Training The Street’s Technical Valuation Primers

Valuation Methodologies

Preparing Financial Professionals for Success

 Introduction

In preparation for this training, we have compiled a summary of the primary and select secondary valuation topics that
will be discussed during this workshop. These valuation summaries provide a foundational overview of the valuation
methodologies most commonly used by practitioners in the financial services sector. Additionally, they serve as a good
foundation for understanding these technical concepts in preparation for technical interviews.

It is important to frame this discussion by stating that the technical valuation techniques frequently referenced by
practitioners to value a company fall under two categories: (i) Primary and (ii) Secondary.

Valuation

Primary Techniques Secondary Techniques

1) Public Comparables Analysis 1) Merger Consequences /
Affordability Analysis
2) Aqcuisition Comparables Analysis
2) Sum of the Parts (S-O-P)
3) Discounted Cash Flow (DCF)
Analysis 3) 52 week hi/lo

4) Leveraged Buyout (LBO) Analysis 4) Analyst Price Target

/ Levered Value / Ability to Pay
Analysis 5) Liquidation / Distressed Value

To gain the most from the workshop and participate in the in-class discussion, it is recommended that this foundational
material is read in its entirety prior to attending the training workshop. A summary of the valuation topics covered in
this document are:

1) Public Comparables Analysis

2) Acquisition Comparables Analysis
3) Discounted Cash Flow Analysis
4) Merger Consequences Analysis
5) Leveraged Buyout Analysis

As you review this material it is important that you seek to understand the underlying concepts and their application.
These technical valuation summaries are an excellent learning aid as they attempt to explain the purpose of each of
the valuation topics covered and the context in which they are typically used. This material should take approximately
1.5 – 2 hours to complete.

We hope that you will find this material useful in demystifying the commonly used valuation methodologies by
explaining each of them in a clear and concise manner.

All the best and enjoy the training!

Sincerely,
Training The Street
Preparing Financial Professionals for Success
www.trainingthestreet.com

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 Table of Contents

A Primer on Public Comparables Analysis ................................................................................... 4

A Primer on Acquisition Comparables Analysis ........................................................................ 11

A Primer on Discounted Cash Flow Analysis ............................................................................. 17

A Primer on Merger Consequences Analysis ............................................................................. 20

A Primer on Leveraged Buyouts ................................................................................................. 25

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A Primer on Public Comparables Analysis

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A Primer on Public Comparables Analysis

Overview
Public comparables analysis is a relative valuation approach used by practitioners to evaluate how the equity
markets are valuing a peer group of companies that are like the target company. The public comparables analysis
operates on the basis that all things being equal, similar companies should have similar valuation multiples. The two
most important statistics used in the relative valuation exercise are: (i) the valuation measure (i.e. price per share)
and (ii) the performance measure (i.e. earnings per share or EPS). Each of them conveys information about the
company’s value or performance. But the real power of these metrics lies in combining them to calculate a multiple.
Hence, every relative valuation multiple has the following fundamental structure:
Valuation Measure “Value”
Performance Measure “Value Driver”

The multiples of the peer group are likely to diverge due to several factors, including but not limited to, each
company’s degree of financial risk, profitability & margins, growth prospects and takeover speculation. By analyzing
the key multiples for each of the companies in the peer group, it is possible for practitioners to estimate how the
public equity markets should value the target company. More importantly, this analysis allows practitioners to form
an opinion as to whether a target company is overvalued, fairly valued, or undervalued relative to its peers using
benchmark valuation multiples and performance measures. This approach is usually the first valuation methodology
used by practitioners when undertaking a valuation analysis of a target company.

There are several steps involved in doing a public comparables analysis. They include:

1) Selecting a comparable peer group (comps universe) 4) Calculate performance measures

2) Gathering the appropriate information 5) Calculate the multiples
3) Calculate valuation measures 6) Analyze the results (i.e. benchmarking) and derive a
valuation range

1) Selecting a comparable peer group

Selecting a peer group to include in a relative valuation analysis can be challenging. Therefore, it is important that
practitioners understand the target company's business beforehand. Ideally, companies that are to comprise the
peer group should have similar operational and financial characteristics as those of the target company. While the
list of common characteristics below is not exhaustive, it provides a broad overview of the practice and includes
suggested sources commonly used by practitioners to create a peer group:

Operational Financial Suggested sources for finding comparables

1) Industry/Sector 1) Size (i.e. Revenue, market • The target's annual report, 10-K (especially the section
on competition – equivalent to an annual report and
2) Products & services capitalization)
specific to US companies), or prospectus
3) Markets (geography 2) Growth prospects
base) 3) Profitability / Margins • Proxy statements in which the target compares its stock
price performance with a that of peers
4) Business structure 4) Financial leverage
(i.e., manufacturer, 5) Liquidity • Previous analysis from in-house professionals

distributor) 6) Shareholder base • Analyst research reports S&P Capital IQ, Value Line, and
5) Customers 7) Business outlook (i.e. Moody's company reports

6) Seasonality maturity, restructurings) • Recent news – focus on market-moving headlines

A meaningful comparison in a relative valuation analysis may only occur when the companies in the peer group
have similar products, profitability statistics, financial leverage, prospects for growth, return measures etc. as the
target company. However, such a scenario is often difficult to realize as practitioners can rarely find companies that
have the exact same operational and financial characteristics. Depending on the size of the peer group,
practitioners may create sector subgroups to better understand and analyze the multiples.

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 2) Gathering the appropriate information

Practitioners typically gather several documents for each company included in the peer group. Gathering the public
information to complete this analysis can be time-consuming and there are some items on the information list that
require a premium service subscription in order to view this information. Below is a list of items required to begin the
exercise of calculating valuation multiples.

1) 10-K (US) or annual report (non-US) for the most recent fiscal year
Obtained from a subscription-based database service, or freely available on the company’s website (usually
under investor relations or a similar section).

2) 10-Q (US) or interim report (non-US) for the most recent period
Obtained from a subscription-based database service, or freely available on the company’s website (usually
under investor relations or a similar section).

3) News announcements since the most recent filing

Obtained from the company’s website, a news provider’s website, or a subscription service. Focus on
newsworthy items that could have an impact on the company’s share performance since the filling of the
latest interim or annual results.

4) Financial statistics estimates

─ Typically, practitioners use consensus estimates for revenues, EBITDA, EPS and so on. An example of
an aggregator service would be S&P Capital IQ. However, a subscription may be required.
─ Choose one research report for all estimates. A subscription may be required.

5) Most recent closing share price (and most recent dividend per share)
Obtained from a subscription-based database, or freely available on a company’s website or another finance
website (such as Yahoo! Finance or Google Finance).

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 3) Calculate valuation measures
The two commonly used measures of a company’s economic value are: (i) Equity Value and (ii) Enterprise Value.
These two values form the basis of technical business valuation and seeks to value the company based on a market
value. These technical terms are defined below in more detail.

Noncontrolling
Interest*

Preferred
Stock

Enterprise
Net Debt
Value

Equity
Value
Price x shares
outstanding

Also know as: Market Cap. Also know as: Firm Value. or
or Market Value Aggregate Value

• *It is also referred to as minority interest. It represents the interest of a noncontrolling shareholder in the net assets of a company.

Equity Value Enterprise Value

Reflects the market value of the shareholders' Captures the value of an entire company,
residual interest after repaying all senior claims such comprising the sum of all forms of invested capital.
as debt, noncontrolling interest and preferred stock. More importantly, It represents the value of owning
the operating assets of the firm.

Calculation Considerations Calculation Considerations

• Compute diluted shares to reflect any and all • Use the latest balance sheet information
shares from options, restricted awards, warrants
and convertible securities. • Net Debt = Total debt (interest-bearing liabilities)
less cash and equivalents. Include both the
These instruments are commonly referred to as current portion of long-term debt and long-term
dilutive securities. Practitioners need to know debt as well as short term debt when calculating
what the total number of shares outstanding total debt.
would be if all these instruments were converted • Preferred stock that is not convertible into
into shares. common stock is treated as a financial liability
equal to its liquidation value. Liquidation value is
the amount the firm must pay to eliminate the
obligation.

• Noncontrolling interest, formerly known as

minority interest, represents the interest of a
noncontrolling shareholder in the net assets of a
parent company subsidiary.

• Preference is to use fair market value on all items

above, however, for a variety of reasons it may
not be readily available therefore the values (i.e.
book value) from the latest balance sheet are
used.
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investments, etc.
 4) Calculate performance measures
Some performance measures are more universal in their application, while others are more industry-specific. The
key is to match the performance measure with the appropriate valuation measure. For the purpose of this primer,
the focus will be on the most common performance measures used across most industries.

With most financial performance measures, it is not possible to eliminate all accounting differences between
companies. For example, a company that capitalizes (amount to have been expenses is added onto the balance
sheet and later amortized/expensed over time) most of their research & development costs versus another that
immediately expenses it through the income statement. This treatment would impact key items like operating
income, margins and net income. Therefore, practitioners generally use key performance measures that are least
likely to be distorted because of the company’s capital structure or the adoption of accounting rules. Some of the
standard financial performance measures (and select industry-specific ones) are summarized below:

1) Revenue - referred to as a suitable basis for 4) Unlevered Free Cash Flow (aka UFCF) and can
valuation on the premise that it is largely be defined as:
comparable across different accounting o EBIT * (1 – Tax Rate) + D&A +/- Chng
standards. However, it is an incomplete in W/C – Capex
measure of performance given its lack of focus This amount represents what is available to all
on profitability and cash flow. stakeholders.

Therefore, revenue as a performance measure 5) Earnings Per Share (aka) EPS: The portion of a
and basis for valuation should only be company's net income allocated to each
considered if more relevant profit measures are outstanding share of common stock. Usually, a
unavailable. forward median or average consensus estimate
is used.
2) Earnings Before Interest, Taxes, (aka EBIT)
and; 6) Some industry-specific performance measures
include:
3) Earnings Before Interest, Taxes, Depreciation
and Amortization (aka EBITDA) ─ Same-store sales growth rate compares the
sales of stores that have been open for at
least one year. Allows practitioners to
EBIT and EBITDA capture the "intrinsic core assess the portion of new sales derived from
operational performance" of a business and it is sales growth and the portion that can be
before the effects of the firm’s capital structure attributed to the opening of new stores.
(namely interest expense). In other words, the Commonly used within the retail sector.
performance when all costs that do not occur in
the normal course of business (i.e., restructuring
─ Average revenue per unit (ARPU): allows for
costs, impairment charges, advisory fees) are
the analysis of a company's revenue
ignored. We refer to these as normalized results
generation and growth at the per-unit level.
if any of the aforementioned items have been
Often used in the telecommunications sector.
excluded from the reported results.

Depreciation & amortization are noncash

recurring operating expenses that are added to
EBIT to arrive at EBITDA.

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 5) Calculate the multiples
Valuation multiples capture a firm's operating and financial characteristics in a single value. In other words, a
multiple reflects the relationship between a valuation and performance measure. To be meaningful, the
performance measure – Revenues, EBITDA, EPS or some other measure – must bear a logical relationship to the
valuation measure being observed. The basic formula to calculate a multiple is:
Valuation Measure “Value”
Performance Measure “Value Driver”
There are two categories of valuation multiples that form the basis of the relative value analysis: (i) Enterprise Value
multiples (relevant to all stakeholders) and (ii) Equity Value multiples (relevant to equity holders only).

Enterprise Value Multiples Equity Value Multiples

Enterprise Value / Revenue Eqity Value / Net Income*

Share Price / Earnings Per Share

Enterprise Value / EBITDA* (E.P.S.)*

Enterprise Value / EBIT* P E / Annual EPS Growth Rate

(PEG Ratio)**

Enterprise Value / FCF*

*
Reported results adjusted to exclude any extraordinary items and one-time occurrences (e.g., restructuring charges).
**
The price/earnings to growth (PEG) ratio is used to determine a stock's value while taking the company's EPS growth rate into account. It is
considered to provide a more complete picture than the P/E ratio, and the EPS growth rate is based on consensus estimates.

Hint: The general rule on deriving a multiple is that if the performance measure used in the denominator is before
interest expense, then the numerator is the Enterprise Value. Any performance measure used in the denominator
that is after interest expense, the numerator is the Equity Value.

Once the multiples for the peer group have been calculated and a benchmarking analysis against the peers is
undertaken, the practitioner will use their best judgment when choosing the valuation metrics that will serve as the
basis for reaching a conclusion on how the target company trades relative to its peers. The selection of a multiple is
also driven by your perspective (i.e. equity holder or debt holder) as not all multiples apply to all stakeholders.
When benchmarking against peers the focus is on various data points including, but not limited to, growth, margins,
financial risk and return measures.

The public comparable analysis can also raise questions when significant discrepancies exist between the trading
multiples of the target company and those of its closest peers. In this instance, the practitioner is likely to undertake
additional research to better understand the discrepancy which may result in some companies being excluded from
the analysis. Research reports and news articles are good sources to review for insight. In summary, the
practitioner will provide compelling factual arguments to support their conclusions.

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 6) Analyze the results and derive a valuation range Show standard Enterprise and Equity multiples. Common to include both
historical (Latest twelve months “LTM”) and forward-looking multiples that
are based off consensus estimates. Helpful to show margins to help with
interpretation of the multiples. Also include industry specific multiples if
known.
Market Multiples Analysis of Selected Technology Companies
(Figures in millions, except per share data)
Common to show the
Companies are organized Most recent following values. Enterprise Value as a Multiple of: Price / LTM Projected
in alphabetical order closing share price
Market Value Enterprise Sales EBITDA EBIT CY+1 EBITDA EPS PEG
Company Stock Price of Equity Value (a) LTM LTM LTM EPS Margin Growth Ratio
Apple Inc. 526.24 469,400.3 445,595.3 2.56 7.9 9.0 12.2 32.5% 18.4% 0.7
CA Technologies 33.50 15,000.2 13,917.2 3.04 8.9 9.8 12.9 34.2% 8.9% 1.4
Cisco Systems, Inc. 21.80 112,297.9 82,404.9 1.72 6.5 7.9 10.8 27.1% 7.8% 1.4
Google Inc. 1,215.65 408,520.2 357,605.2 5.98 19.8 25.4 23.0 30.1% 17.1% 1.3
Intel Corporation 24.76 123,106.7 116,556.7 2.21 5.7 9.3 13.4 39.0% 10.9% 1.2
International Business Machine 185.17 192,825.1 221,627.1 2.22 8.9 10.9 10.4 25.1% 9.8% 1.1
Hewlett-Packard Company 29.88 56,845.3 65,667.3 0.59 5.0 7.6 8.0 11.8% 3.8% 2.1
Oracle Corporation 39.11 175,893.7 163,563.7 4.36 10.0 11.2 12.9 43.5% 10.3% 1.3
Samsung Electronics Co. Ltd. 1,262.25 165,212.0 124,663.9 0.58 2.5 3.6 6.9 23.3% 12.3% 0.6
SAP AG 80.62 96,215.3 98,308.5 4.23 12.9 15.6 16.7 34.2% 9.1% 1.8
VMware, Inc. 96.05 41,376.6 35,651.6 6.85 24.4 30.7 27.2 28.1% 19.7% 1.4
Yahoo! Inc. 38.67 39,033.2 36,828.6 7.87 19.1 25.0 24.4 22.0% 10.0% 2.4
There are few companies like MSFT in Include High/Average/
Median/Low multiples and High 7.87x 24.4x 30.7x 27.2x 43.5% 19.7% 2.4x
terms of products sold and size.
Therefore, we have kept the parameters operating statistics to allow Average 3.45 10.8 13.7 14.7 28.8% 11.7% 1.4
broad to capture more companies. for comparison. Consider Median 2.56 8.9 9.8 12.9 28.1% 10.3% 1.3
excluding outliers. Low 0.58 2.5 3.6 6.9 11.8% 3.8% 0.6

Microsoft Corporation $38.31 $318,000.7 $258,703.7 3.10x 8.1x 9.2x 14.0x 38.1% 8.7% 1.6x

(a) Calculated as Market Value of Equity plus total debt, non-controling interest and preferred stock, less cash & equivalents.
(b) Financial data provided by S&P Capital IQ as of Feb-28-2014. Footnotes are used for clarifying difficult
formulas or unusual terminology
A valuation range illustration
To demonstrate the application of deriving an equity value range let’s consider the following. A practitioner
concludes after narrowing the peer group, that a reasonable forward P/E multiple is 12.0x – 15.5x. To calculate an
equity value range, the next step is to apply the P/E multiple ranges to MSFT’s forward EPS consensus estimate of
$2.74. The calculation of the equity value ranges is shown below:
Consensus EPS estimate $2.74 Consensus EPS estimate $2.74
x P / E multiple 12.0x - x P / E multiple 15.5x
= Implied share price $32.88 = Implied share price $42.47

Based on the current share price of $38.31 for MSFT, the company appears to trade at the high end of the range.
The practitioner will defend their conclusion on MSFT being overvalued, fairly valued, or undervalued by performing
a detailed qualitative and quantitative analysis of MSFT against companies in the peer group.

Conclusion
It is important to compare a target company's multiples to those of its peer group in order to bring the comparative
analysis into context. To perform a relative value analysis effectively, practitioners identify the key operating
performance measures and benchmark the subject company against its peers. This analysis can contribute towards
understanding why the multiples trade at different levels. Practitioners in the sector teams will generally have a
fundamental understanding of the business being analyzed and sector nuances. There are a variety of variables
that can influence a company’s market multiple including, but not limited to, market factors, size, financial &
business risk and growth prospects.

The relative value analysis approach is highly subjective and will inherently result in differing valuation ranges, which
is why practitioners often refer to valuation as being part art and part science. To help validate and build confidence
around the valuation ranges, practitioners are likely to perform a Discounted Cash Flow (intrinsic value) analysis to
determine if the intrinsic value falls within the range of those implied under the relative valuation approach as well as
review stock price targets established by equity research analysts that cover the company. Due to the subjective
nature of this exercise, a company’s valuation is rarely quoted as just one value, but rather a range of values.

Remember, a goal of the analysis is to understand how the market is valuing the target company relative to the peer
group. Therefore, it is important to understand what has been priced into the stock of the target company or that of
its peers. For example, has a merger premium been built into the share price of the target company or peers? Are
any of the companies undergoing a restructuring? Analyzing market multiples allows practitioners to form an
opinion as to whether the target company is overvalued, fairly valued or undervalued relative to its peers.

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A Primer on Acquisition Comparables Analysis

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A Primer on Acquisition Comparables Analysis

Overview
Acquisition comparables or precedent transaction analysis is another relative valuation technique that is used by
practitioners to derive an implied value of a target company in an M&A context (sometimes referred to as M&A
value). This valuation approach is based on the premise that the implied value of a target company can be
estimated using historical transaction multiples and premiums paid by acquirers for comparable companies under
similar circumstances (i.e. timing, takeover environment, etc.). Examining prior transaction multiples and
premiums allows practitioners to assess what may be necessary for the current situation to gain full or majority
control of a target company or aid the target company’s shareholders on what they should expect to receive in an
acquisition. In other words, the offer price per share takes into consideration both control and potential cost synergies.
However, a limitation of using this analysis is that it is based on historical information.

There are several steps involved in doing a precedent transaction analysis. They include:

1) Determining the transaction list and information sources 4) Compute premiums paid
2) Calculate the valuation measures 5) Analyze the results and derive a valuation range
3) Calculate the multiples

1) Determining the Transaction List and Information Sources

Selected precedent transactions should be as comparable to the proposed transaction as possible. Perhaps the
easiest way to screen for historical transactions is by performing a database search using an online subscription
service such as S&P Capital IQ. Since no two companies or transactions are the same, the most similar
companies and transactions are sought. Practitioners aim to screen for precedent transactions in which a variety
of similarities exist. Ideally, the target companies (precedent and contemplated target) should have similar
profiles (i.e. business activities, geographical location and profitability profile), and characteristics including, but
not limited to, the following:

• Industry and financial characteristics – Similar Sales, • Transaction-specific characteristics Domestic vs.
EPS growth and operating margins cross-border, full auction vs. negotiated deal, underlying
market conditions
• Size of the deal – as measured by offer and transaction
value • Timing – The more recent the data, the more relevant
the benchmark. Good to identify any significant
• Nature of the transaction - Hostile, friendly and did industry-wide events occurring at the time (i.e. wave of
multiple bidders exist. Full or majority control consolidation)
• Buyer type: Strategic vs. financial buyer

The precedent transaction analysis requires practitioners to study various documents and extract the relevant
information required to calculate the transaction multiples. Finding appropriate information for this analysis is akin
to putting together pieces of a puzzle using various information sources (i.e. merger agreement, investor
presentations, and regulatory filings). Research reports and industry magazines provide useful background
information on things like the strategic rationale for the transaction etc.

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 2) Calculate the Valuation Measures
When practitioners reference value in an M&A context, the following terms are used:

NCI*

Preferred
Stock

Transaction
Net Debt
Value

Offer Value
Offer Price x diluted
shares outstanding

* NCI = noncontrolling interest. It is also referred to as minority interest. It represents the % of equity in a consolidated subsidiary that is
owned by someone else.

Offer Value Transaction Value

Reflects the amount an acquirer agrees to pay for all A measure reflecting the true cost of the transaction to the
outstanding shares of the target company and any security acquirer. It includes not only the offer value but also the
that can be converted into shares. This is collectively referred target’s net debt obligations (net of cash), including
to as total potential shares outstanding. Practitioners apply obligations to preferred stockholders and noncontrolling
the proceeds from in-the-money options to reduce the amount interest holders as of the most recent balance sheet date.
needed to calculate at the offer value. The acquirer cannot just acquire the equity of the target and
not the other components of the capital structure, as these
obligations are likely to contain change-of-control provisions
with specific terms of liquidation.

Calculation Considerations Calculation Considerations

• Offer Value Gross-Up - There may be instances when less • Use the latest balance sheet information
than 100% of the target equity is acquired. In order to
perform a precedent transaction analysis under this • Net Debt is equal to total debt less cash and equivalents.
scenario, the offer value will need to be adjusted to reflect Include both the current portion of long-term debt and
the value of the transaction as if 100% of the target long-term debt as well as short term debt when calculating
company’s equity was acquired. This is important since total debt.
the offer value is being compared against a performance
measure (i.e. Sales or EBITDA) that is wholly attributable • Preferred stock that is not convertible into common stock
to the target. is treated as a financial liability equal to its liquidation
value. Liquidation value is the amount the firm must pay to
To correct the above inconsistency, practitioners adjust the eliminate the obligation.
offer value (and, as a result, the transaction value) for each
deal to assume a 100% acquisition using the gross-up • Noncontrolling interest, formerly known as minority
formula below: interest, represents the interest of the noncontrolling
shareholder in the net assets of a company.
Implied 100% Offer Value = Offer Value / % Acquired
• Preference is to use fair market value on all items above,
• It is worth noting that the premium paid in a transaction however, for a variety of reasons it may not be readily
resulting in less than a 100% ownership stake may not be available therefore the values (i.e. book value) from the
the same as the premium the acquirer might have paid to latest balance sheet are referenced.
gain full control of the company. Therefore, it is important
to highlight transactions of this type in the analysis. With
the grossed-up offer value calculated, the next step is to
calculate the transaction value.

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 3) Calculate the Multiples
A goal of the acquisition comparables analysis is to interpret the price paid by the acquirer to gain control of the
cash generating assets of a target company. One of the ways this can be achieved is by calculating transaction
value multiples. A transaction multiple compares the relationship between a valuation measure (i.e. transaction
value) and a performance measure (i.e. Sales, EBITDA, EBIT). That mathematical equation can be expressed as
follows:
Valuation Measure “Value”
Performance Measure “Value Driver”

The illustration below depicts the standard multiples that are calculated using the transaction and offer value:

Transaction Value Multiples Offer Value Multiples

Transaction Value / Revenue Offer Value / Net Income*

Transaction Value / EBITDA* Offer Value / Equity Book Value

Transaction Value / EBIT* Offer Price / Earnings Per Share

(EPS)*
(PEG Ratio)**
*
Reported results adjusted to exclude any extraordinary items and one-time occurrences (e.g., restructuring charges).

4) Premiums Paid Analysis

An acquisition premium is the difference between the estimated fair value of a company and the actual price paid
to acquire the target company.

An acquirer usually pays a premium above the current share price in order to compensate for the control it is
receiving over the target company. The premium also reflects the buyer’s expectation that the merger will yield
positive synergies (i.e. cost savings) once the two companies are combined, resulting in higher earnings on a
combined versus a standalone basis. Shareholders of the target company recognize this and want to be paid
upfront for it. So, in effect, the premium represents the price paid for control of the company and for the expected
resulting synergies. Because of the inherent price inflation, this analysis typically leads to a higher valuation range
in comparison to those derived from public comparables analysis. The acquisition premium is calculated using
the following formula:

Acquisition Premium (%) = Offer Price / Target Company Share Price * − 1

* Based on the closing price of the target company prior to the announcement of a business combination

Because information leaks in these kinds of transactions can occur, sudden target company share price increases
may not necessarily reflect improving underlying company fundamentals. Such a share price increase would
ultimately affect the premium paid which is to be used in the precedent transaction analysis. Under this scenario,
practitioners seek to calculate the premium using the company’s unaffected share price. To do so, the share
price at various time periods (i.e. one week prior to announcement) are used to calculate a “true” premium.

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 5) Analyze the Results and Derive a Valuation Range
To compute an implied transaction or offer value for the target company, the multiples from precedent
transactions are applied to the relevant performance measure of the target company. There are several ways
practitioners select the transaction multiples to be used in this analysis. For simplicity, a practitioner may use the
average / median transaction multiple or the lowest and highest multiples and premiums. However, the
aforementioned has several shortcomings.

Alternatively, the practitioner could create a subset incorporating transactions that occurred in similar market
conditions, involved companies with similar products and services, the companies exhibited similar growth
prospects, operating margins and financial risk. The most appropriate method will depend on the perspective
(target or acquirer) and the situation.

A valuation illustration
To demonstrate the application of deriving an implied transaction and offer value, let’s consider the following. A
practitioner concludes, after a review of precedent transactions, a transaction value multiple of 18.0x – 19.5x and
premium of 30% - 40% are reasonable acquisition parameters to expect under the current situation. Using the
performance measures of the target company and transaction value multiple ranges, the practitioner will calculate
the following transaction and offer values:

Select Financial Information & Valuation Analysis

(amounts in millions unless otherwise indicated, except per share data)

Sales $1,200.0 Net debt (175.0)

EBITDA 165.0 Diluted shares outstanding 145.000
% Margin 13.8% Consensus CY EPS estimates $1.35

EBITDA $165.0 EBITDA $165.0

x Transaction multiple 18.0x x Transaction multiple 19.5x
= Transaction value $2,970.0 = Transaction value $3,217.5
- Net debt (175.0) - Net debt (175.0)
= Offer value $2,795.0 = Offer value $3,042.5
÷ Diluted shares outstanding 145.000 ÷ Diluted shares outstanding 145.000
= Offer price per share $19.28 = Offer price per share $20.98
÷ Current share price $14.38 ÷ Current share price $14.38
= Offer Premium 34.0% = Offer Premium 45.9%

Consensus CY EPS estimates $1.35 Consensus CY EPS estimates $1.35

Offer price per share / CY EPS 14.3x Offer price per share / CY EPS 15.5x
Notes: The one year forward EPS estimate is based on a calendar year (CY) fiscal year end.
Offer Premium (%) = Offer price per share / Current share price − 1

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 Sample Summary of Acquisition Comparables
Calculate premium over
Select Apparel and Retail-Jewelry Transactions Multiples calculated based of the target’s different time periods in
(Figures in millions, except per share data) performance measures and transaction value. order to arrive at the “true”
Helpful to show margins to help with interpretation premium paid
Aggregate value of of theTransactions
multiples.
Multiples Analysis of Selected Precedent Apparel and Retail-Jewelry
100% of the target's
(Figures in millions, except per share data)
Common to show the legal diluted common equity
names of the Target first PRE-SYNERGIES:
then Acquiror Offer Value / Transaction Value / LTM Premiums Paid
Date Offer Value Transaction LTM Book LTM LTM EBITDA 1 Day 1 Week 1 Month
(a)
Target / Acquiror Announced of Equity Value CY EPS Value Sales EBITDA Margin Prior Prior Prior
Harry Winston Luxury Brand Segment / Swatch Group 01/14/13 $750.0 $1,000.0 NA NM 2.34x 24.4x 9.6% -- -- --
Warnaco Group / PVH Corp. 10/31/12 2,903.9 2,862.9 15.0x 2.6x 1.19 9.2 13.0% 34.5% 31.1% 33.4%
Benetton Group SpA / Edizione S.r.l. 02/01/12 1,099.1 2,134.9 8.5 0.6 0.80 6.0 13.3% 13.6% 45.6% 47.5%
The Timberland Company / VF Corporation 06/13/11 2,310.9 2,045.7 20.7 3.1 1.40 12.3 11.3% 43.4% 45.8% 28.9%
Jimmy Choo / Labelux 05/22/11 842.7 842.7 NA NM 3.55 15.2 23.3% -- -- --
Gruppo Coin SpA / BC Partners 05/09/11 1,331.9 2,023.5 NA 1.9 0.83 6.8 12.2% 1.4% 0.0% 8.3%
Volcom, Inc. / PPR SA 05/02/11 607.6 516.2 NA 2.5 1.55 15.8 9.8% 24.2% 31.9% 32.9%
Bulgari SpA / LVMH 03/07/11 5,886.6 5,880.6 39.5 3.7 3.93 27.2 14.5% 61.4% 59.5% 59.6%
J Crew Group, Inc. / Leonard Green & Partners 11/23/10 2,991.1 2,679.4 19.8 4.5 1.57 8.5 18.3% 15.5% 23.1% 37.3%
Tommy Hilfiger B.V. / Phillips-Van Heusen Corp. 03/15/10 3,029.4 3,167.1 NA 186.1 1.40 9.4 14.9% -- -- --
Bailey Banks & Biddle / Finlay Enterprises, Inc. 09/27/07 200.0 199.9 NA 1.2 0.70 10.9 6.4% -- -- --
Oakley, Inc. / Luxottica Group S.p.A. 06/20/07 2,097.8 2,261.8 29.9 4.0 2.80 18.5 15.1% 16.1% 20.9% 20.5%
Hugo Boss AG / Permira Advisors Ltd. 06/01/07 2,296.8 4,432.5 NA 3.1 2.15 14.5 14.8% 7.6% 4.9% 6.1%
Valentino Fashion Group / Permira Advisors Ltd. 05/16/07 3,506.7 6,141.5 21.9 5.6 2.26 14.3 15.8% 8.0% 9.9% 13.6%
Puma AG Rudolf Dassler Sport / PPR SA 04/10/07 7,095.4 6,630.8 18.6 5.0 2.08 12.2 17.1% 4.8% 18.3% 22.5%

Organised in chronological order, all

Include High/Average/ High 39.5x 186.1x 3.93x 27.2x 23.3% 61.4% 59.5% 59.6%
financial data should be as of the
announcement date. Reflects all Median/Low multiples Average 21.7 17.2 1.90 13.7 14.0% 20.9% 26.4% 28.3%
information known to the acquirer at and operating statistics to Median 20.2 3.1 1.57 12.3 14.5% 15.5% 23.1% 28.9%
the time. allow for benchmarking Low 8.5 0.6 0.70 6.0 6.4% 1.4% 0.0% 6.1%

For training purposes only Footnotes are used for clarifying difficult
Note: All transactions reported in USD$ formulas or unusual terminology
(a) Calculated as Offer Value of Equity plus total debt, minority interest and preferred stock, less cash & equivalents & unconsolidated affiliates.

Conclusion
The objective of a precedent transaction analysis is to calculate and to understand the premiums and multiples
paid in precedent transactions in which the acquirer sought control of the target company. It also sheds light on
the kind of structure that was used to facilitate the purchase (i.e. % stock / % cash). This analysis lays the
foundation for setting a realistic expectation of an acceptable premium and purchase price multiple in a
contemplated transaction by the shareholders of the target company. An important difference in this analysis,
when compared with the public comparables analysis, is that a control premium is built into the offer price and
therefore the transaction multiples.

Like other valuation techniques, precedent transaction analysis is as much an art as it is a science. Interpretation
of the data requires familiarity with the industry and the assets involved. Often, practitioners will specify a small
subset from a broader group of precedent transactions. These "most comparable transactions" can be analyzed
in more detail to get a better understanding of the circumstances leading to specific valuation levels.

A practitioner needs to know the story for each transaction in order to understand the transaction multiple when
compared to similar transactions. Besides the three main considerations that typically influence multiples –
company size, financial & operating risk and growth prospects – it is important to also understand the impact the
structure (70% stock / 30% cash) and potential synergies had on the final offer price and the resultant multiple.

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A Primer on Discounted Cash Flow Analysis

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A Primer on Discounted Cash Flow Analysis
Discounted Cash Flow (DCF) Analysis yields the theoretical valuation of a firm. The concept behind a DCF
analysis is that the value of a company is based on the present value of the cash flows that it can generate in
the future. The technical term commonly used is “Intrinsic Value”.
A DCF valuation has three major components:
1) A discount rate, called the weighted average cost of capital (WACC), which we will use to discount the
future cash flows and the terminal value back to their present value;
2) Forecasting cash flows or, more precisely, unlevered free cash flows;
3) A terminal value of the company.
Let’s take each of these in turn:

2) Weighted average cost of capital

In a DCF analysis, a company’s value is determined by estimating its future free cash flows over several
years (i.e. 5 – 10 years), then discounting those cash flows back to the present, using a risk factor called
the weighted average cost of capital (WACC). WACC captures the risk of those future cash flows and
reflects the cost of the company’s equity capital (cost of equity) and of its debt capital (cost of debt). You
can also think of WACC as the blended rate of return that the company’s equity and debt investors require
to compensate them for the risk of investing in the company. The formula for weighted average cost of
capital (WACC) is illustrated below:
Cost of
Debt
Where:
After tax
X
cost of debt • The tax rate is the marginal rate
1 – Tax rate X
Weighted cost • The risk-free rate is typically the yield
of debt
Percentage
on the 10-year U.S. Government Bond
of debt
Weighted Average
• Beta measures the volatility of a
Risk free
rate + Cost of Capital company’s stock price compared to the
(WACC)
Percentage overall market
+ of equity • Market risk premium is the rate of
Weighted cost
Beta X
of equity
return in the market minus the risk-free
Cost of rate. For example, the historical U.S.
X
equity market risk premium is often in the
Market risk
premium
range of 5.0% to 7.0%

3) Unlevered free cash flow

Unlevered free cash flow is cash available to capital holders before debt holders are paid. “Free” implies
that it is the cash flow in excess of what is needed to fund the company’s operations. Loosely translated, it
is the cash flow after taxes are paid, capital expenditure requirements are met, and working capital needs
are satisfied.
Historical Projected
FYE-2 FYE-1 FYE FYE+1 FYE+2 FYE+3 FYE+4 FYE+5
Sales $7,385.0 $7,998.0 $7,586.0 $7,705.5 $7,826.8 $7,950.0 $8,075.2 $8,202.4
Cost of goods sold 4,121.0 4,549.0 4,272.0 4,339.3 4,407.6 4,477.0 4,547.5 4,619.1
Gross Profit 3,264.0 3,449.0 3,314.0 3,366.2 3,419.2 3,473.0 3,527.7 3,583.3
Selling, General and Administrative 1,808.0 1,885.0 1,782.0 1,810.1 1,838.6 1,867.5 1,896.9 1,926.8
EBITDA 1,456.0 1,564.0 1,532.0 1,556.1 1,580.6 1,605.5 1,630.8 1,656.5
Less: Depreciation (263.0) (271.0) (264.0) (297.9) (315.0) (332.6) (350.7) (369.3)
Less: Amortization 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
EBIT 1,193.0 1,293.0 1,268.0 1,258.3 1,265.6 1,272.9 1,280.1 1,287.2
Less: Taxes @ 36.7% (437.9) (474.6) (465.4) (461.9) (464.6) (467.2) (469.9) (472.5)
Tax-effected EBIT 755.1 818.4 802.6 796.4 801.1 805.7 810.2 814.7
Plus: Depreciation and amortization 271.0 264.0 297.9 315.0 332.6 350.7 369.3
Less: Capital expenditures (298.0) (345.0) (350.4) (356.0) (361.6) (367.2) (373.0)
Less: Additions to intangibles 0.0 0.0 0.0 0.0 0.0 0.0 0.0
(Increase)/decrease in w orking capital (119.0) (59.0) (3.9) (4.0) (4.1) (4.1) (4.2)
Unlevered Free Cash Flow $672.4 $662.6 $739.9 $756.1 $772.7 $789.6 $806.8

In practice, finance professionals typically select a forecast period of 5 to 10 years. The length of the
projection period depends on the characteristics of the company and its industry. The main consideration
for determining the length of this period is when the company will reach a “steady state.” One steady-state
indicator is when a company is sustaining its capital investment – that is, all the company’s new spending
goes simply to replacing the fixed assets that they are losing each year from depreciation. This implies that

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 the business is only replacing existing fixed assets in order to sustain its current levels of production, rather
than investing in new or additional property, plants or equipment. Another sign of steady-state operations
is when the company’s working capital or short-term operating cash flows have stabilized.
4) Terminal value of the company
The terminal value of a company represents the present value of the sum of the additional cash flows
beyond the forecasted period. Two methods are widely used to project the terminal value:
a) The Terminal Multiple Method: This assumes that at the end of the forecast period, the company is
worth a lump sum that is calculated as a multiple of an operating metric, e.g., a multiple of EBITDA:

Terminal Value = multiple x EBITDAn Where

• n equals the final year of the forecast period
There are many important factors to consider when determining the terminal multiple. Most practitioners
begin with the current trading multiple, then examine whether that multiple is sustainable and reasonable. If
it is not, they adjust reflect the estimated multiple in a mature-state and in a normal economic environment.
b) The Perpetuity Growth Rate Method: This assumes that the company’s free cash flows will grow at a
moderate, constant rate indefinitely:
Where
FCFn x (1 + g) • FCF is the normalized free cash flow in period n
Terminal Value =
(r - g) • g is the nominal perpetual growth rate, and
• r is the discount rate or WACC
The nominal perpetual growth rate (g) is the company’s sustainable long-run growth rate. This rate can be
higher than inflation but should not exceed the growth rate of the overall economy. Rates vary by situation
and company, but the typical range is 2% to 5%.
Getting to a per share value:
PV of PV of The present value of unlevered free cash flows
Free Cash Flows Terminal Value plus the present value of the terminal value
gives you the enterprise value of a firm. To
derive equity value from enterprise value,
Enterprise subtract net debt.* For a public company, most
Value professionals will calculate down to equity
value per share, so that they can compare the
Net Debt* calculated intrinsic value to the current share
price.
Diluted Shares
Equity Equity Value
To calculate equity value per share, take the
Value Diluted Shares total equity value calculated above and divide it
by the number of diluted shares outstanding.

Conclusion
There is no single right answer when doing a DCF analysis, but there are simple steps one can take to improve
the quality of the analysis. First, use reasonable and defensible assumptions for your forecasted period. The
starting point for assumptions is usually management, consensus estimates, historical analysis or based on
performance of peers. Second, consider materiality when you are trying to develop your assumptions; what is
the impact on the final output? Third, there is no perfect WACC or terminal multiple to use, but observe
industry averages as a sanity check which can be sourced from equity research reports. Fourth, compare your
final equity value per share to the current stock price and calculate the implied CY+1 P/E multiple and compare
against the peer group to build confidence around your assumptions. If your assumptions reflect general
market consensus, then your implied share price should be within a reasonable range of the current share
price. Finally, because a DCF analysis has so many variables, your final equity value per share should be
shown as a range rather than as one single number in order to account for some variability in those
assumptions.

* In this example, net debt refers to all interest-bearing liabilities, plus the value of preferred stock, plus the value on any non-controlling interest
(often called minority interest), less all cash and cash equivalents.

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A Primer on Merger Consequences Analysis

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A Primer on Merger Consequences Analysis
Merger Consequences Analysis, also known as affordability analysis, is used to determine what an acquirer
could afford to pay for a potential target. The affordability analysis is performed in the pre-transaction phase to: (i)
evaluate the effect of the transaction on shareholder value, (ii) validate whether the EPS for the acquirer will
increase or decrease post-transaction and (iii) evaluate the impact of the transaction on the credit profile of the
acquirer. Both the acquirer and target will perform this analysis. The acquirer’s objective is to determine how
much it can pay while the target is focused on how much it could potentially receive. This analysis does not
reflect the fair or appropriate price for an acquisition but addresses the maximum price that the acquirer can afford
to pay considering certain financial constraints and parameters.
Merger Consequences Analysis for publicly traded companies is often referred to as accretion/dilution analysis.
This analysis helps quantify the impact a combination of the two companies will have on the combined
consolidated earnings. In other words, will the newly combined company report stronger EPS than the acquirer on
a standalone basis in the years following the transaction?
Another affordability question that this analysis seeks to validate, this time, focusing on financial risk, is how much
new debt the acquirer can borrow without adversely affecting its credit profile and/or credit rating.
The analysis requires evaluating how all the costs and benefits (pro forma impact) of a transaction impact the
acquirer. Therefore, one way to approach the analysis is to divide it into three steps:
Step 1: Structure the Terms of the Transaction
Step 2: Calculate the Transaction Adjustments
Step 3: Analyze the Pro Forma Impact

Step 1: Structure the Terms of the Transaction

Determine the offer price per share
The first assumption is to determine a price per share that the acquirer will offer the target in exchange for
ownership. Although we can’t determine what price the acquirer can afford to pay just yet, we can make
preliminary assumptions on the target’s valuation expectations based on public comparables, acquisition
comparables, and DCF analyses.
The offer price is typically higher than the target’s share price and is expressed as a percentage premium.
Another way of thinking about it is the extra amount which the acquirer is willing to pay in order to gain control
of the target. Historically, control premiums have averaged around 20-40%, but are influenced by both
macroeconomic conditions as well as transaction specifics (i.e. the nature of the transaction (hostile or
friendly), expected synergies, and the type of consideration paid).
Decide on consideration mix
The next step is assessing if the acquirer can raise the funds necessary to complete the transaction. The
three typical forms of consideration are stock, borrowed funds (or debt) and excess cash from the acquirer’s
balance sheet. When issuing stock, the acquirer is issuing new shares of its own stock which they then
exchange for shares of the target. In other words, the acquirer is matching the value of the offer price with its
own shares. The consideration mix will be influenced by financial constraints and parameters.

Step 2: Calculate the Transaction Adjustments

Balance sheet adjustments and goodwill
When combining the acquirer and the target, there is more to do than summing the assets and liabilities. One
of the key adjustments to the balance sheet is accounting for the impact of the financing consideration and
transaction costs. The incremental debt and/or equity used to fund the purchase price is debited or credited to
the balance sheet of the acquirer. Also, certain transaction fees (i.e. advisory fees) are either immediately
expensed while others (i.e. financing costs) are deferred and amortized over time.
Since the acquirer is assuming all the target’s balance sheet items (not just purchasing shares), the target’s
assets and liabilities must be restated to their fair market value. If the value offered to the target is greater
than the market value of the assets (net of existing goodwill and liabilities), the residual amount is allocated to
goodwill. The accounting for these adjustments is called “purchase accounting” or “acquisition method”.

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 Step 2: Calculate the Transaction Adjustments – continued
Basics of “purchase accounting”
Offer Value Offer Value
Goodwill
Excess
Purchase
Price Write – up to fair Write – up to fair
market value market value

Net Identifiable Net Identifiable Net Identifiable

Assets Assets Assets
of Target of Target of Target

Phase 1 Phase 2 Phase 3

Phase 1: Calculate the excess purchase price. Simply take the offer value and subtract the book value of the
target’s net identifiable assets.

Net Identifiable Assets = Assets – Existing Goodwill – Liabilities – Noncontrolling Interest

Phase 2: Determine the fair market value.

Typically, a professional appraiser will use cash Purchase Price Allocation
flow analysis, comparables analysis, and other Offer Value 10,450.0
valuation techniques to estimate the fair market Less: Net identifiable assets of target (235.0)
value of the target’s assets. Any adjustment Excess purchase price for allocation 10,215.0
needed to restate book value to fair value is called Less: Fixed asset write-up(a) (2,043.0)
a write-up and will be reflected on the combined Less: Indefinite life intangibles write-up(b) (1,532.2)
balance sheet. A common modeling technique is Less: Definite life intangibles write-up(c) (1,021.5)
to estimate the write-up as a percentage of the Plus: Deferred tax liability (d) 1,746.8
excess purchase price for allocation. The write-up Goodwill Created 7,365.0
percentages will vary from industry to industry. You
(a) Fixed asset write-up: 10,215.0 x 20.0% = 2,043.0
can review the merger documents of precedent
transactions to try and analyze historical write-up (b) Indefinite life intangibles write-up: 10,215.0 x 15.0% = 1,532.2

amounts as a percentage of the purchase price (c) Definite life intangibles write-up: 10,215.0 x 10.0% = 1,021.5
and use that as a preliminary assumption. (d) Deferred tax liability = SUM(write-ups) x acquirer tax rate (38.0%)

Phase 3: Calculate Goodwill. Now that you have allocated the excess purchase price to specific assets, the
"residual" goes to goodwill. Goodwill is the excess purchase price over the fair market value of net identifiable
assets acquired.
Note: A deferred tax liability is generated as a result of the incremental depreciation and amortization
from the write-ups. A temporary timing difference arises from this disconnect between when taxes are
reported as opposed to when they’re actually paid.
This is an advanced tax concept and should be discussed in detail with an experienced tax advisor.
Income statement (pre and post-tax) adjustments
There are a few core transaction adjustments that most merger models account for. They are:
(a) Incremental interest expense from new debt issued to finance the transaction
(b) Synergies
▪ Additional cash flows or cost savings resulting from the combination of two similar businesses, divided
into two categories: incremental revenue or cost savings
(c) Additional depreciation and amortization expense resulting from the asset write-ups
(d) Adjusting for forgone interest income on the cash off the existing balance sheet used to finance the
acquisition
(e) New shares issued as part of the transaction consideration
After-tax
Acquirer’s Target’s “Incremental
Calculate pro forma EPS by combining the Pro Forma Net Income + Net Income +/- Adjustments”
=
two companies’ net incomes and then accounting for all EPS
Acquirer’s New
+
incremental adjustments. Shares Outstanding Shares Issued

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 Step 3: Analyze the Pro Forma Impact
Income statement impact – accretion / (dilution)
One of the central questions is whether the deal will be accretive or be a benefit to the acquirer’s bottom-line.
By calculating pro forma EPS, or the estimated EPS post-transaction, we can compare the combined
business’s earnings to the acquirer’s on a standalone basis.
Pro Forma EPS > Acquirer’s Standalone EPS: ▲ Accretive
Pro Forma EPS < Acquirer’s Standalone EPS: ▼ Dilutive
Pro Forma EPS = Acquirer’s Standalone EPS: EPS neutral
It is also common to analyze the incremental synergies required to keep EPS neutral or to “breakeven”. This
is particularly helpful if the deal appears dilutive. It gives you a sense of the amount of synergies that are
needed before there is no negative impact on EPS. In the example below, 221.2 of synergies are needed in
the first projected year to make the transaction EPS neutral (Pro Forma EPS = Acquirer’s standalone EPS). In
FYE+3, the transaction is accretive by 0.03. This creates a “cushion” of 39.0 pre-tax earnings. The cushion
refers to the amount of synergies that do not have to be realized while still maintaining a neutral EPS impact.
FYE+1 FYE+2 FYE+3 Calculating Pre-Tax Synergies:
EPS Accretion / (Dilution)
Pro Forma EPS 2.83 3.18 3.53
x Pro Forma shares outstanding
Acquirer Stand-Alone EPS 3.00 3.25 3.50
= Net income accretion / (dilution)
Accretion / (Dilution) ÷ (1 - Tax rate)
EPS Accretion / (Dilution) (0.17) (0.07) 0.03 = Pre-tax (cushion) / synergies to
EPS Accretion / (Dilution) - % (5.7%) (2.1%) 0.7%
Pre-tax (cushion) / synergies to breakeven 221.2 91.1 (39.0)
breakeven

Balance sheet impact – pro forma leverage

One key metric to analyze on the balance sheet is the Debt / EBITDA leverage ratio. This gives an indication
of whether the combined company will be able to meet its principal obligations. One of the primary concerns
of an acquirer is if the acquisition debt raised could cause the rating agencies, such as Standard and Poor’s, to
either place the ratings on watch or immediately downgrade their current credit rating.

Calendarizing Different Fiscal Year Ends Between Target and Acquirer

If the target and acquirer are on different fiscal year ends, you will need to adjust the target’s projections to reflect
the same year-end as the acquirer. Because the balance sheet is a snapshot in time, there is generally no need
for adjustments since the most recently reported information reflects the assets the acquirer will be taking over.

In the example below, the acquirer’s fiscal year end is December while the targets is September. Only 75% of the
target’s FYE+1 overlaps with FYE+1 of the acquirer’s. 25% of FYE+2 overlaps as well.

FYE FYE + 1 FYE + 2 To match

FYE +fiscal
3 year ends the following
1 2 3 4 5 6 7 8 9 10 11 12 1 2 3 4 5 6 7 8 9 10 11 12 1 2 3 4 5 6 7 8 9 10 11 12
math must be done to the target:
FYE + 1 Acquirer
FYE + 1 Target = 2.20 75% x 2.20 = 1.65
FYE + 2 Target = 2.40 25% x 2.40 = 0.60
Calendarized FYE+1 1.65 + 0.60 = 2.25

“Adjusted EPS” or “Cash EPS”

This removes the impact of the additional non-cash D&A resulting from the write-ups of PP&E and intangibles. It
is important to understand that neither “Cash EPS” nor “Adjusted EPS” are GAAP terms, so the methodology for
calculating them will vary from industry to industry, and perhaps even from company to company.

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 Conclusion
There is no right answer when doing Merger Consequences Analysis. A merger model is simply a tool to
measure the financial impact of a transaction on the acquirer’s financial statements. Therefore, it is commonly
referred to as a secondary valuation methodology. Accretion/dilution is primarily an affordability analysis and
does not reflect any value creation. Just because a deal is EPS accretive, doesn’t mean it is a good deal. There
are many other factors influencing the quality of a transaction, including, but not limited to, strategic rationale and
integration success. How much an acquirer can pay may differ from the amount they should pay or how much
they will pay. Generally, shareholders do not prefer dilutive transactions; however, if the transactions are
expected to generate enough value to become accretive in a reasonable time (i.e. within 3 years), a proposed
combination could be justified.

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A Primer on Leveraged Buyouts

© 1999-2020 Training The Street, Inc. Page 25 of 30

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A Primer on Leveraged Buyouts
Overview
A Leveraged Buyout (LBO) is an acquisition of a business by a private equity firm or financial sposnor which is
funded using a significant amount of debt (bank (maturity of 5 – 7 years) and bonds (maturity of 7 – 10 years) with
the balance of the purchase price funded with an equity contribution from a financial sponsor. Historically, the
purchase price has been funded with 60% - 70% debt with balance contributed by the financial sponsor. These
investments are held for a medium term (i.e. 5 years).

LBO Math
An important valuation concept to understand when seeking to derive a levered value is that LBO transactions are
financed and purchased on a multiple of EBITDA. For example, if the purchase price (i.e. transaction value)
multiple for a business is 9.0x EBITDA and the banks determine that their maximum financing level is 5.0x Total
debt / EBITDA, it means that the balance of 4.0x EBITDA would be contributed in the form of equity. The return
(IRR) threshold on these types of investments is typically in excess of 20% over a 5-year period. In other words,
the equity invested grows annually at an average rate of 20% each year until year 5 which is the typical time
period for exiting the investment.

When evaluating a potential LBO on a target company, one of the main areas of focus for a financial sponsor is
the amount of projected free cash flows generated during the investment period of three to five years. This is
important as the cash flows generated will be used to service debt (interest and repayment of principal) created in
connection with the transaction and fund ongoing working capital requirements. Below are some common
calculations to arrive at the potential free cash flow (refer to Private Equity 2) that can be generated by the target
company. The amount of free cash flow would then be used to service interest, principal and possibly pay
dividends, if permitted.

Free Cash Flow Calculations

Investment Banking Private Equity 1 Private Equity 2

Tax-effected EBIT Net Income EBITDA

+ D&A + D&A - Cash Taxes
- CapEx - CapEx - Cash Interest Expense
-/+ ∆ Working Capital -/+ ∆ Working Capital - CapEx
= Unlevered FCF = FCF -/+ ∆ Working Capital

= FCF

What Makes A Good LBO Candidate?

There are multiple factors used by private equity firms when evaluating investment opportunities. Many
successful LBOs in the past have had some or all the following attributes:
1) Strong, predictable operating cash flow to service the debt while continuing to fund the business
2) Mature, steady, defensive industry characteristics
3) Leading market position and or strong brands
4) Limited capital expenditure and product development requirements
5) Undervalued (low valuation statistics relative to peers; e.g., P/E or EV/EBITDA multiples)
6) Owned by a motivated seller
7) Opportunities for an immediate rationalization for the financial sponsor (e.g., margins improvements,
working capital improvements, synergies with other portfolio companies)
8) Viable exit strategies (e.g., IPO or strategic sale)

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 General Limited Partners
(Fund Investors)
Partner
(Private Equity Firm)

Stock of Newco Cash

Pledge /
Cash Security
Equity

Target Assets Lender(s)

Debt
Assets or Cash
Stock Newco
A LBO transaction has three constituents that need to come to an agreement:
1) Target shareholders
2) Private Equity firm / Financial sponsor
3) Lender
Answers to the following questions need to be considered.
1) What is the fair value of the target company?
2) What offer price will the target shareholders accept?
3) What is the maximum amount of debt that can be supported by the cash flow?
4) What are the financial sponsor’s return rate thresholds on the investment?
The answers to the above questions must deliver acceptable outcomes for each of the three constituents for the
LBO transaction to occur. It is because of these varied interests, LBO structuring can be complex.

Overview of Transaction Constituents

1) Target Company
The primary concern of the board of directors, acting on behalf of the target’s shareholders, is agreeing to an
acceptable offer price. Typical valuation methods used to support an acceptable offer price include a
combination of analyzing public comparables and acquisition comparables, as well as a discounted cash flow
analysis (note that some valuation methodologies may not be applicable based on the availability of relevant
comparable companies or other specific business characteristics). There are many factors that may influence
an offer price including, but not limited to, market conditions, the level of comfort with the operating
assumptions and the target’s management’s willingness to “rollover” their existing equity and remain involved
in the business.

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 2) Financial Sponsor Value Creation Themes
The private equity firm seeks to create value (IRR) in the target company through (1) deleveraging, (2)
operating improvements and (3) possible “multiple expansion”. Deleveraging refers to the use of excess
cash flow to repay the transaction debt. Assuming the value of the company hasn’t changed since going
private, as the debt is reduced, the equity value will increase. Most operating improvements are the result
of productivity and efficiency gains resulting in enhanced operating cash flows that are used to repay debt.
Typically, these improvements include growing sales, increasing operating margins and instituting more
efficient working capital programs. If these operating improvements are made, there is a possibility of selling
the company at a higher multiple then what it was acquired for. This is referred to as “multiple expansion”.
Financial sponsors typically look to exit an investment between three and five years. Exit strategies include
selling the business to a strategic buyer who views the target as complimentary to an existing business line,
an initial public offering (IPO) or a sale to another financial sponsor. When calculating sponsor IRRs, we
assume that the entry and exit multiples (8.0x) are the same. While exiting the investment at a multiple higher
than the purchase price multiple will help boost a sponsor's IRR, it is often difficult to justify a higher multiple
in the initial IRR analysis. Returns sought by sponsors often depend on the perceived risk of their investment
and the health of the sector but are typically in excess of 20%.
Calculating returns to the sponsor assuming
Future: Sold for 8.0x's
LTM EBITDA of $137.5 they exit in 5 and 3 years…
Initial: Acquired for 8.0x's
LTM EBITDA of $125.0. Future PV = $300, FV = $725, N = 5, IRR = 19.3%
$1,100
Initial PV = $300, FV = $725, N = 3, IRR = 34.2%
$1,000

Equity  1

$300  FV  N 
Equity IRR =   −1
$725  PV  
 

 1

$700
Debt   Equity Value exit  Holding period 
IRR =   
 Equity Value   −1
Debt $375  entry 


3) Lender
The funding sources for the LBO include excess cash from the target’s balance sheet, leveraged loans
(secured bank debt), subordinated debt (high yield bonds), mezzanine financing and sponsor equity.
Because the use of financial leverage (or debt) allows for acceptable returns to the sponsor, the lenders play
a pivotal role in a LBO transaction. Debt capacity refers to the amount of leverage that the target company
can support based on the projected cash flow stream. Debt capacity is usually expressed as a multiple of
EBITDA. Determining the debt capacity is a function of assessing the following risks: (i) industry (ii) company,
(iii) structural and (iv) market. Also important is the management track record and the stability of the cash
flows to service the debt. Some of the key factors that
impact debt capacity are: Excess Cash
• Determining “financeable” EBITDA
• Maintenance versus growth CapEx Leveraged • Revolving credit facilities
• Average versus peak working capital requirements Loans • Term loans
• 2nd lien loans
• Historical performance 2.0x – 3.0x

• Achievability of projections
High yield • Senior secured notes
• Depth and quality of management bonds • Senior unsecured notes
• Growth capability given leverage constraints up to 5.0x • Subordinated notes
• Structural risk Mezzanine • PIKs
– Size capital • Warrants
• Convertible securities
– Leverage (e.g., Total and senior debt / EBITDA) up to 6.5x
– Coverage (e.g., EBITDA / Interest coverage) Equity Note: These parameters will
• Precedent LBO transaction debt structures 40% - 50% change with market conditions.

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 TTS Modeling Summary
A TTS LBO model is essentially a financing model layered on top of cash flow projections.
1) Transaction assumptions:
Because the level of debt lenders will provide is critical to the success of a LBO, it is important to understand
what the capital markets will support in terms of capital structure (e.g., total debt / EBITDA and debt/equity
mix) and then work backwards to derive an offer price that will allow for all three constituents to reach an
agreement.
In the model, total funding sources, including all levels of debt and equity, must be set equal to the uses of
funds including the actual purchase price to acquire the business, refinance existing debt and pay any
associated fees. The sponsor’s equity should be “the plug”, representing the remainder of the funds required
to fund the transaction after all debt levels and any other sources of funding have been exhausted.
2) Operating assumptions:
The cash flow portion of the model needs to take into consideration any changes in operating performance
and capital investments. After the operating model for the target company is completed, you can reference
the transaction assumptions in order to illustrate its impact on the pro forma balance sheet, post-transaction
capital structure and more importantly the cash flows. It is important to analyze how the new debt levels will
impact the credit quality of the business and to make sure higher interest expense will not damage the
company’s underlying ability to operate.

3) Sponsor Returns (IRR) or Multiple of Money (M-o-M):

Sponsors typically hold onto an investment in the target company for five years and look to exit via either a
trade sale (sold to another financial sporsor or corporate) or Initial Public Offering (aka IPO). The return
thresholds on the equity is typically in excess of 20%. This calculation is based on the initial equity
investment and the implied future value of the equity in five years. Another expression used is the multiple of
money defined as: Implied Future Value of Equity / Initial Equity Investment.

The remaining steps to complete in the model include the calculation of all the relevant ratios and credit
metrics which are usually summarized on one page.

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 Target shareholders
look for a reasonable
premium

Purchase Price Potential IRR to the

multiple Financial Sponsor

Operating
improvements
driving cash flow

Conclusion
The LBO analysis will result in the practitioner arriving at a “levered” value for the target company.

This resultant value is determined by focusing on key variables such as purchase price multiple, debt financing
parameters, cash flow generation, debt reduction and IRR. Therefore, the LBO model allows a practitioner to
analyze and balance the trade-off between the purchase price multiple, leverage, equity contribution, and IRR in
order to establish what the company is worth to a financial sponsor.

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