How
to enhance a company's valuation prospects?
Newsletter Q3 2006
Introduction
Valuation methodologies
Discounted Cash Flow
Comparable Company Valuations
Valuation in merger and acquisition discussions
Valuation at the time of flotation
Improving valuation prospects
Conclusion
Enhancing shareholder value is a key objective for the
management teams of both private and public companies. A company’s
strategic plan requires a clear focus on the options to crystallise an
increase in value through a liquidity event such as a flotation, an M&A
transaction, or a joint venture.
In our previous newsletters we have examined strategic business options
including management buy-outs, acquisitions and stock market listings.
All these transactions require an appreciation of the valuation of a business
and how this can be enhanced. Below, we will review the alternative methods
which can be used and discuss the applicability to both private and public
situations.
top
Valuation methodologies
Valuing a business is often more an art than a science.
For a public company, the market capitalisation or the equity value, of
the business provides an important reference point based on publicly available
information. To assess the full value of a business, the following factors
need to be taken into account:
- the liquidity of the shares;
- the premium required to take control of the business; and
- the capital structure.
For private companies and divisions of public companies, straightforward
mathematical formulae can be employed. These calculations generate the
company’s value based on either forecasted cash flow, earnings,
or by analysing the value of comparable listed companies and recent M&A
transactions in an industry.
Prior to performing the arithmetic, it is important to take a strategic
view of the industry and of the future prospects of the company in order
to place the valuation figures in the correct context. An analysis of
the competitive environment, barriers to entry, potential for substitute
products and the strengths and weaknesses of the company will put the
forecasted cash flow and earnings into perspective. Below, we will review
the three most commonly employed valuation techniques.
top
Discounted Cash Flow
The discounted cash flow (DCF) approach is the most commonly
used method to value companies, or specific projects. The basis of the
calculation is free cash flow. This is cash available for distribution
to the debt and equity providers after all planned investments have occurred,
including both working capital and taxes. Adjustments are made to the
financial statements for non-cash items including depreciation and goodwill.
A financial model is developed of the forecasted profit and loss, balance
sheet and cash flow statements for the company. Typically, a five year
period is used. The assumptions underlying the forecasts are important
to the integrity of the model. Furthermore, the process of developing
the model and checking the consistency with the competitive strategy of
the company within the industry is as important a process as the calculation
of the final valuation figure.
As a going-concern a business will normally operate well beyond the 5
year forecast period. It is therefore necessary to estimate the “terminal”
or “continuation” value of the business. Over time, with competition,
a firm’s performance tends to converge to the industry average with
5-7% growth rather than say an initial 15-20% growth. With normalised
cash flow and growth prospects a valuation according to comparable multiples
will provide reasonable accuracy. This is typically an EBITDA multiple;
or earnings before interest, tax, depreciation and amortisation. Therefore,
the valuation of a company taking into account the time value of money
can be separated into its constituent parts.
| Value
of |
= |
Present
value of |
+
|
Present
value of |
The resulting value represents the enterprise value of
the business available to all security holders discounted with the Weighted
Average Cost of Capital, or WACC. The WACC reflects the combined cost
of debt and equity with the weights of these capital sources based on
their market, rather than book values. The key point to highlight is that
a company’s WACC declines as it employs additional lower cost debt,
thereby reducing the proportion of the more expensive equity. This is
due to the tax shield resulting from the tax deductibility of interest
payments. Typical WACC rates are set out below. These are not industry
specific.
| Weighted Average Cost of Capital |
|||
| Large cap |
Mid-small cap |
Larger private company |
VC
backed and smaller private company |
| 5% |
10% |
15% |
25% |
The DCF process provides a valuation of the enterprise. The value of the
equity can then be calculated by subtracting the net debt (total debt
minus cash) from the enterprise value of the business. As with all valuation
methodologies, it is important to carry out sensitivities around the key
assumptions and to focus on a valuation range rather than on a specific
number. Furthermore, as we discuss in the next section, comparing the
DCF valuation with alternative methods is important as a sanity check.
Each valuation approach contains useful information and, relying on several
approaches in combination, is likely to produce more accurate valuation
ranges.
A more direct approach often used in practice relies
on valuation multiples including:
- Price to earnings (P/Earnings per share);
- Price to book (book value of net assets); and the
- EBITDA multiple (market value plus net debt/EBITDA).
Multiples are estimated from the prices of public companies with growth
and risk characteristics comparable to the company being valued. Firms
in the same industry are the usual source of comparables. Precedent M&A
or IPO transactions in the same industry are likely to be a good match
especially if the targets had similar growth rates and margins. M&A
transactions will provide an understanding of the premium paid under recent
business scenarios. In the late 1990’s the premiums paid approached
the 40-50% range. Since then, management teams have become more discerning
and have been able to conclude transactions within a more reasonable 15-20%
range. However, as we shall see in the current example of the Mittal and
Arcelor hostile bid, eagerness to win the deal can lead to overextension
by the bidding company.
Multiples can be applied to historic of forecast financials to obtain
the present value of the enterprise or of the equity. Alternatively, the
multiples are often used for the termination value in a DCF calculation.
A forward multiple can give a better estimate of value because it incorporates
expectations about the future. P/E multiples often differ between similar
companies due to accounting differences, such as depreciation in earnings
calculations. Net debt differences can also affect interest expense and
earnings. For these reasons the EBITDA, or cash flow multiple is often
used. For a business with good growth prospects a forward EBITDA multiple
in the 8-12 times range provides a useful rule of thumb.
Revenue multiples are calculated by dividing the enterprise value by revenues.
They are used to value companies for which no earnings are expected in
the short-term. They can also provide an idea of value where no reliable
cost information is available. These multiples are often used for technology
companies with strong growth prospects. It must always be remembered that
the key element in a company’s valuation is not the revenue generated,
but the free cash. Many expensive acquisitions have occurred in the technology
sector on the mistaken assumption that revenue growth leads to free cash
flow!
Choosing the value to apply in a particular situation can only be made
after a careful study of the company and its industry. A comparison of
the value of similar public companies can provide a reasonable guide to
value, particularly in private situations.
top
Valuation in merger and acquisition discussions
It is essential to have a disciplined approach to the
valuation of the business and to be able to walk away from a transaction
at the appropriate time.
The intrinsic value of the business is the net present value of expected
future cash flows independent of any acquisition. This is the stand alone
value and the basis for negotiations. Any price paid above the intrinsic
value represents the control premium to be shared between the target company
and the acquirer’s shareholders. This premium includes a market
premium and the potential synergy value. These synergies comprise revenue
enhancements, cost savings including financial engineering and tax benefits
as well as process improvements.
The current hostile bid discussions between Mittal Steel and Arcelor is
an interesting example of valuation in M&A discussions. An initial
hostile bid in January 2006 valued each Arcelor share at €28.21,
a 27% premium to the closing price on the day before the bid. However,
the share price increased to €35 and this forced Mittal to increase
the price offered by a third to €37. To pre-empt a takeover, Arcelor
approached a white knight, the Russian steel company Severstal for a merger.
This led at the end of June 2006 to a higher offer from Mittal of €40.4
per share which is 90% above Arcelor’s share price in January and
is a full price. The transaction is expected to be approved by shareholders.
However a minimum of €1.3 billion of synergies is required to generate
value for the acquiring shareholders. This transaction highlights that
valuation discussions are only one element in the decision to acquire.
Strategic interests and in this case the desire to become the largest
steel company in the world, are also important factors.
top
Valuation at the time of flotation
With regard to a flotation, or a secondary offering of shares, it is typical for a company to be valued based on the comparable multiples of similar listed companies. In these offerings it is normal for the sale to take place at a slight discount to the existing equity value of companies. This discount is typically in the 2-5% range depending on the situation.
top
Improving valuation prospects
Whilst strong growth prospects for both an industry and
an individual company are important factors in a valuation, there are
a number of additional factors where a company can improve its prospects
prior to a strategic transaction:
Depth of management team
Developing a core group of managers to lead a business without over–reliance
on one person will be value enhancing for new shareholders. It is typical
for an acquirer to enhance a management team with financial expertise
whilst retaining an experienced Chief Executive and operating management
team. However, in turnaround situations, replacing the top management
team is often essential to revitalise the business.
Share Structure
A simplified share structure with one class of shares and one share one
vote will enhance the transparency of the company. Private companies often
have several classes of shares which have been issued during several rounds
of financing. Alternatively, certain shareholders often retain voting
control irrespective of the amount of financing. A simplified share structure
will improve a company’s valuation, particularly when a flotation
is under consideration.
Capital Structure
An under leveraged balance sheet will provide an opportunity to a private
equity firm to restructure a business, increase debt levels and improve
the return on equity. Furthermore, existing shareholders should question
whether the current or an enhanced management team can restructure the
business and increase the value without changing ownership. This has occurred
successfully at Marks & Spencer over the last 18 months following
the unsuccessful bid from Philip Green who attempted a leveraged public
to private transaction.
Effective Corporate Governance
A board with effective independent directors successfully challenging
the Chief Executive will lead to improved decision taking compared to
an autocratic board. Separating the role of Chairman and Chief Executive
has improved the governance at UK companies, although in the US there
remains a preference for a combined role. A more effective board structure
is important for key strategic decisions including acquisitions, divestitures
and flotation. All of these transactions have a key impact on valuation.
top
Conclusion
Generating a valuation is basic arithmetic. The key factor
to enhancing a company’s value is through the execution of opportunities
that enhance the prospective free cash flow of the business. A company’s
strategic position within an industry with solid growth prospects is essential
plus a well structured business and an experienced management team.
Valuation is an art and not a science, but the process of calculating
a company’s value in a systematic way can uncover key growth opportunities
for a business.
The views expressed in this newsletter are those of DC Dwek Corporate Finance Limited and are provided for information purposes only.
© DC DWEK Corporate Finance
Previous newsletters