Amortisation and Depreciation) is then calculated as it can then provide the approximation for the operating cash flow of a company (the depreciation and amortisation are non-cash expenses).
Once the financials have been determined for the company, any non-recurring expenses are found, and the total valuation is adjusted accordingly.
Non-recurring expenses may include legal settlements, demise of a business division or through restructuring.
By excluding these items, you bring yourself closer to the underlying valuation of the company.
Sometimes, it may be necessary to have to adjust for multiple non-recurring expenses which could potentially have affected each other’s’ final cost.
It is also worth noting that some non-recurring expenses may be hidden in other line items in the income statement of a company, so achieving the true valuation of a one off expense can take a lot of analysis.
Employees working in the Global Banking section of Investment Banks must work extensively to provide valuations for companies, and justifications for their findings.
Given that this requires a lot of in-depth analysis, and is based on multiple assumptions, the outcomes can understandably vary significantly from bank to bank.
It would be fair to assume that theory can only get you so far with corporate valuation, as the ones who are most successful are probably the ones who have the most practical experience.
What is the Public Comparables Model?
The Public Comparables model is a relative assessment of a firm’s value when compared to similarly traded companies in the market (often referred to as the “peer group”).
The assessment analyses key financial indicators at a specific point in time between the firms such as P/E (Price to Earnings ratio), EBITDA and EPS (Earnings per Share).
In addition to this, it also looks into other performance metrics such as growth rates, or margins.
These metrics will often be taken from the stock price at the latest date to ensure that all available information is reflected in the valuation.
The benefit of analysing these metrics is that it can provide a relative valuation of underlying financial statistics.
How Does a Valuing Company Decide on the Peer Group?
There are two main determinants which are used when choosing firms for a peer group: the “Operational” factors, and the “Financial” factors.
The Operational factors which are assessed can vary from the products or services that the company provides, the markets they operate in, the industry or the types of customers who purchase their products.
Two companies which would be ‘operationally’ similar would be Tesco and Sainsbury’s, both of which operate in the UK, targeting consumers looking to purchase food and drink in the retail industry.
The Financial factors which are assessed to validate similarities include the size of the company, how much leverage the company owns, future growth prospects or margins.
Despite the factors for comparison being clear cut, evaluations in practice are far from straight-forward.
Trying to find companies which are perfect comparisons is incredibly difficult (especially when considering that a ‘good’ number of companies to comprise a peer group is between five and ten).
Once the Peer Group is Established, Then What?
The next step is to gather a list of information for each of the companies selected. This information can include:
- Annual Reports for the last full fiscal year
- The latest quarterly reports since the last full fiscal year
- Share Prices and EPS
- Any recent news relating to the company in question
After obtaining this data, the valuing company will need to calculate the metrics outlined in the previous blog post (covering the basics of Corporate Valuation): the Equity Value, Enterprise Value and Last Twelve Month values for EBIT, and EBITDA.
How is the Equity Value Calculated?
1) The Option Proceeds Need to be Calculated for all Outstanding Options
This means that if there are 2 million options for the stock in question, where each option exercise price is £1.50, then the value of Option proceeds is £3m.
2) Calculate How Many Shares can be Repurchased with the Proceeds
Now that the Option Proceeds have been calculated at £3m, if the current stock price is £10 per share, the number of shares that can be repurchased is 300,000.
3) Calculate the Diluted Shares Outstanding
If the company has a total of 50 million outstanding shares, then the diluted shares outstanding are 50 million, plus the 2 million options for the stock, minus the 300,000 shares repurchased.
The number of diluted shares outstanding is therefore 51.7 million.
4) Determine the Equity Value of the Firm
The equity value here is therefore 51.7 million multiplied by the stock price £10, giving us an equity value of £517m.
This Equity Value can then be used to calculate the Enterprise Value (which is Equity Value plus Net Debt – the total debt minus cash and other liquid equivalents).
Which Other Information Helps with Public Comparables Analysis?
The Income Statement can now be utilised to assess the last twelve months (LTM) of information as a historical benchmark amount of time.
This period of time can be calculated by summing the income statements for the last two halves or four quarters of the year.
The annual report and latest quarterly reports can also be used to infer the most up-to-date LTM from this.
In addition to the financial metrics outlines earlier in this guide (EPS, P/E etc.), valuing individuals may need to assess other financial measures which are specific to the industry relating to the company being valued (e.g. looking at book value for institutions in the financial industry).
Information relating to specific industries can be acquired from press releases, research reports, or by aggregating financial reports for all companies in the industry.
After We Collect all the Data, Now What?
Once all of this data has been collected and brought together, the in-depth assessment of each comparable company needs to be analysed by looking at the big picture.
What do the figures explain?
Could the findings relate to the company I am trying to value?
Typically, the three main factors which can have a significant effect on all of the calculated metrics above are:
- Size: How much of the Market Share a Company has,
- Risk Profile: Operational Effectiveness, Return on Investment Capital, Margins, Credit Profiles,
- Growth: Sales Forecasts, Projected Cash Flows, EBITDA and EPS.
Once all of the information has been assessed, a valuation range must be given to the company being valued.
The valuation of a company is not an exact science, and is highly subjective.
It could be argued that there is no perfect guide to being able to value a company, and judgment based on experience rather than education is almost certainly going to be the most accurate and effective in this industry.
What is the Acquisition Comparables Model?
The second method which is used to provide relative valuation is the Acquisition Comparables Model.
This valuation typically provides higher estimates of a firms value than Public Comparables as it takes into account the takeover premium (synergy) which is gained when two companies merge.
This is often due to the anticipated increase in cash flows from either increasing market share, or cutting out a link in the supply chain leading to increased cost savings.
Similarly with Public Comparables, the analysis focuses on key financial performance indicators and multiples such as growth, margins, leverage etc.
In addition, it also adds in premiums paid in precedent transactions between acquisitions and mergers of companies, so perhaps provides a better estimation of the true value of a firm when considering a merge or takeover.
What Do You Need for Acquisition Comparables Analysis?
As with Public Comparables, a list of similar transactions (deal list) needs to be established for the assessment.
To be able to do this the valuing institution needs to find precedent transactions where the target and the acquiring firm have similar financial and operational features, and to write a “story” behind each of these transactions to understand the reasons for the deals.
It’s also needs to be able to explain potential outliers in the key indicators which would be used for comparison.
Where Public Comparables analysis may not be able to provide an entirely accurate estimate to the true value of a firm due to the lack of inclusion of synergy; Acquisition Comparables analysis has the downfall of not having many previous transactions to choose from.
Even when the deals have been found, market conditions, political factors and other issues at the time the deal was struck may mean that similarities may be tenuous, and the comparison could suffer as a result.
To form the deal list, the valuing firm will ask questions such as “Was the takeover friendly or hostile?” and “What were the market conditions like during the transaction?”, and ideally, the deal list should be composed of 5-10 separate deals for analysis.
How Are Previous Deals Identified?
To find data pertaining to the transactions found for the deal group is a difficult and sometimes impossible task.
Analysis of the deals can often be found through popular databases (Thomson Financial Securities Data, Mergerstat, Capital IQ and Dealogic to name a few), through press releases, M&A journals and through public analysis done by industry experts.
Where there is a lack of information available, the valuing institution will need to make assumptions, and use judgment in order to plug these holes.
Public information available for analysis includes the Merger Proxy (a document used to petition for votes from shareholders to approve a takeover), the Schedule TO (the tender offer), and the 14D-9 which is the target company’s reply to the tender offer.
Similar with the Public Comparables Analysis, the Annual Report and any quarterly period reports since the last full fiscal year are used for financial comparisons.
Once all of the relevant information pertaining to each company has been gathered, the same financial analysis as in the public comparables is calculated:
1) Offer Value (Equity Value in Public Comparables)
This is calculated by multiplying the offer price per share but the number of outstanding shares, and then the option proceeds are subtracted from this value.
2) Transaction Value (Enterprise Value in Public Comparables)
This is just the offer value plus the net debt (total debt minus cash and equivalents).
3) Income Statement Information
Similarly to the Public Comparables analysis, the LTM (Last Twelve Months) of financial information is extracted, and the key metrics are assessed.
Are There Other Factors to Consider?
As Acquisition Comparables looks at previous deals, there are additional factors which need to be assessed in addition to a company’s financials pre and post merge.
If an acquisition has occurred where less than 100% of the company has been bought (a common occurrence), the value needs to be normalised to 100% for comparison analysis.
If a company buys 20% of the stake in a company at £2m, then normalising this value to 100% gives an ‘Implied Offer Value’ of £10m.
Furthermore, the offer price in stock needs to be considered (the current share price of the company to be acquired multiplied by an exchange factor – the multiple that the acquirer is willing to pay in excess of the share price to obtain control of the company).
As there is a premium paid for the shares of the acquired company, the percentage premium needs to be calculated.
When analysing the premium paid for the shares of the company to be acquired, this percentage is calculated for specific time periods before announcement (one day, one week, and one month before), and then compared.
This is because a share price is likely to rise over time as more people anticipate a takeover (to profit from an inflated share offer in the company).
Finally as with the Public Comparables analysis, a holistic view needs to be taken for the acquisitions in the deal group; analysing the size of the companies, and the risk and growth profiles.
In addition to these three influences, the synergy impact on the premium needs to be considered (as the amount that an acquirer is willing to pay increases as the potential synergy increases).
Again, the process of analysing acquisitions or mergers of two companies in the past is not an exact art, and there are a lot of factors which require approximations or assumptions assigned to them.
As there are many ways that individuals can differ in their valuations, it is usually the valuing firm who presents the best justification for their valuations who usually get the deal.
What is the Discounted Cash Flow Model?
The final method of estimating the value of a company is the Discounted Cash Flow Model which looks to use the expected future cash flows discounted at projected interest rates.
The intrinsic value of the firm estimated using DCF analysis provides a theoretical value of the firm at the present day, by looking at future unlevered free cash flows.
This means that the cash flows being analysed are estimated before taking into account any payments on maturing loans or interest payments.
The cash flows are essentially claimable by all capital structure holders of the company.
How Do you Perform Discounted Cash Flow Analysis?
In order to begin the Discounted Cash Flow Analysis, you will need to obtain/infer three sources of information:
- The Present Value of the Unlevered Free Cash Flows due to occur from now until the future,
- The Discount Rates which have been used to adjust future cash flows to the present value,
- The Present Value of the Terminal Value of the firm.
The summation of the unlevered free cash flows and the terminal value when discounted using the appropriate interest rate, will provide the enterprise value of the company in question (the same target goal as in Acquisition Comparables model, and Public Comparables model).
Why Do We Have Three Models for Analysis?
The first major benefit of using Discounted Cash Flow over the other methods is its direct measurement of factors which are inherent to the company in question.
This is done rather than using comparative companies in a market which may be either over or under valued.
If the methods of analysis were to be used in the technology boom of the late 90s, then the relative analysis would likely price a company higher than its intrinsic value. This is because the industry was overvalued as a whole.
Discounted Cash Flow would provide a closer estimate of the correct value in this scenario.
In addition to providing a more confident estimate of enterprise value, the valuation method is objective needing only unlevered future cash flows, and discount rates (both of which are easily obtainable).
Finally, any changes to the factors of a firm (i.e. plans for expansion, changes in growth estimates, regulations) can be factored into the future unlevered cash flows, and their impact on the total enterprise value can be seen easily.
Are There Any Difficulties with the Discounted Cash Flow Model?
Despite the ease of use of Discounted Cash Flow analysis, there are some considerations which need to be taken into account when attempting to infer the intrinsic value of the company.
The first is that the cash flows are forecasted by a variety of sources (which are likely to contrast with each other).
These sources can be heavily in favour or against the forecasts (a valuation from the company itself is likely to be optimistic, while an in-house model forecasting future cash flows will likely err on the side of caution).
Furthermore, the previously identified flexibility of the Discounted Cash Flow analysis when analysing individual factors such as growth estimates, and regulations also is a key consideration which needs to be taken into account.
As the main bulk of information such as the discount rate and future cash flows are heavily dependent on these factors, the intrinsic value estimation is usually presented as a range of values to account for any and all identified eventualities.
How is the Discounted Cash Flow Model Implemented?
To begin the Discounted Cash Flow analysis, we need an estimate of the discount rate.
This value is usually the Weighted Average Cost of Capital (WACC), which is a required rate of return for equity and debt investors.
The individual factors of the WACC are defined as:
Ke = Cost of Equity
The cost of equity is a representation of the investor’s expected rate of return on equity (inclusive of dividends and capital gains).
The value of Ke is typically estimated using the Capital Asset Pricing Model (CAPM).
The model is represented as:
- rf: The risk free rate (typically a sovereign bond). This is the rate at which an investor could invest their money and return a risk-free profit.
- β: The beta of a firm (levered). This is a measurement of comparable volatility to the market. A beta value of 1 means it has the same volatility as the market. A beta of greater than 1 makes it more volatile than the market, a beta less than 1 makes it less volatile, a beta of 0 means the security has the same return as the risk free asset (no systematic risk), and a negative beta implies a price change of the equity which moves in the opposite direction of the market in magnitudes indicated by the absolute value of the beta.
- rM: The expected return of the market portfolio. A portfolio of all stocks in the market will provide a certain rate of return.
- rM – rf: The market premium, which is the expected rate of return achieved from a market portfolio in excess of the risk free rate.
Kd = Cost of Debt
This is the cost of the company raising debt capital for their operations. The cost of debt is observable in the marketplace if the debt is publically traded (for example corporate bonds).
As the cost of debt usually assesses the cost of borrowing on a mid to long term basis, the typical step is to assess corporate bonds with maturity at least ten years in the future.
If there is no publically observable and traded debt, the value can be estimated from:
- Debt Capital Markets in a Financial Institution
- 10-K or Annual Report
- Use a comparable company which has publically traded debt
Once the cost of debt has been assessed, the marginal tax rate (T) needs to be used to deduct tax expense, as interest expense is tax deductible (providing the true cost of borrowing).
E = Market Value of Equity
The market value of equity is calculated as the number of diluted shares outstanding in the market, multiplied by the share price.
D = Market Value of Debt
This is calculated as the book value of debt (book value being the price paid for the asset, rather than its market value).
As a company’s credit profile is liable to change, and the risk free rate in the market can fluctuate, caution must be taken when using the book value (as the market value can be substantially different).
Now that the WACC has been calculated to provide the discount rate, we can use it to adjust the terminal value and future unlevered free cash flows to provide a present value.
To calculate the Unlevered Free Cash Flow, we need to start with the EBITDA value (Earnings Before Interest, Tax, Depreciation and Amortisation), and either add or subtract a number of factors.
The next stage is to forecast the future expected cash flows to a point where the company reaches a point known as a “steady state” where its cash flows provide stable growth and can be sustained in perpetuity.
Usually the steady state does not exceed the expected growth rate of the economy.
The length of the forecast period can vary hugely, and typically depends on how long the forecaster expects the company to reach the steady state.
A company which is already quite mature would usually require a shorter forecast period than one which is in a growth sector.
Now that the projected flows have been calculated, the discounting of these flows for future interest rates needs to be done.
The terminal value is usually the valuation of the company beyond the forecast period (once the steady state has been achieved).
How to Calculate the Terminal Value in the DCF Model?
There are two methods which can be used to calculate this value:
1) Exit Multiple
This method assumes that the business is sold at a multiple of a specified operating factor at the end of the forecast period (the financial statistic can be any relevant factor such as EBITDA).
The multiple is estimated using Comparables analysis (either through Public Comparables estimating the worth of a company using the market of similar companies, or by Acquisition Comparables which measures the control premium and potential synergies the company may get from being sold).
2) Perpetuity Growth
This method assumes that the company will continue to grow at a constant rate forever past the forecast period.
The Free Cash Flow is the value of cash flows from the terminal year.
From the terminal value, it can then be discounted using the WACC to provide a present value (in a similar way to the unlevered free cash flows).
Now that the three components of DCF analysis have been gathered, we can then begin to construct the analysis.
How to Perform Discounted Cash Flow Analysis
The first step is to derive the Enterprise Value of the firm.
The Equity Value then needs to be extracted (as it is a component of the Enterprise Value).
This can be done by subtracting all debt; preferred stock and minority interest, and then add on any cash and cash equivalents.
Finally, the Equity Value per Share needs to be ascertained, and this can be done by dividing the equity value from the previous step, by the number of diluted shares outstanding.
Once these steps have been complete, you should have an estimate range of values that the equity value per share can take (the range has to be specific, but also within reason (and easily explainable for different states of the world).
When you have all three values of the equity value per share (from Public Comparables, Acquisition Comparables and DCF), you should notice that the values from Public Comparables and DCF should provide similar valuations.
This is because they value a business where there is no additional analysis to identify synergies from mergers or takeovers.
Furthermore, Acquisition Comparables will typically provide a higher valuation to account for potential synergies and the control premium.
The three analyses will need to be assessed side by side to make an approximate value of the true value of the firm.
What is the Merger Consequences Model?
The Merger Consequences Model is a method of analysis that aims to rationalise the expected financial impact of a merger or acquisition.
How do we Identify the Impact of a Merger?
There are three important factors which need to be assessed to make a fair judgement on any potential impact:
This takes the potential price that acquirers could potentially pay and afford for the required amount of stock to complete the takeover/merge.
It also identifies the optimal proportions of cash and stock which would be offered to shareholders of the target company once the takeover/merge has been completed.
To determine how much an acquirer can afford to pay, there are two information sources which can be used to analyse this figure:
Affordability is determined by comparing the pro forma earnings per share (EPS), to the EPS of the acquirer. If the EPS increases post deal, then this would be an accretive deal (typically good). Conversely, the EPS is due to decrease post deal, and then this is dilutive.
Although accretive is seen as the better of the two, an acquirer may accept a dilution if the long term strategy will provide additional benefit in the future (increasing stakeholder value).
This analysis aims to see the impact on the balance sheet after a takeover/merge has been completed.
By taking into account the total potential debt, coverage, and debt to capitalisation, this will allow the acquirer to understand whether part of a deal can be financed by issuing debt.
This concerns whether the merge/takeover would be carried out tax free or taxable to the seller.
The amount of tax payable by the seller is heavily dependent on the composition of the “consideration”.
A consideration made up entirely of stock would be called a “reorganisation”, and doesn’t require any tax payable by the seller.
Any proportion of the consideration which is made up of cash or debt is immediately taxable to the shareholders, also known as “boot”.
Business Combination Adjustments
This concerns the allocation of the purchase price, and also the impact of all potential synergies from the merge/takeover.
The fair market value of the firm to be acquired is determined by analysing its net tangible assets which are defined as physical property (land, machinery, inventories etc.)
The value of net tangible assets is defined, and then added to the write-up of the net tangible assets (to reassess the tangible assets at a fair market value).
If the acquiring company elects to scrap the inventory of the target, then this can result in a write down.
The purchase price is an amalgamation of the fair market value (calculated above), and the goodwill added by the acquiring company.
It is assessed as an intangible asset, and provides a level of incentive for the target company to accept the merge/takeover.
Whether a deal is 100% funded by stock or cash, the implied offer value, and generated goodwill are the same:
What Proportion of Cash and Stock Should be Used?
There are some key differences which should be considered when acquiring a company entirely through stock, or cash:
100% Stock Acquisition
Implied Exchange Ratio
This refers to how many shares an acquirer will have to issue for every share of the target company.
Shares Issued by Acquirer
Pro Forma Earnings per Share
This is a calculation of the earnings per share where after-tax adjustments are made concerning synergies, new debt issued to fund the acquisition and depreciation & amortisation of written up tangible assets:
As calculated earlier, this is done by subtracting the Pro Forma EPS by the Acquirer EPS.
A positive number indicates an accretive deal, and a negative indicates a dilutive deal.
Pre-tax Synergy to Break Even
When a deal is diluted, the valuation can include the required amount of synergy (post tax) to break even.
The dilution value per share in the previous step needs to be retained in order to calculate the required breakeven amount.
This analysis provides a simple benchmark to assess whether breaking even is a realistic prospect in the merge/takeover.
100% Cash Acquisition
As this is a 100% Cash transaction, the new debt issued to fund the purchase is equal to the offer value.
The pre-tax expense needs to be tax deducted to find its impact on net earnings.
Pro Forma EPS
This is calculated in the same way as the 100% stock acquisition example; however the key difference is that the pro forma net income is now calculated by taking into account the after-tax interest expense (which is not present in the stock example).
This has the effect of lowering the pro forma net income value relative to the stock example, and as a result, lowers the pro forma EPS.
The affordability of the acquiring firm is also a key part of the analysis, looking at three main aspects of the acquirer and target’s balance sheets to calculate the pro forma version.
Pro Forma Debt
Simply the summation of the total debt of the two companies, plus any new debt created through debt issuance to fund the merge/takeover.
Pro Forma Interest Expense
We can use the existing interest expense payments on the acquirer’s and target’s current debt in this calculation.
The only step that needs to be taken is to calculate the interest expense on the newly issued debt, and then the three elements can be summed.
Pro Forma EBITDA
This is simple to calculate as EBITDA is before interest, and so this measure is just an addition of the EBITDA from the acquirer and the target:
Once all of the above factors have been calculated, and assessed, the analyses can continue to a number of other areas. These include (but are not limited to):
- The Cash/Stock Consideration Mix
- Not all deals are financed 100% by cash or 100% by stock.
- Synergy Impact on Pro-Forma Earnings
- This analyses the increase in cash flow gained from the combination of operations of the two companies (most commonly in the form of cost-savings).
- Depreciation and Amortisation effect on Pro Forma Earnings
- Pro forma earnings would be lowered for a write up on any tangible goods.
- Contribution Analysis
- Identifying what percentage the target and acquirer individually contribute to the sales, EBITDA, net income etc. of the pro forma company.
- Other Unquantifiable Factors
- What will be the composition of the new management structure?
- Will there be a new joint vision for the company
- Will employee benefits be streamlined or retained for individuals as before the merge/takeover?
What is the Leveraged Buyout Model?
The Leveraged Buyout model would be used by a potential buyer to estimate whether a company which it has targeted for takeover is undervalued
It can help to understand whether the buyer could purchase the company using a significant portion of debt in addition to a small amount of their own equity capital.
After purchase, the buyer would then pay off the debt which improves the strength of the company (deleveraging).
The best way to understand a Leveraged Buyout is to compare it to individuals who look to purchase dilapidated property using a small amount of equity (deposit), and a significant proportion of debt (mortgage).
It can then look to renovate it, and sell it for a profit at a later date.
Who are the Main Participants in a Leveraged Buyout?
The financial sponsor expects typically shorter time period per investment pay-out than the buyers in Merger Consequences Model (which was 20+ plus – with forecast plus terminal value).
A financial sponsor in an Leveraged Buyout will typically look to raise funds from investors and institutions looking for a valuable investment, put the capital into an undervalued company, and then sell the strengthened company within 3 to 5 years.
A unique type of financial sponsor is a private equity buyer which looks to purchase non-publically traded companies and also providing funding for early investments (also known as venture capital), in addition to the purchase of more established, and publically traded companies.
These are the institutions which provide the leverage in order to facilitate the buyout.
A lender will provide funding when considering the risk of the investment, the likelihood of interest repayments, and how much they trust the financial sponsor to make the correct decision with respect to the purchase.
Target Company Shareholders
Finally the last important party in the Leveraged Buyout transaction are the shareholders of the target company.
Given that the Leveraged Buyout Model looks to purchase enough shares to take a controlling portion in the company, it is necessary to create a price to incentivise the sale of existing shares to the buyer.
If this isn’t the case, the shareholders will hold onto their shares, and the Leveraged Buyout will not happen.
What Makes a Company an Ideal Target for an Leveraged Buyout?
The initial target for a Leveraged Buyout will be a company which is seen to be undervalued.
A company can signify that it is undervalued in the market if it holds valuable patents which haven’t been fully utilised.
It could also have operations which are struggling to achieve the growth potential of the company, or it could have just fallen out of favour in the market.
If there is a potential to improve the value of a company, then there is a possible profit to be realised.
As the buyer has identified an undervalued company, it then needs to understand which areas are required for improvement.
If the needs are identified early, the potential cost of improvement can be established, and any time it will require getting the improvements made.
Costs could include research and development, or capital expenditure. A company will also be desirable with stability in its cash flows.
If a company is generating stable cash flows, it will be easier to finance the interest payments on the debt used to buy the company (with a lesser risk of default).
Finally, a legitimate exit strategy needs to be determined for both a successful and failure of an investment.
Whether the investor decides to sell the company to another strategic buyer who is looking to improve the value of the company, or if the investor decides to list the company on the stock market through an Initial Public Offering (IPO), the strategy is an important aspect of the analysis stage.
Leveraged Buyout Model Sources of Funding?
In an Leveraged Buyout, there are three main sources of funding which are used in the transaction; senior debt, subordinated debt, and sponsor equity (the sponsors own money to make up the deficit in a transaction).
Senior debt is the cheapest form of loan, and is typically obtained from an investment or commercial bank (although this funding is being obtained more frequently from hedge funds now).
If interest payments on senior loans are missed, the bank has the seniority to claim assets to finance the debt.
Typically, the interest payments on senior debt is around 8%, with a maturity of 5-8 years, and comprise of about 30-50% of the total amount of funding in the Leveraged Buyout.
Subordinated debt is the additional form of leverage obtained by the sponsor, and is provided by funds, merchant banks and other financial institutions that do not have a claim to any assets of the borrowing company to finance the debt obligations in the case of default.
Given that the lender assumes a greater risk (without recovery in the case of a default); the interest yield is typically 10-12%, with a maturity of 8-10 years.
They can be obtained in the “bullet” form, which has an entire principal payment at maturity. Subordinated debt will make up 15-35% of the typical Leveraged Buyout transaction.
How Much Debt can a Financial Sponsor Borrow for the Leveraged Buyout?
To calculate the amount of each debt a financial sponsor can borrow is determined by a number of credit ratios:
- Leverage Ratio: A measure of the total debt burden of a company relative to operating cash flow, e.g. total debt/EBITDA,
- Coverage Ratio: The ability of a company to pay for interest payments, e.g. EBITDA/Interest Expense,
- Equity vs Total Capital Ratio: To assess whether the investor has enough “skin in the game”.
Once the Leveraged Buyout has completed, the investor must then start to deleverage (paying off the loans).
This will increase the value of the company as the firm becomes less risky, and the equity value increases.
How is the Residential Equity Value of the Firm Calculated?
The residential equity value of the company is calculated by taking the enterprise value of the firm, and subtracting the net debt.
If a company in year 1 has 75% debt, and 25% equity, by deleveraging (keeping the EBITDA level constant) to a 25% debt and 75% equity, the value of the company will have tripled.
How Can the Firm Start to Deleverage after the Leveraged Buyout?
Deleveraging is achieved through the use of free cash flow left over from operating cash flow expenses (such as capital expenditures and investments in growth).
An investor will also achieve value through improving the operations of the firm.
Free cash flow can be increased by; moving into new international markets, and through increases in market share in the domestic markets.
Cash flow can also be increased by becoming more efficient (getting the correct managers who know how to drive down costs and maximise profits).
This can be achieved through incentivising appropriate behaviour (through bonus schemes, or offering shares options in a company).
The return on the investment from a Leveraged Buyout is calculated using the Internal Rate of Return formula (IRR).
This formula finds the ideal discount rate to make the debt repayments through the life of the investment equal to the company’s ability to finance the debt using its cash flows.
The IRR is essentially the rate at which the net present value of the investment is zero (the breakeven point).
If the three main parties in the Leveraged Buyout transaction are satisfied by achieving a satisfactory IRR, good credit ratios (through minimal leverage), and through a good purchase price of the shareholders stock, then the purchase can go ahead.
The potential returns on a Leveraged Buyout can be vast, and this is justification enough for some investors to assume a high risk associated with the amount of leverage required to initiate this form of investment.