Methods of Valuation for Mergers and Acqisition
Graduate School of Business Administration University of Virginia
UVA-F-1274
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
UVA-F-1274
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