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nullValuation for ”dummies” - A beginners’ guide to valuation in an M&A situationValuation for ”dummies” - A beginners’ guide to valuation in an M&A situationPeter Bonnén – CP John Hansen – CP Jørgen Rugholm – CP Kasper Vaala – CPCONFIDENTIALApril, 2001This report contains information that is confidential and proprietary to McKinsey & Company and is solely for the use of McKinsey & Company personnel. No part of it may be used, circulated, quoted, or reproduced for distribution outside McKinsey & Company. If you are not the intended recipient of this report, you are hereby notified that the use, circulation, quoting, or reproducing of this report is strictly prohibited and may be unlawful.CONTENTSCONTENTSCONTENTSCONTENTSThe purpose of valuation is to estimate the net present value of a company The result of the valuation yields the accumulated value of the equity and the net debt, in total called the aggregate value The basis for valuation is historical and future financial parametersOUR BELIEFS ABOUT VALUATIONOUR BELIEFS ABOUT VALUATIONValuation is not an exact science There is no single value of a company, rather a range of potential values Valuation should be carried out using more than one method, if at all possible Each of the conventional methods (DCF, trading multiples, precedent transaction multiples, etc.) have inherent risks of biases Technical parameters (WACC and terminal growth rate) have great impact on value and it is paramount to allocate enough time on these Use of multiple valuation methods opens up the negotiation space It is critical to fully understand the implications of various methods to focus the negotiations in the preferred direction Actual value agreed upon in a transaction usually differs from perceived value In many situations there may be a CF&S specialist on the team but it is still important for the whole team to have a basic understanding of valuation methodologies THE VALUE OF A COMPANY CONSISTS OF TWO PARTSTHE VALUE OF A COMPANY CONSISTS OF TWO PARTS * Aggregate value is sometimes called Enterprise Value (EV), which in turn is sometimes confused with Equity value. To avoid confusion, when referring to the total value of an entity, the investment banking notation of Aggregate Value (AV) is used throughout this presentation ** In principle, market value of Net debt should be used. This, however, is rarely available and, as an approximation, the latest balance sheet figures are used insteadValue belonging to shareholdersValue belonging to debt holdersAggregate value (AV)*Net debt**Equity valueIn mergers, ownership shares are based on equity-value A DCF valuation yields the aggregate value If a company is listed, market capitalization equals the equity value Equity value is the combined value of the shares Be careful not to confuse book value of equity with Equity value = Short term interest-bearing debt + Long term interest-bearing debt + Minorities interest + Preferred stock + Capitalized leases - Cash and cash equivalents THE CALCULATION OF AGGREGATE VALUE IS BASED ON A NUMBER OF KEY PARAMETERS THE CALCULATION OF AGGREGATE VALUE IS BASED ON A NUMBER OF KEY PARAMETERS ParameterDefinitionHow/where to find it?EBIT IS A FUNDAMENTAL PARAMETER WHEN CALCULATING THE VALUE OF A COMPANYEBIT IS A FUNDAMENTAL PARAMETER WHEN CALCULATING THE VALUE OF A COMPANYAggregate value (AV)Net debtEquity valueDebt holdersShareholdersGovernmentInterestTaxNet income Earnings before interest and taxes (EBIT) EBIT is an earnings flow available to all capital providersVALUATION METHODOLOGIESVALUATION METHODOLOGIESMethodologyMarket’s rationaleNote that alternative methodologies exist, e.g. private equity firms often use leveraged buy-out (LBO) analysis. These methodologies are not covered in this presentation * Aggregate valueOVERALL VALUATION IS BASED ON MULTIPLE VALUATION METHODOLOGIES AND SCENARIOSOVERALL VALUATION IS BASED ON MULTIPLE VALUATION METHODOLOGIES AND SCENARIOSDCF valuationMultiples valuationSales (0.4-0.6x)EBIT (10.0-12.0x)EBITDA (6.5-7.5x)Valuation rangePrecedent transactions (10.0-12.0x)Downside case*: WACC 6.0–7.0% Management case*: WACC 6.0–7.0% 1,8009001,5001,4002,1005006001,0007001,1001,400600Terminal growth rate 1.5–2.5%Terminal growth rate 1.5–2.5% * Normally, a DCF valuation will be made based on management’s own forecasts. The downside case will usually be a less optimistic case1,2001,200The valuation range is based on intervals from the different methodologies and scenarios. To some extent, the range is subjectively selectedKEY HISTORICAL PARAMETERS CAN BE FOUND IN ANNUAL REPORTSKEY HISTORICAL PARAMETERS CAN BE FOUND IN ANNUAL REPORTSSales- Cost of goods sold (COGS)= Gross profit- Operating expenses= EBIT- interest= Profit before tax- tax= Net incomeEBIT+ Depreciation and amortization= EBITDA19972000Historical figures are used as a base to ensure reasonable forecasts199819991,000600400200200201805013020050250(Example)OTHER PARAMETERS NEEDED IN A VALUATION PROCESS CAN BE FOUND USING VARIOUS SOURCESOTHER PARAMETERS NEEDED IN A VALUATION PROCESS CAN BE FOUND USING VARIOUS SOURCESNecessary parameterNeeded in DCFMultiples analysisPossible sourceCONTENTSCONTENTSBeliefs and key learnings about DCF Overview of DCF calculation The four steps of the DCF process Sample DCF calculationOUR BELIEFS AND KEY LEARNINGS ABOUT DCFOUR BELIEFS AND KEY LEARNINGS ABOUT DCFBeliefWhyImplicationOVERVIEW OF THE DCF CALCULATIONOVERVIEW OF THE DCF CALCULATIONNet debtEquity valueFor every year in the forecast period, the free cash flow is calculated and discounted back to the time of valuationThe last year of the forecast period should be a ”normalized” year with stable cash flow elements, e.g. EBIT, CAPEX, etc.WACC = XX%AVThe terminal growth rate is used to grow the free cash flow in the last year of the forecast period into perpetuityFree cash flow is discounted at WACCAV is the net present value of future free cash flows01234Terminal growth rate= XX%The last year of the forecast period is also used as the basis for the calculation of terminal valueTerminal value+THE DCF PROCES CONSISTS OF 4 STEPSTHE DCF PROCES CONSISTS OF 4 STEPSDiscounting cash flowsForecastFree cash flow calculationWACC calculation and terminal value+BUILDING THE BASICS FOR A BULLET PROOF FORECASTBUILDING THE BASICS FOR A BULLET PROOF FORECASTHistorical developments for all elements of the forecasts (e.g. cost of goods sold, personnel costs) are required to demonstrate that the starting point is realistic Forecasts need to be tested with key managers in a format they can relate to Use budget values for year 1 if at all possible as this normally has good supporting data and action plans Key parameters in the forecast (e.g. EBIT) should line up with published figures to reduce suspicions of manipulation and allow for consistency checksAnchor forecast to known definitions and reporting formatsIdentify 5-10 levers that will drive EBIT Quantify impact of specific improvements for each lever over the full DCF period based on historical evidence or best practice within the industry Develop short profiles of programs to drive improvements for each lever Identify key levers to drive improvementsWork through each lever and discuss size of improvement Review ways of documenting that improvement is achievable Discuss how to present improvement, in particular what level of detail is required to describe improvement program Test improvements with managementEXAMPLE: FORECASTING REVENUES FOR A RETAILEREXAMPLE: FORECASTING REVENUES FOR A RETAILERExpand number of stores Remodel stores Improve sales per customer Assortment development Allocation of space Execution of in-store promotions Stock-out reduction Etc. Increase number of customers per store Marketing Pricing New assortments/services Etc.2001Better space allocation2005EUR millionsPotential levers to drive revenuesNew storesMarket growthRevenue forecastChosen leversForecast can be broken down by lever and impact from each lever is backed by previous results and/or references to best practiceSAMPLE INCOME STATEMENT FORECASTSAMPLE INCOME STATEMENT FORECASTEUR millionsSales- COGS= Gross profit- Operating expenses= EBIT- interest= Profit before tax- tax= Net incomeEBIT+ Depreciation and amortization= EBITDA20062007200820092010200120022003200420054,555.64,722.24,888.95,055.65,222.23,458.03,560.33,830.34,108.34,399.33,335.43,458.33,579.23,700.03,820.82,558.22,628.42,818.73,014.23,222.31,220.11,263.91,309.71,355.61,401.4899.8931.91,011.71,094.21,177.01,111.81,152.81,193.11,233.31,273.6852.7876.1939.61,004.71,074.1108.3111.1116.7122.2127.847.155.872.189.4102.96.15.65.65.65.612.411.811.29.36.6102.2105.6111.1116.7122.234.744.060.980.196.333.634.436.237.939.614.617.322.427.731.968.671.174.978.882.620.126.738.552.464.4108.3111.1116.7122.2127.847.155.872.189.4102.960.060.661.162.863.350.155.858.459.459.3168.3171.7177.8185.0191.197.2111.6130.6148.9162.2SAMPLE FREE CASH FLOW FORECASTSAMPLE FREE CASH FLOW FORECASTEUR millions- Tax* 31%= Unlevered** net income+ Depreciation and amortization (D&A)- Capital expenditure- Change in working capital= Unlevered** free cash flowEBIT * Note that in some countries amortization is not tax deductible, i.e., tax is paid on EBIT + amortization ** Unlevered means regardless of capital structure (note that interest expense is not deducted). Capital structure affects value only through its impact on the WACCThe free cash flow statement must reflect all cash flow items, including those not reflected in the income statement, e.g. capital expenditure. Tax is calculated on EBIT and D&A is added back. The cash flow effect of working capital is the incremental change from year to yearTHE TECHNICAL PARAMETERS IN THE DCF ANALYSIS HAVE A SIGNIFICANT IMPACT ON VALUETHE TECHNICAL PARAMETERS IN THE DCF ANALYSIS HAVE A SIGNIFICANT IMPACT ON VALUECommentsNumber to be calculated or estimatedWEIGHTED AVERAGE COST OF CAPITAL (WACC) CALCULATIONWEIGHTED AVERAGE COST OF CAPITAL (WACC) CALCULATIONWACC Cost of equityMarket valueAggregate value*x+Cost of debtNet debtAggregate value*xRisk free rate = Rate on government bond, e.g. 10-year bond Market risk premium = Premium that the investor requires to invest in the market portfolio instead of a risk free investment. The figure is a constant.* Aggregate value = market value + net debt=SAMPLE CALCULATION OF WACCSAMPLE CALCULATION OF WACCAssumptionsRisk free rate:Market risk premium:Relevered beta:Market value:Aggregate value*:Borrowing rate**:Tax rate:5.12%5.00%0.504,8366,6365.12%30.0%CalculationsCost of equity x weight(5.12% + 5.00% x 0.50) x= 7.62% x 0.73 = 5.55%4,8366,636Borrowing rate x (1-tax rate) x weight5.12% x (1-0.3) x1,8006,636= 3.58% x 0.27 = 0.97%5.55%0.97%WACC 6.52%* Aggregate value = market value + net debt = 4,836 + 1,800 = 6,636 ** A risk premium may have to be added. Check with CF&S R&INet debt:1,800A DCF VALUE RANGE IS CALCULATED FROM THE FORECASTED FREE CASH FLOWSA DCF VALUE RANGE IS CALCULATED FROM THE FORECASTED FREE CASH FLOWSCalculations should be made in a model in ExcelA good output sheet in Excel contains DCF ranges and control-parameters for sanity checksDCF CALCULATION SAMPLE DCF CALCULATION SAMPLE 2281,214WACC = 7%1,442Sep. 30, 20012001200220032004Terminal growth rate = 2%201035.78.432.152.692.1In this example the valuation is at Sep. 30, 2001 which means that only 25% of the free cash flow in 2001 should be included** Refer to appendix for further explanation1,943Terminal valueSAMPLE DCF SPREADSHEET OUTPUTSAMPLE DCF SPREADSHEET OUTPUTRefer to appendix to see the underlying calculationsValues should be calculated for a range of WACCs and terminal growth ratesAggregate value is the sum of the present value of the free cash flows and the present value of the terminal valueTo get Equity value, Net debt is subtracted from Aggregate valueTerminal value should be reasonable compared to EBITDA in the last year of the forecast periodTerminal value of total value should be reasonable considering the target’s situationCONTENTSCONTENTSIdentification of peer group and comparable benchmarks Selection of multiple intervals Calculation of valuation rangesUSING MULTIPLES VALUATION IS AN IMPORTANT PART OF OVERALL VALUATIONUSING MULTIPLES VALUATION IS AN IMPORTANT PART OF OVERALL VALUATIONMultiples valuation is a method in its own right, not just a supplement to DCF analysisMultiples valuation is widely used in the market and by investment banks Based on public information Based on the current value of publicly traded companies and valuations made in precedent transactions of comparable naturePEER GROUP AND COMPARABLE BENCHMARKS SHOULD REFLECT THE MARKET’S VALUATIONPEER GROUP AND COMPARABLE BENCHMARKS SHOULD REFLECT THE MARKET’S VALUATIONComparable companies are selected considering: Size Market position Operational effectiveness (best practice) Etc. Benchmarks are selected considering: Actual use in the market when valuing companies How to capture effect of future earnings and potential for growthEXAMPLE: COMPARABLE COMPANIES IN THE RETAIL SECTOR IN EUROPEEXAMPLE: COMPARABLE COMPANIES IN THE RETAIL SECTOR IN EUROPE * Estimated 2001 Source: Broker reports, BloombergEUR millionsCompanyCasinoDelhaize-Le LionIceland GroupWM MorrisonSafeway plc.SainsburySomerfieldTescoCarrefourAholdEBIT*7651,2663423726411,079512,0892,8772,966EBITDA*1,1931,8704865199121,7911672,8965,1774,457Market Cap9,0623,0478764,4144,96811,50478028,11645,79327,062Floor space (m2)*4,062,0004,170,000338,133351,540939,715522,3811,074,1501,983,7616,569,0005,585,968Sales*21,41021,0339,1116,06613,56528,7557,56836,48774,63761,701MULTIPLE INTERVALS FOR TARGET ARE SELECTED BASED ON THE PEER GROUPS’ MULTIPLESMULTIPLE INTERVALS FOR TARGET ARE SELECTED BASED ON THE PEER GROUPS’ MULTIPLESIntervals are selected based on: Average, median and distribution of peer groups’ multiples Likely multiple interval for target relative to peer group The selection of intervals is subjective to some extentEXAMPLE OF SELECTED MULTIPLE INTERVALS EXAMPLE OF SELECTED MULTIPLE INTERVALS Source: Team analysisCompanyCasinoDelhaize-Le LionIceland GroupWM MorrisonSafeway plc.SainsburySomerfieldTescoCarrefourMinimumMaximumAverageMedianSelected interval (x)AholdThe selection of multiple intervals depends on the target and its position relative to peer group. The interval does not necessarily have to be around the average/median of peer groupSAMPLE PRECEDENT TRANSACTIONSSAMPLE PRECEDENT TRANSACTIONS Source: Bloomberg, team analysisTargetEBITDA multipleAcquirorYearPromodesCarrefour200017.9Comptoirs Modernes SACarrefour199810.2ICAAhold199913.5Gruppo GS SpACarrefour200011.1AverageSelected interval (x)10.0-12.013.2As with trading multiples, selected range is based on target’s relative position. The interval does not necessarily have to be around the average/median of precedent transactionsESTIMATE OF VALUE IS BASED ON THE SELECTED MUTIPLES INTERVAL AND THE TARGET’S OPERATING STATISTICSESTIMATE OF VALUE IS BASED ON THE SELECTED MUTIPLES INTERVAL AND THE TARGET’S OPERATING STATISTICSCalculation of valuation ranges The target’s operating statistic (e.g., EBIT 2001) is multiplied by the selected multiples interval (e.g., 10.0–12.0x) This yields a valuation range for each of the different operating statistics Overall valuation range is selected based on: The valuation ranges from the different operating statistics The relative valuation of the different ranges Overall valuation range indicates the potential value of the target in the market SAMPLE MULTIPLES VALUATIONSAMPLE MULTIPLES VALUATIONOperating statistic*Valuation - Rounded (EUR millions)Multiples interval (x)0.4–0.66.5–7.510.0–12.02.5–4.010.0–12.01,4006005001,0001,0002,1007006001,6001,200 * Estimated 2001nullAPPENDIXCALCULATION OF BETA VALUES*CALCULATION OF BETA VALUES* * For further reading on beta refer to “Valuation” by Copeland, Koller & Murrin or “Principles of Corporate Finance” by Brealey & MyersSAMPLE UNLEVERED BETA CALCULATION FOR COMPARABLE COMPANIESSAMPLE UNLEVERED BETA CALCULATION FOR COMPARABLE COMPANIESCompanyLevered betaLeverage (%) Tax (%)Unlevered beta*Average unlevered beta0.40 * Unlevered beta = levered beta/(1+ leverage x (1 – tax rate)) Source: BARRA and Bloomberg; team analysisEXAMPLE OF UNLEVERED AND RELEVERED BETA CALCULATIONEXAMPLE OF UNLEVERED AND RELEVERED BETA CALCULATIONUnlevered beta=Levered beta(1 + (1 – tax rate) * Leverage)Unlevered beta=0.56(1 + (1 – 0.35) * 0.18)Unlevered beta=0.50Relevered beta=Unlevered beta * (1 + (1 – tax rate) * Leverage)Relevered beta=0.71Relevered beta=0.50 * (1 + (1 – 0.31) * 0.62)To show how to get from levered to unlevered beta, this example only uses one comparable company. When using more than one comparable company, the average unlevered beta (see page 36) is used in the calculation of the target’s relevered betaCALCULATION OF MARKET VALUE TO BOOK VALUE (FOR USE WHEN TARGET IS UNLISTED)CALCULATION OF MARKET VALUE TO BOOK VALUE (FOR USE WHEN TARGET IS UNLISTED) Source: Bloomberg, team analysisWhen calculating WACC and relevered beta for an unlisted company, an estimate for market value is calculated based on the target’s equity multiplied by a market/book ratio derived from comparable companiesWEIGHTED AVERAGE COST OF CAPITAL (WACC) CALCULATION – UNLISTED COMPANYWEIGHTED AVERAGE COST OF CAPITAL (WACC) CALCULATION – UNLISTED COMPANYWACC Cost of equityEstimated market value*Estimated aggregate value**x+Cost of debtNet debtEstimated aggregate value**x* Estimated market value = Book value of equity x market value factor ** Estimated aggregate value = Estimated market value + net debtRisk free rate = Rate on government bond, e.g. 10-year bond Market risk premium = Premium that the investor requires to invest in the market portfolio instead of a risk free investment. The figure is a constant.SAMPLE CALCULATION OF WACC – UNLISTED COMPANYSAMPLE CALCULATION OF WACC – UNLISTED COMPANYAssumptionsRisk free rate:Market risk premium:Relevered beta:Book value of equity:Estimated aggregate value*:Borrowing rate**:Tax rate:5.12%5.00%0.501,2006,6365.12%30.0%CalculationsCost of equity x weight(5.12% + 5.00% x 0.50) x= 7.62% x 0.73 = 5.55%4,8366,636Borrowing rate x (1-tax rate) x weight5.12% x (1-0.3) x1,8006,636= 3.58% x 0.27 = 0.97%5.55%0.97%WACC 6.52%* Estimated aggregate value = Book value of Equity x Market value factor (Market value/Book value) + Net debt = 1,200 x 4.03 + 1,800 = 6,636 ** A risk premium may have to be added. Check with CF&S R&INet debt:1,800VALUATION DATE AFFECTS THE FREE CASH FLOW IN THE FIRST YEARVALUATION DATE AFFECTS THE FREE CASH FLOW IN THE FIRST YEARValuation dateIn the first year, use the portion of the year during which the target will be owned:Free cash flow (FCF) 2001: 200 Valuation date: 30/9Portion of FCF received:12–912X 200 = 50100% = 2001/130/931/1225% = 50Example:Note that when calculating the value, the cash flow is discounted back to 30/9 and not to 1/1MID-PERIOD CONVENTION AFFECTS THE OVERALL VALUE OF CASH FLOWSMID-PERIOD CONVENTION AFFECTS THE OVERALL VALUE OF CASH FLOWSThe mid-period convention assumes that cash flows occur at the middle of the period to better approximate the time the cash is actually received Assuming mid-period cash flows effectively moves each cash flow closer to time zero by half a period To move the present value up to time zero, grow the NPV by half a period Note that the mid-period is not necessarily the same as mid-year (e.g. if the valuation date is on September 30)0123-1Year end cash flow Cash flow with mid-period conventionPV of cash flowsCOMBINING VALUATION DATE AND MID-PERIOD CONVENTION COMBINING VALUATION DATE AND MID-PERIOD CONVENTION 1/130/915/1131/1230/631/1230/631/1250100150FCF2001200220035010015030/615/8Valuation dateWhen calculating the present value of the above FCFs, Mid-period convention and discounting puts the received 2001 FCF of 50 at Aug. 15, 2001 and 2002-