M&A Blog #18 – valuation (Precedent Transaction)

As I mentioned in the last post, when one is buying or selling a house, condo, or other real estate property; often time, one would like to know the going price of similar nearby properties. The same concept applies to Precedent Transaction: what price tags are other buyers putting on similar assets? As I mentioned in my valuation preparation post, Precedent Transaction is a valuation method that uses the price paid for similar businesses in the past as indicators to a company’s value. In this post, we will discuss the mechanics of Precedent Transaction step by step, starting from the point where all the needed tools and data for such analysis as outlined here have been gathered.

The major steps of Precedent Transaction are:

1. Deriving the appropriate market multiples (or range of multiples) and control premium from sample recent transactions.

2. Calculating implied transaction Total Enterprise Value (TEV) from the company’s most recent financial data and Consideration Per share.

3. Comparing the proposed transaction’s implied multiples and control premium to that of the market’s to make sure that they are sensible.

4. Performing sensitivity / scenario analysis using Monte Carlo analysis.

We will delve deeper into each steps above in the following paragraphs of this post. It is worth noting that each step can justifiably warrant an entire post in itself. For the purposes of this post though, we will keep matters concise by discussing only the most practical and commonly accepted aspects of each step.

The 1st step in Precedent Transaction is to derive the appropriate market multiples (or range of multiples) and control premium for the valuation. We start with gathering a sample of 5 or more recent - preferably within the last 5 years - transactions that are reflective of our proposed transaction. Reflective here means that the sample targets and acquirers are similar to our situation. Using a data source like Pitchbook (or similar transaction data services), we list the samples’ target’s LTM Revenue, EBITDA, and EBITDA Margin at the time of the transaction. Data sources like Pitchbook would often capture the Transaction Value at the time of the transaction announcement as well, so we list this information in our model and use it to calculate the sample transactions’ Implied TEV/Revenue and TEV/EBITDA as follow:

• Implied TEV/Revenue Multiple = Transaction Value / target’s LTM Revenue.

• Implied TEV/EBITDA Multiple = Transaction Value / target’s LTM EBITDA.

For informational and comparison purposes, we also captured the sample transactions’ Control Premium. Data sources like Pitchbook would typically captured this information; or it can be calculated using the samples’ Consideration Per Share and sample targets’ stock prices at the time of the announcements - both pieces of data can be found in press releases of the sample transactions or in Pitchbook. The Control Premium information (range) helps sanity-check our own proposed transaction’s Control Premium. We repeat this step with every sample transactions that we have gathered.

The next (2nd) step in Precedent Transaction calls for the calculation of our own proposed transaction’s TEV from the company’s most recent financial data and Consideration Per Share. The needed pieces of data to perform this step are outlined here. Using these information, the implied transaction TEV can be calculated as follow:

• FD (fully-diluted) Shares Outstanding = Basic Shares Outstanding + Shares Converted from Options using the Treasury Stock Method (TSM).

  • TSM basically dictates that when the Consideration Per Share is higher than the option strike price, the options holders will exercise and convert the options into shares. The number of shares that resulted from the conversion is calculated as: Number of Options Outstanding - (Strike Price * Options Outstanding / Consideration Per Share). We add the resulting number to Basic Shares Outstanding to get FD Shares Outstanding.

• Implied Purchase Price = FD Shares Outstanding * Consideration Per Share.

• Implied Transaction TEV = Implied Purchase Price + Debt + Preferred Stock + Minority Interest - Cash. The last four components of this formula can be found in the target’s most recent balance sheet.

The 3rd step in Precedent Transaction is to compare the proposed transaction’s implied multiples and control premium to that of the sample transactions to make sure that they are sensible (i.e. we are not paying way too much compare to what the market’s have paid in the past). This particular step is similar to our first step in Precedent Transaction, the only difference is we are using our proposed transaction in this step instead of sample transactions from the past. Using the target’s most current 10-K and 10-Q, we calculate its LTM Revenue, EBITDA, and EBITDA Margin. Using the Implied Transaction TEV calculated in the previous step as our Transaction Value, we calculate the proposed transaction’s Implied TEV/Revenue and TEV/EBITDA multiples and Control Premium as follow:

• Implied TEV/Revenue Multiple = Transaction Value / proposed target’s LTM Revenue.

• Implied TEV/EBITDA Multiple = Transaction Value / proposed target’s LTM EBITDA.

• Control Premium = Consideration Per Share / target’s current stock price - 1.

Using mean and median calculations, when we compare our proposed transaction’s LTM EBITDA Margin, Implied TEV/Revenue multiple, Implied TEV/EBITDA multiple, and Control Premium; we should see that our proposed target’s margin, proposed multiples, and proposed premium are within reasonable boundaries of what the market has paid in the past (assuming we have picked good sample transactions to compare to). If the multiples and premium that we intend to pay are much higher than the samples’, it may be a signal that we are paying too much for the target.

The 4th and final step in a proper Precedent Transaction method is to perform sensitivity / scenario analysis, preferably using a Monte Carlo simulation. Because this step is similar in this method as it is in the other valuation methods (DCF, Comparable Company, etc.), we will discuss sensitivity / scenario analysis in great details in the last post of this valuation series in 3-4 posts from now. A sample file for a Precedent Transaction analysis on the company Wrigley can be accessed here.

As we can tell from the steps laid out thus far, Precedent Transaction has advantages and disadvantages. The advantages include its ease of calculation and usage, its realistic value (what the market paid), an illustration of market trends over time (who are the strategic buyers and financial buyers in a sector, are they domestic or foreign, are there signs of consolidation, etc.), a depiction of the reasons for acquisitions in a sector (geographic expansion, product range, customer relationships, etc.), and the range of multiples and premiums that have been justified in the past. Precedent Transaction’s disadvantages include the difficulty of finding comparable past transactions, the usually wide range of values obtained (which limits their usefulness), the misleading multiples caused by companies bought on projections rather than LTM values, the misleading multiples caused by synergies that exist only in certain deals (and might not in our proposed transaction), cyclical business’ multiples vary widely depending on where it is in its cycle, and the fact that private transactions are not always captured skewing publicly available transaction data only to larger public deals.

So, to re-cap, we have discussed the development of a Precedent Transaction model and its supporting elements, along with its strengths and weaknesses. Given its advantages and disadvantages, Precedent Transaction is best used in conjunction with other valuation methods (like DCF and Comparable Company). It is only then that the closest-to-correct value of the target can be deduced via comparison. In the next post, we will discuss another valuation method, Leveraged Buy Out (LBO).