M&A Blog #15 – valuation (tools and data preparation)
Just as any home appraiser or credit officer does before going through the analytical exercise to produce a score for a home or a borrower, valuation professionals go through several steps of preparation before the actual exercise of producing a number that can be used as a value of a company. The specific tools and data required for the analysis is determined by the type of valuation method used in the analysis. I will discuss general tools and credible sources of information that a valuation professional can use for the analysis. I will also detail the data required and recommended to perform four very popular valuation methods (Discounted Cash Flow, Comparable Company, Precedent Transaction, and Leveraged Buy Out) and an upcoming valuation method currently popular with academics and expected to be a part of the mainstream methods in the near future (Dividend Discount Model). There are other methods one can use to value a company and we will discuss these methods briefly in a future post. For the sake of comparison, I recommend using more than one method to value a company - if anything, to see if there is a consistency between methods when it comes to the result. Lastly, for the sake of simplification, in this series of valuation posts, I will assume a valuation of a public company.
The following are the tools for valuation:
Microsoft Excel - required
Monte Carlo simulator - highly recommended (for scenario / sensitivity analysis). Inexpensive Excel-plugin simulator such as @RISK are available for download online.
Access to credible sources of information such as SEC EDGAR database, Treasury.gov, OECD GDP Forecast, Mergent Online, S&P Capital IQ, Hoovers, ValueLine, Yahoo Finance, MarketWatch, and Damodaran Online. Some of these information sources are free, some require paid subscription to the information. For the paid subscription, check with your local public and university libraries to see if any of them already subscribed to the information sources - if yes, chances are the information can be gotten for “free” via a free (or inexpensive) library membership card.
It is worth noting that different valuation professionals have different preferences when it comes to specific tools and information sources. The ones listed above are my go-to tools and sources. It is also worth noting that, although the high-level framework of each valuation method we will discuss shortly is well established, different valuation professionals has different levels of granularity when it comes to which underlying data is incorporated into the valuation models. To simplify the exercise in reality, different companies / valuation teams may have different valuation templates that standardize how each company approach valuation based on their beliefs and opinions.
Discounted Cash Flow (DCF) is a valuation method that uses free cash flow projections, a discount rate, and a growth rate to find the present value estimate of a potential investment. To perform this analysis, the following are needed:
Target’s financial statements (income statement, balance sheet, cash flow): Preferably audited historical statements, cleaned up and re-formatted in Excel properly (we will see an example of this in the next post). For a public company, a reliable source of this information can be the SEC EDGAR database or sources like Mergent Online that provide easily downloadable data. For a private company, these statements will be provided by the target company (assuming non-hostile takeover environment). A 5- or 10- year historical data is preferable. DCF can be used on young companies with no historical financial (forward projections are used instead) as long as it is understood that such valuations will have a huge margin of error.
Target’s last two Word / PDF 10-Ks and 10-Qs: Can be obtained from SEC EDGAR.
Target’s current stock price: Can be obtained from sources such as Yahoo Finance.
Target’s Beta: Can be obtained from sources such as S&P Capital IQ / Value Line reports, Yahoo Finance company profile, or calculated using historical return data of the company’s stock price from Yahoo Finance. Beta is a controversial subject that many business professionals and academics debate on - specifically the use of historical vs forward beta, and how it should be calculated. Different sources will cite different betas for the same company.
Target’s primary country (where the company is likely to borrow) risk-free rate: Can be obtained from government sources such as Treasury.gov’s 10-years Treasury Bond Yield.
The primary country market risk premium: Can be obtained from sources such as Damodaran Online.
The primary country long-term GDP growth rate: Can be obtained from sources such as the OECD GDP Forecast.
The primary country sector return on equity (ROE) metrics (optional): Can be obtained through country specific sector ROE online resources commonly published by the country’s government’s economic / commerce / banking department or central banks.
Comparable Company is a valuation method that uses metrics of other similar businesses (same industry, size, geography, valuation multiples, etc.) to find the value estimate of a potential investment. To perform this analysis, the following are needed:
A peer group of 5 or more similar businesses: Can be obtained from sources such as S&P Capital IQ report; or individual research.
Each peer business’ share price, fully-diluted shares outstanding, total debt, total cash, last 12 months (LTM) revenue and EBITDA, book value of equity, and goodwill: Can be obtained from sources such as MarketWatch.
Information listed in the DCF analysis: See the items listed under DCF above.
Precedent Transaction is a valuation method that uses the price paid for similar businesses in the past as indicators to a company’s value. To perform this analysis, the following are needed:
A sample of recent (within the last 5 years preferably) similar transactions: can be obtained from industry-specific and M&A reports such as Pitchbook. “Similar” here means same industry, targets’ and acquirers’ natures of business and transaction sizes.
Target's current stock price: Can be obtained from sources such as Yahoo Finance.
Target's most current 10-K and 10-Q: Can be obtained from SEC EDGAR.
Consideration per share: Assumed cash and stock offer for the proposed transaction. Can be obtained as a metric from past transactions (average, median, etc.) or as a premium percentage to current target’s stock price. The premium percentage can also be calculated as a metric from past transactions (average, median, etc.).
Leveraged Buy Out (LBO) is a valuation method that uses assets of the acquired and the acquiring companies as well as cost of borrowing money for acquisition to find the value estimate of a potential investment as measured by its internal rate of return (IRR). To perform this analysis, the following are needed:
Target’s financial statements (income statement, balance sheet, cash flow): Preferably audited historical statements, cleaned up and re-formatted in Excel properly (we will see an example of this in the next post). For a public company, a reliable source of this information can be the SEC EDGAR database or sources like Mergent Online that provide easily downloadable data. For a private company, these statements will be provided by the target company (assuming non-hostile takeover environment). A 5- or 10- year historical data is preferable.
Market multiple (EBITDA or revenue) for the proposed transaction: Can be obtained from market research.
Fees from the proposed transaction, including the exit from the proposed transaction: These are any financing, investment banking, legal, and other fees and expenses; can be obtained through quotes from the service providers (lenders, bankers, legal firms), past transactions, or market research.
Assumptions about the debt portion of the proposed transaction: Remember that LBOs are heavily financed with short-term loans (revolver, etc.), longer-term loans (term loans, senior bonds, unsecured debts), and (small portion of) cash on hand. For this analysis, assumptions about how much of the proposed transaction would be financed using which source and the interest rate associated with each source would be needed (remember that cash on hand also receives interest). The interest rate assumptions can be based on LIBOR and can be obtained from market / banking reports.
The length of the holding period: Typically 5 to 7 years given the PE firm.
Any expected capital injections by and expected dividends to the PE firm within the holding period window (optional): Can be obtained from the PE firm.
Dividend Discount Model (DDM) is a valuation method that uses the predicted dividends and a discount rate to find the present value estimate of a potential investment. To perform this analysis, the following are needed:
Target’s primary country (where the company is likely to borrow) risk-free rate: Can be obtained from government sources such as Treasury.gov’s 10-years Treasury Bond Yield.
The primary country market risk premium: Can be obtained from sources such as Damodaran Online.
Target’s Beta: Can be obtained from sources such as S&P Capital IQ / Value Line reports, Yahoo Finance company profile, or calculated using historical return data of the company’s stock price from Yahoo Finance. Beta is a controversial subject that many business professionals and academics debate - specifically the use of historical vs forward beta, and how it should be calculated. Different sources will cite different betas for the same company. We will delve into this topic deeper in the next post.
Target’s financial statements (income statement, balance sheet, cash flow): Preferably audited historical statements, cleaned up and re-formatted in Excel properly (we will see an example of this in the next post). For a public company, a reliable source of this information can be the SEC EDGAR database or sources like Mergent Online that provide easily downloadable data. For a private company, these statements will be provided by the target company (assuming non-hostile takeover environment). A 5- or 10- year historical data is preferable.
Target’s historical stock prices matching the period of the financial statements: Can be obtained from sources such as Yahoo Finance in raw data format that has to be reformatted.
So, to recap, the exercises of valuations require preparation that involves having the right tools and data. Some of them are free to the public, some requires payment, and a good private company valuation requires the cooperation of the target in providing historical financial statements. In this post, we discussed the tools and data required for DCF, Comparable Company, Precedent Transaction, LBO, and DDM. In the next post, we will delve into our first valuation method, DCF, including a discussion on how one can develop the Free Cash Flow to Firm (FCFF) and Weighted Average Cost of Capital (WACC) needed to do DCF properly. The next 4 to 5 posts afterward will each be dedicated to a different valuation method.
