written by : William F Bryant
When contemplating the process for valuing anything, it would seem to be a subjective endeavor. How do you put a price on something with so many parts? Well, as it turns out, every price that you encounter, whether in a retail store or from a contractor has to be determined by those selling the product. You, as a consumer, then determine whether you will purchase the product at the listed price. There is no difference when selling a company except that, in this case, both the buyer and the seller each will calculate what they believe to be the price and then both parties either agree or disagree. From here, perhaps there are negotiations or perhaps not, but there is a generally accepted process for valuing a company that is done by most investment banks or private equity firms. Of note is how certain aspects of this process change for the private versus public company valuations. Obviously, data and information are needed to complete any evaluation of a company and, because of necessary filings of public companies, a public company can be roughly valued much more easily than a private company. Akin to appraisals in the real estate market, the valuation of a company begins with the search for comparable companies. This should make sense. Think of houses in similar neighborhoods, similar number of bedrooms, similar number of bathrooms, similar sized lots and so on. By this, companies in the same industry should have a similar value. Companies that conduct in similar transactions should have a similar value. And so on, you search out companies that have similar characteristics that could be considered similar to the target company being valued. I know what you are thinking, what about revenues, PPE differences, financing or perhaps distribution channels. Absolutely, no companies are identical and this part is a bit of experience and art, but you also select as many as you feel necessary to get a good idea of similar company values. When you get down to the reasoning, you can think of this weeding out and selection of comparable companies as developing scaling factors to pinpoint the various differences on the bounded range of possibilities, which will come up later. Scaling, as I tend to think of it, is drawn from financial ratios and statistics that are generally found right on the income statement and balance sheet. Numerous statistics can be considered for the comparable companies, credit worthiness, profitability, and returns on investment. Each statistic helps to create a capital structure and efficiency model about each company and provide multiples for comparison to the target company being valued. By the time you are done you will have laid out a “fitted” chart of the comparable companies and how the target company should be placed in this chart. Your company may be better in some areas and worse in others, but these comparisons create a benchmark for where the target company compares and how much these ratios could be scaled to achieve equivalency. Certain statistics may be more important to a buyer than others and so each of these differences, and by extension the amount of scaling, will have value weighted attributes. At this point the valuation of the target company would commence, using a DCF model or the like, however I will come to this after precedent transactions. Precedent transactions are exactly that, transactions that have happened for similar companies within an acceptable time frame. If comparable companies provide a scaling context, precedent transactions provide the range or upper and lower bounds of a price that a buyer might pay for the target company. Finding these transactions can be difficult. There are times of highly active M&A transactions and those of far fewer transactions. These transactions may not take place in the same industry, time period or economic environment. There may even be different types of buyers and therefore different pricing considerations. This all adds complexity to the analysis, but the statistics desired are the same as those in the comparable companies’ analysis, Enterprise Value, Equity Value, EBIT, EBITDA, the consideration and, of course, the financing structure. One of the key pieces of price that is able to be determined from the precedent transaction analysis is expected premiums on the value of the company. This premium stems from the fact that the offer is being made to the equity holders of the company and the premium will compensate the equity holders for turning over control, future earnings or benefits gained from the transaction by the acquiring company. The premium may also have additional external factors dependent on time period, implicitly fiscal or monetary policy influences on interest rates or taxes and internal factors based on method of financing the acquisition. Once the value of the target firm has been arrived at, it is useful to know that there is an additional premium to be added to the purchase and this premium too has precedence. Now let’s go back to the modeling and calculations from the financial statistics for the ratios and scaling multiples. As mentioned, the comparable companies will all contribute financial ratios and as much detail as needed to compare to the target company, but the basis is still a valuation for the target. This value is referred to as the firm value or the enterprise value (EV). However, note two things; first, this reference to firm value may have subtle differences found in the net debt in contexts outside of an M&A reference and second, EV is also used to represent equity value. Why is this important to distinguish? The Enterprise value is the market value of the equity (equity value) and the total net debt, that is total debt minus the cash and equivalents. It seems simple, the equity and the debt, but a substantial amount of information can be gleaned from these statistics, not the least of which is the chosen capital structure that may or may not be similar throughout the industry. Debt is fairly straight forward, bonds, commercial paper and revolving lines but also non-controlling interest and preferred stock. If an acquisition was being assessed, a deeper dig into current market value of the debt and strategy in regards to the debt structure, usage, repayment and the financial ratios may be evaluated. For now, a look at the equity value will consume the following paragraphs because it does involve conversions. The numbers used in the equity calculation, for the business modeling throughout the website, are taken from an actual 10K. I like to use the data from beverage companies because these companies’ entire operation is a great example of every business unit, from inventory controls and supply given the usage of grains to deep channels of distribution, marketing, manufacturing operations and finance. The equity valuation is an indicator of market size. To find this value, it is the share price multiplied by the fully diluted shares outstanding, which are all available shares, including those in the options, warrants and converted securities. For this particular company there are 315,678 total exercisable options, warrants and rights at an exercise price of $186.00. The price of the share, at the time of the reporting of this 10K, is $408.00 and 12,143,380 shares are outstanding. This calculation method is called the Treasury Stock Method. The figurative idea is similar to exercising a call option. The holder of the option or warrant, exercises the right to buy at a price. This money is “pooled” and used to purchase shares on the market. Because the “pooled” proceed is well below the necessary amount to purchase the total number of needed shares at the market price, new shares are issued to fill the total number of exercise options or warrants. This activity will have a dilutive affect since the shares outstanding would increase.
The next equity linked element to consider are convertible debt and the several types of instruments used the have characteristics of equity and debt. This particular company does not have a listing of outstanding equity linked securities in its 10K, but these items would affect equity value and use a similar calculation method called the If-Converted method. Once again consider the total amount that could be converted. This value would be the dollar amount of debt that is allowed to be converted into equity. This amount is then divided by the price that it is allowed to be converted. Since this is a dollar value divided by a dollar value, the answer gives the incremental shares that would need to be newly issued to the converter. The newly issued shares would be added to the above ‘Full Dilution After Exercise’ value to give the total Fully Diluted Outstanding Shares. I think it is pertinent to bring up two things, the first is the reliance on the share price in the determining of the equity value. The second, is what the equity value represents. I bring this up because it is common to refer to a stock price as undervalued or overvalued. It is important to recall that the stock price is representative of the claim an equity holder has on future earnings. If the stock price is significantly higher than the present value of future earnings, it is overvalued and if lower it is undervalued. If a stock is overvalued, consideration must be given to how this will impact the valuation and final price that incorporates a premium. This is where the representation fits in. Equity value is a call option on the assets at the strike price of the value of debt. Basically, this means that as long as the productive value of the assets is greater than the debt, the leftover is the equity holders. Thinking of it in this manner allows an analyst to conceptualize the operations; after debt is covered, is there enough market share to support the current share price and equity value. I know this is a very rough conceptualization, but if you understand revenues, market shares and barriers to market penetration or development, then this idea will give an immediate indication of how to approach synergy evaluations and what the acquisition must offer to justify an overvalued share price. This valuation continues with the approximation of the 'intrinsic value' of the target firm with a cash flow valuation. The example is the DCF (Discounted CashFlow) model. |
Areas of Interest
Financial Analysis
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