Graduate School of Business Administration University of Virginia
METHODS OF VALUATION FOR MERGERS AND ACQUISITIONS This note addresses the methods used to value companies in a merger and acquisitions (M&A) setting. It provides a detailed description of the discounted cash flow (DCF) approach and reviews other methods of valuation, such as book value, liquidation value, replacement cost, market value, trading multiples of peer firms, and comparable transaction multiples.
Discounted Cash Flow Method Overview The discounted cash flow approach in an M&A setting attempts to determine the value of the company (or ‘ enterprise’ by computing the present value of cash flows over the life of the ) company.1 Since a corporation is assumed to have infinite life, the analysis is broken into two parts: a forecast period and a terminal value. In the forecast period, explicit forecasts of free cash flow must be developed that incorporate the economic benefits and costs of the transaction. Ideally, the forecast period should equate with the interval in which the firm enjoys a competitive advantage (i.e., the circumstances where expected returns exceed required returns.) For most circumstances a forecast period of five or ten years is used. The value of the company derived from free cash flows arising after the forecast period is captured by a terminal value. Terminal value is estimated in the last year of the forecast period and capitalizes the present value of all future cash flows beyond the forecast period. The terminal region cash flows are projected under a steady state assumption that the firm enjoys no opportunities for abnormal growth or that expected returns equal required returns in this interval. Once a schedule of free cash flows is developed for the enterprise, the Weighted Average Cost of Capital (WACC) is used to discount them to determine the present value, which equals the estimate of company or enterprise value. This note focuses on valuing the company as a whole (i.e., the enterprise.) An estimate of equity value can be derived under this approach by subtracting interest bearing debt from enterprise value. An alternative method, not pursued here, values the equity using residual cash flows. Residual cash flows are computed net of interest payments and debt repayments plus debt issuances. Residual cash flows must be discounted at the cost of equity. This case was prepared by Susan Chaplinsky, Associate Professor of Business Administration, with the assistance of Paul Doherty, MBA ’ 99. Portions of this note draw on an earlier note, “Note on Valuation Analysis for Mergers and Acquisitions” (UVA-F-0557). Copyright © 2000 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an e-mail to firstname.lastname@example.org. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means— electronic, mechanical, photocopying, recording, or otherwise— without the permission of the Darden School Foundation. Rev. 6/00. 1
-2Review of basics of DCF
Let’ briefly review the construction of free cash flows, terminal value, and the WACC. s It is important to realize that these fundamental concepts work equally well when valuing an investment project as they do in an M&A setting. Free cash flows The free cash flows in an M&A analysis should be the operating cash flows attributable to the acquisition, before consideration of financing charges (i.e., pre-financing cash flows). Free cash flow equals the sum of after-tax earnings, plus depreciation and non-cash charges, less capital investment and less investment in working capital. From an enterprise valuation standpoint, “earnings” must be the earnings after taxes available to all providers of capital or “NOPAT” (net operating profits after taxes.) The expression for free cash flow is: Free Cash Flow = EBIT (1- T) +...
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