Some notes on firm valuation in M

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Some notes on firm valuation in MA transactions
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Firm valuation approaches in MA transactions

• There are several approaches to valuing a firm
  before an acquisition transaction, but we will
  focus on the following (the list below is
  incomplete)
• Current market value of the firm
• Trading multiples based on comparable firms
• Transaction multiples of comparable acquisitions
• Discounted cash flow approach

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• The valuation exercise can be quite complex, but
  it is important to remember a few guiding
  principles
• Throughout the exercise, it is important to
  always think like an investor meaning focus on
  whether an MA transaction will create value or
  not
• The aim of valuation analysis is to assess the
  true or intrinsic value of the firm this value
  is not observable and the valuation estimates
  obtained through the various approaches not only
  do not give us the intrinsic value but also
  include measurement errors

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• The aim of valuation is to exploit profit-making
  opportunities form a difference between the
  current price and the intrinsic value of a firm
• The estimates obtained by the various approaches
  offer a range of values for the firm and will be
  very useful during negotiations
• Thus, it is important to scrutinize the
  estimators, the underlying assumptions, to
  perform sensitivity analysis and to eliminate
  estimates in which we dont have confidence

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Current market value, trading multiples and
transaction multiples

• The current market value of a firm is the sum of
  the market value of its equity and the market
  value of its debt
• For debt, we should use market values, but book
  values will be close to market values unless
  there has been a change in the firms credit
  rating or the general level of interest rates
• Calculating the firms debt, we ignore deferred
  taxes and current liabilities
• The current market value is an important
  reference point because it gives us the markets
  valuation of the firm

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• Valuation through trading multiples is nothing
  other than the multiples valuation approach that
  we discussed earlier
• It is important to select the appropriate sample
  of peer firms that match the evaluated firm in
  terms of current line of business, outlook for
  the future, financial policy and size
• We can use equity or firm multiples
• Equity multiples such as P/E ratio,
  market-to-book ratio, can be used to obtain
  estimates of stock prices

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• Firm multiples are
• Firm value/EBIT
• Firm value/EBITDA
• Firm value/sales
• Firm value/book value of assets
• These can be used to estimate market values of
  the firm
• Transaction multiples are used as an additional
  benchmark because they include the premiums paid
  for target firms

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• Similar equity and firm multiples are used in the
  case of transaction multiples
• The difference between trading and transaction
  multiples is that the latter will include the
  premiums paid for obtaining control of the
  acquired firms

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DCF valuation of a firm

• Obtain forecasts of Free Cash Flows to the Firm
  (FCFF) for an horizon of 5-10 years
• Estimate the terminal value of the firm under
  some reasonable growth assumption
• Estimate the firms cost of capital
• Use the above information to obtain the PV of
  future FCFF plus the firms terminal value

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• To obtain estimates of the firms value of equity
  through the DCF approach we can
• Use DCF to estimate the firms value and subtract
  from that the value of the firms debt
• Use DCF to discount the FCFE at the firms cost
  of equity (we use the same steps as described
  above in the case of FCFF)

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• FCFF is given by
• FCFF EBIT (1-tax rate) (capital spending
  depreciation) change in noncash working capital
  
• The terminal value is given by
• TV (FCFF(1g))/(WACC-g)
• FCFE is given by
• FCFE FCFF debt payments new debt issued

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Example Valuation of UIUC Corp.

• To value this firm, we will use three approaches
  (example shown in class)
• DCF approach based on forecasts of earnings,
  capital expenditures and working capital needs
  for the next five years
• Trading multiples from peer firms
• Information from transaction multiples