Mergers and Acquisitions FINC3013 – Valuation in an M&A context Angelo Aspris

Valuation Analysis Valuation is a critical part of the merger/acquisition process. A deal that may be sound from a business standpoint may be unsound from a financial standpoint. The purpose of a valuation analysis is to provide a disciplined approach for arriving at a price. This approach combines procedural valuation procedures with a fair degree of scepticism and sound business judgement. In other words, for a merger/acquisition process to be successful NV > 0 Where NV = net value, VBT = value of the combined firm, VB = value of the bidder and VT = value of the target.

Valuation Analysis Valuation in M&A is used to answer key questions related to shareholder value creation.

Valuation Methodologies Publicly traded comparable companies analysis “Public Market Valuation” Value based on market trading multiples of comparable companies Applied using historical and prospective multiples Does not include a control premium Comparable transactions analysis “Private Market Valuation” Value based on multiples paid for comparable companies in sale transactions Includes control premium Discounted cash flow analysis “Intrinsic” value of business Present value of projected free cash flows Incorporates both short-term and long- term expected performance Risk in cash flows and capital structure captured in discount rate Leveraged buyout/recap analysis Value to a financial/LBO buyer Value based on debt repayment and return on equity investment Other Liquidation analysis Break-up analysis Historical trading performance Expected IPO valuation Discounted future share price EPS impact Dividend discount model 4

Most Common Valuation Tools Trading Multiples Live observations of how companies are being valued by investors. Intuitive link with fundamental value: e.g. high growth will normally be associated with a higher multiple and higher risk with a lower multiple. Non-control transactions Transaction Multiples Historical observation of how much investors have paid for companies. Change of control situations – includes mix of control premium and synergies paid. Discounted Cash Flow (DCF) Theoretical value (often used to establish “base valuation) Useful for period of non-constant growth for finite life Requires significant number of assumptions for future periods. Leverage Buy-Out (LBO) What can financial sponsors pay for assets? Based on our knowledge of their required returns, access to leverage, ability to extract operational synergies.

1. Trading Multiples

Trading Multiples A method that allows us to calculate the value of an asset by comparing it to values assessed by the market for similar or comparable assets. The process: 1) Identify the comparable assets and obtain market values for the assets. 2) Convert these market values into standardised values. 3) Compare the standardised values (multiples) for the asset analysed with the comparable asset controlling for any differences between the firm that affect the multiple

Trading Multiles

Trading Multiples – Boral Example Company Name Market Capitalisation ($US) Total Enterprise Value ($US) Basic EPS PEG Ratio EV/EBITDA Return on Equity % EBITDA, 1 Yr Growth % Adelaide Brighton Ltd. (ASX:ABC) 1,786.14 1,959.53 0.2 2.8x 9.96x 15.5 (7.1) CSR Limited (ASX:CSR) 2,320.11 3,128.4 (0.1) 2.0x 7.12x (7.2) 13.8 James Hardie Industries SE (ASX:JHX) 2,172.22 2,303.99 (0.2) 1.2x 9.22x NM 474.2 Boral Ltd. (ASX:BLD) 2,629.58 3,746.23 0.9x 9.02x 4.8 (21.7) Summary Statistics High Low Mean 2,092.82 2,463.97 (0.0) 8.77x 4.2 160.3 Median

Trading Multiples – Calculation Issues Choice of Multiple: Which should we chose? Common choices include P/E, EV/EBITDA, EV/EBIT, PEG “Hairballs” – minority interests, investments, non-comparable divisions Post balance sheet events Acquisitions, divestitures, buy-backs, equity/debt placements Outliers Data providers often use different procedures to calculate the same ratio. Fiscal v Calendar year

Trading Multiples Advantages: Disadvantages: Based on public information (therefore reflect market perceptions/moods) Market Efficiency – valuation should in theory reflect all available information Assets are always relatively undervalued/overvalued Not as computationally intensive as other approaches Does not include control premium Disadvantages: Difficult to find large sample of truly comparable companies Trading valuation may be affected by thin trading, small capitalisation, or poor research coverage The market can be “wrong” Undervalued may still equal overvalued.

2. Precedent (Comparable) Transaction Analysis

Precedent (Comparable) Transaction Analysis Conceptually similar to the trading multiples approach. The multiples used to estimate the value of the target are based on purchase prices of comparable companies that were recently acquired. Uses of Comparative Transaction Analysis include: Valuing a business in a change of control situation (i.e. inclusive of a control premium) Provide statistics on particular transactions as a basis for discussion. Display historic acquisition appetite of industry of industry participants and determine willingness to “pay full price”. Determine the market demand for different types of assets i.e. frequency of transactions and premiums paid

Australian Acquisition Premia - (Deal Size > $100m)

Presentation of Transaction Multiples

Transaction Multiples – Advantages and Disadvantages Based on public information Captures control premium May show trends i.e. consolidation, foreign/financial acquirers Provides guidance to likely interlopers and their willingness and ability to pay. Disadvantages Public data can be limited and misleading Precent transactions are rarely directly comparable (stock market, business, financing, bidders may have all changed) Values obtained often vary over a wide range Not all aspects of a transaction can be captured in multiple valuation. Market conditions at time of transaction may have significant influence on valuation.

3. Discounted Cash Flow Analysis (DCF)

DCF Analysis DCF value is simply the present value of the projected cash flows of a business. Cash flows are discounted to reflect the time value of money and riskiness of the asset. In practice DCF analysis is used for: A base case scenario (to satisfy market convention) An asset with a finite life A start up business or early stages of development A turnaround situation (i.e. when earnings will be very different in a few years) Key Steps: Determine forecast horizon cash flows Determine Terminal Value cash flows (i.e. perpetual growth rate, asset/equity multiple) Calculate the WACC to discount cash flows. Various cases can be evaluated upside (favourable) versus downside (unfavourable) cases base / low cases to manage expectations, establish floor key sensitivities on price, cost, growth etc.

DCF Components Forecasted free cash flows: Terminal value: cash flows before debt service or distributions to shareholders Terminal value: estimate of future value at “steady state” a number of methodologies can be used Cost of capital represents current return requirements on capital invested (debt and equity) and the appropriate risk of the underlying cash flows reflects target capital structure on a market weighted basis

Free Cash Flow Free cash flow is the cash that remains after all necessary reinvestments (e.g. capital expenditure and working capital) have been made. Free cash flow is measured prior to any debt service (interest and debt repayment), but after cash taxes Free cash flow therefore is the amount of cash that can be distributed to shareholders and debt holders (also known as the ‘unlevered cash flow’) Cash flows discounted at the weighted-average cost of capital to calculate firm value Occasionally and primarily for financial institutions, we calculate cash flows after interest expense and interest income (‘levered’ cash flow) Levered cash flows discounted at the cost of equity Present value represents equity value

Calculating Unlevered Free Cash Flow (UFCF) Unlevered cash flow is the cash generated without regard to capital structure and financing (hence “un-levered”). One way of arriving at UFCF: Net Income Depreciation Amortisation Change in Deferred Taxes Other Non-Cash Charges After-tax interest expense Capital Expenditures Investment in Working Capital Unlevered Free Cash Flow (UFCF) - + =

Free Cash Flow – Terminal Value Terminal value is the portion of a company’s total value that can be attributed to cash flows expected in the period beyond the specific forecast period the terminal value period is the time from the end of the specific forecast period to infinity Can be measured via perpetual growth method, or multiples approach Terminal value should be estimated when the forecast reaches “steady state” long-term assumptions have been stabilised little added value by forecasting more years for practical purposes around ten years The terminal value is equivalent to making infinite year-by-year forecasts

Weighted Average Cost of Capital The Weighted Average Cost of Capital is defined by: Where E is the value of equity, D the value of debt and V the value of the firm. For the calculation of WACC one should always: Use market weights Use market based opportunities Use forward looking weights and opportunities

Summary of DCF results Free cashflow summary Key valuation outputs 13

Summary of DCF results Summary of sensitivity analysis: Key sensitivities for DCF valuations include WACC / discount rates Terminal growth rates / multiples Earnings growth / margins

DCF – Advantages and Disadvantages Theoretically, the most sound valuation method Forward looking analysis, based on cash flow (rather than net income). Incorporates expecting operating strategy into the model Less influenced by volatile market conditions Allows a valuation of the separate components of a business or synergies separately from the business. Disadvantages Valuation is highly sensitive to underlying assumptions, terminal value calculation and discount rate. Terminal value often represents a significant portion of total value Impervious to market dynamics and control premia

4. Leveraged Buy-out Analysis (LBO)

LBO Analysis How does the LBO analysis fit into the range of valuation methodologies? It is based on cash flow projections like a DCF but takes the Company’s leveraged capital structure into consideration From a technical perspective, it is therefore similar to a leveraged DCF analysis LBO analysis should answer the following questions: Does the LBO work within a sensible range of purchase prices? Are equity returns high enough (>15%)? How much debt can be put into the company? Reimbursed before/within maturity while maintaining credit ratios in acceptable ranges at all times?

LBO modelling Step 1 Determine purchase price Determine how much will be paid for using debt vs. equity What is the entry multiple (i.e. EV/EBITDA of x) Step 2 Project company’s cash flows over investment horizon (e.g. over 5 years) Use any excess cash (after operating expenses and interest has been paid) to pay down debt Equity holders receive no cash during these years

LBO Modelling Step 3 Assume an exit multiple (i.e. EV/EBITDA of x) Multiply this with EBITDA in exit year (e.g. in year 5) You now have EV. EV – outstanding debt = Value of Equity at Exit Using Equity put in from Step 1 and Equity at exit from Step 3, you can calculate IRR of equity investment Step 4 Assess key sensitivities: Entry vs. Exit multiple (EBITDA multiples) Gearing vs. Entry multiple Exit year vs. Exit multiple

LBO Methodology: A summary INPUTS Projected Cash Flows Discount Rate (WACC) Terminal Value OUTPUT Enterprise Value (PV) DCF Analysis INPUTS Projected Cash Flows Purchase Price (PV) Sale Price (TV) OUTPUT IRR (Equity Discount Rate) LBO Analysis IPO Trading Multiple Sale to Buyer Transaction Multiple

5. Conclusion

Final Valuation Determining a final valuation recommendation is a process of triangulation using insight from each of the relevant valuation methodologies 1. Discounted cash flow Utilises data from M&A transactions involving similar companies. Analyses the present value of a company's free cash flow. Utilises market trading multiples from publicly traded companies to derive value. Used to determine range of potential value for a company based on maximum leverage capacity. 3. Comparable Acquisition Transactions 4. Leveraged Buy Out 2. Publicly Traded Comparable Companies

Summary of Results Typically results are presented to management using a “football field” type presentation analysis

Factors affecting the takeover premium Must win! Potential cost to bidder if a competitor gets target Cost of building from scratch vs. purchase Potential value of ownership, either due to high return investments or unforeseen events Defensive / greenfield / platform / option Buyer’s perception of the future is different from the market’s view Outlook Net cost savings and revenue enhancements Synergies Buyer’s cost of capital is lower than target’s (sometimes viewed as a synergy) Cost of capital Under-valuation Target trades at a discount to DCF value (eg. Diversified holdings; industry out of favour, poor communications with investors, etc.) Highest final offer Trading price before announcement Target company price Potential control premium 29

Transaction Values can differ from Valuation Methodologies Higher level of synergies revenue enhancements cost savings Cross border differences in capital costs, tax rules, repatriation levels, etc. Differences in view of the future buyer may have a dramatically different view of the future than the market Other strategic reasons buy versus build platform for other investments defensive acquisition