Valuation, Leveraged Buyouts, and Mergers and Acquisitions by Joshua Rosenbaum & Joshua Pearl.pdf

Investment Banking Valuation, Leveraged Buyouts, and Mergers & Acquisitions JOSHUA ROSENBAUM JOSHUA PEARL FOREWORD BY JOSEPH R. PERELLA Investment Banking Founded in 1807, John Wiley & Sons is the oldest independent publishing com- pany in the United States. With offices in North America...

Investment Banking Valuation, Leveraged Buyouts, and Mergers & Acquisitions JOSHUA ROSENBAUM JOSHUA PEARL FOREWORD BY JOSEPH R. PERELLA Investment Banking Founded in 1807, John Wiley & Sons is the oldest independent publishing com- pany in the United States. With offices in North America, Europe, Australia, and Asia, Wiley is globally committed to developing and marketing print and electronic products and services for our customers’ professional and personal knowledge and understanding. The Wiley Finance series contains books written specifically for finance and investment professionals as well as sophisticated individual investors and their financial advisors. Book topics range from portfolio management to e-commerce, risk management, financial engineering, valuation, and financial instrument analy- sis, as well as much more. For a list of available titles, please visit our Web site at www.WileyFinance.com.  Investment Banking Valuation, Leveraged Buyouts, and Mergers & Acquisitions JOSHUA ROSENBAUM JOSHUA PEARL John Wiley & Sons, Inc. Copyright
C 2009 by Joshua Rosenbaum and Joshua Pearl. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions. Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages. For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762-2974, outside the United States at (317) 572-3993 or fax (317) 572-4002. Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. For more information about Wiley products, visit our web site at www.wiley.com. Library of Congress Cataloging-in-Publication Data: Rosenbaum, Joshua, 1971– Investment banking : valuation, leveraged buyouts, and mergers & acquisitions / Joshua Rosenbaum, Joshua Pearl. p. cm. — (Wiley finance series) Includes bibliographical references and index. ISBN 978-0-470-44220-3 (cloth) 1. Investment banking. 2. Valuation. 3. Leveraged buyouts. 4. Consolidation and merger of corporations. I. Pearl, Joshua, 1981– II. Title. HG4534.R67 2009 332.6’6068—dc22 2008049819 Printed in the United States of America. 10 9 8 7 6 5 4 3 2 1  To my wife, Margo, for her unwavering love and support. —J.R. To the memory of my grandfather, Joseph Pearl, a Holocaust survivor, for his inspiration to persevere and succeed. —J.P.  Contents About the Authors xiii Foreword xv Acknowledgments xvii Supplemental Materials xxi INTRODUCTION 1 Structure of the Book 2 Part One: Valuation (Chapters 1–3) 3 Part Two: Leveraged Buyouts (Chapters 4 & 5) 5 Part Three: Mergers & Acquisitions (Chapter 6) 6 ValueCo Summary Financial Information 6 PART ONE Valuation CHAPTER 1 Comparable Companies Analysis 11 Summary of Comparable Companies Analysis Steps 12 Step I. Select the Universe of Comparable Companies 15 Study the Target 15 Identify Key Characteristics of the Target for Comparison Purposes 16 Screen for Comparable Companies 20 Step II. Locate the Necessary Financial Information 21 SEC Filings: 10-K, 10-Q, 8-K, and Proxy Statements 21 Equity Research 23 Press Releases and News Runs 24 Financial Information Services 24 Summary of Financial Data Primary Sources 24 Step III. Spread Key Statistics, Ratios, and Trading Multiples 25 Calculation of Key Financial Statistics and Ratios 27 Supplemental Financial Concepts and Calculations 39 Calculation of Key Trading Multiples 44 Step IV. Benchmark the Comparable Companies 48 Benchmark the Financial Statistics and Ratios 48 Benchmark the Trading Multiples 48 vii viii CONTENTS Step V. Determine Valuation 49 Valuation Implied by EV/EBITDA 50 Valuation Implied by P/E 50 Key Pros and Cons 52 Illustrative Comparable Companies Analysis for ValueCo 53 Step I. Select the Universe of Comparable Companies 53 Step II. Locate the Necessary Financial Information 54 Step III. Spread Key Statistics, Ratios, and Trading Multiples 55 Step IV. Benchmark the Comparable Companies 65 Step V. Determine Valuation 69 CHAPTER 2 Precedent Transactions Analysis 71 Summary of Precedent Transactions Analysis Steps 72 Step I. Select the Universe of Comparable Acquisitions 75 Screen for Comparable Acquisitions 75 Examine Other Considerations 75 Step II. Locate the Necessary Deal-Related and Financial Information 77 Public Targets 78 Private Targets 80 Summary of Primary SEC Filings in M&A Transactions 81 Step III. Spread Key Statistics, Ratios, and Transaction Multiples 81 Calculation of Key Financial Statistics and Ratios 81 Calculation of Key Transaction Multiples 89 Step IV. Benchmark the Comparable Acquisitions 92 Step V. Determine Valuation 93 Key Pros and Cons 94 Illustrative Precedent Transaction Analysis for ValueCo 95 Step I. Select the Universe of Comparable Acquisitions 95 Step II. Locate the Necessary Deal-Related and Financial Information 95 Step III. Spread Key Statistics, Ratios, and Transaction Multiples 98 Step IV. Benchmark the Comparable Acquisitions 105 Step V. Determine Valuation 106 CHAPTER 3 Discounted Cash Flow Analysis 109 Summary of Discounted Cash Flow Analysis Steps 110 Step I. Study the Target and Determine Key Performance Drivers 114 Study the Target 114 Determine Key Performance Drivers 114 Step II. Project Free Cash Flow 115 Considerations for Projecting Free Cash Flow 115 Projection of Sales, EBITDA, and EBIT 116 Projection of Free Cash Flow 118 Step III. Calculate Weighted Average Cost of Capital 124 Step III(a): Determine Target Capital Structure 125 Step III(b): Estimate Cost of Debt (rd ) 126 Contents ix Step III(c): Estimate Cost of Equity (re ) 127 Step III(d): Calculate WACC 131 Step IV. Determine Terminal Value 131 Exit Multiple Method 132 Perpetuity Growth Method 132 Step V. Calculate Present Value and Determine Valuation 134 Calculate Present Value 134 Determine Valuation 135 Perform Sensitivity Analysis 137 Key Pros and Cons 139 Illustrative Discounted Cash Flow Analysis for ValueCo 140 Step I. Study the Target and Determine Key Performance Drivers 140 Step II. Project Free Cash Flow 140 Step III. Calculate Weighted Average Cost of Capital 146 Step IV. Determine Terminal Value 151 Step V. Calculate Present Value and Determine Valuation 153 PART TWO Leveraged Buyouts CHAPTER 4 Leveraged Buyouts 161 Key Participants 163 Financial Sponsors 163 Investment Banks 164 Bank and Institutional Lenders 165 Bond Investors 166 Target Management 167 Characteristics of a Strong LBO Candidate 168 Strong Cash Flow Generation 169 Leading and Defensible Market Positions 169 Growth Opportunities 169 Efficiency Enhancement Opportunities 170 Low Capex Requirements 170 Strong Asset Base 171 Proven Management Team 171 Economics of LBOs 171 Returns Analysis – Internal Rate of Return 171 Returns Analysis – Cash Return 172 How LBOs Generate Returns 173 How Leverage is Used to Enhance Returns 174 Primary Exit/Monetization Strategies 176 Sale of Business 177 Initial Public Offering 177 Dividend Recapitalization 177 LBO Financing: Structure 178 LBO Financing: Primary Sources 180 Bank Debt 180 x CONTENTS High Yield Bonds 184 Mezzanine Debt 186 Equity Contribution 187 LBO Financing: Selected Key Terms 188 Security 188 Seniority 189 Maturity 190 Coupon 190 Call Protection 191 Covenants 192 CHAPTER 5 LBO Analysis 195 Financing Structure 195 Valuation 195 Step I. Locate and Analyze the Necessary Information 198 Step II. Build the Pre-LBO Model 198 Step II(a): Build Historical and Projected Income Statement through EBIT 199 Step II(b): Input Opening Balance Sheet and Project Balance Sheet Items 201 Step II(c): Build Cash Flow Statement through Investing Activities 203 Step III. Input Transaction Structure 206 Step III(a): Enter Purchase Price Assumptions 206 Step III(b): Enter Financing Structure into Sources and Uses 208 Step III(c): Link Sources and Uses to Balance Sheet Adjustments Columns 209 Step IV. Complete the Post-LBO Model 215 Step IV(a): Build Debt Schedule 215 Step IV(b): Complete Pro Forma Income Statement from EBIT to Net Income 222 Step IV(c): Complete Pro Forma Balance Sheet 224 Step IV(d): Complete Pro Forma Cash Flow Statement 226 Step V. Perform LBO Analysis 230 Step V(a): Analyze Financing Structure 230 Step V(b): Perform Returns Analysis 232 Step V(c): Determine Valuation 235 Step V(d): Create Transaction Summary Page 236 Illustrative LBO Analysis for ValueCo 238 Transaction Summary 238 Income Statement 238 Balance Sheet 238 Cash Flow Statement 238 Debt Schedule 238 Returns Analysis 238 Assumptions Page 1—Income Statement and Cash Flow Statement 238 Assumptions Page 2—Balance Sheet 238 Assumptions Page 3—Financing Structures and Fees 238 Contents xi PART THREE Mergers & Acquisitions CHAPTER 6 M&A Sale Process 251 Auctions 252 Auction Structure 255 Organization and Preparation 257 Identify Seller Objectives and Determine Appropriate Sale Process 257 Perform Sell-Side Advisor Due Diligence and Preliminary Valuation Analysis 257 Select Buyer Universe 258 Prepare Marketing Materials 259 Prepare Confidentiality Agreement 261 First Round 262 Contact Prospective Buyers 262 Negotiate and Execute Confidentiality Agreement with Interested Parties 263 Distribute Confidential Information Memorandum and Initial Bid Procedures Letter 263 Prepare Management Presentation 264 Set up Data Room 264 Prepare Stapled Financing Package 265 Receive Initial Bids and Select Buyers to Proceed to Second Round 267 Second Round 270 Conduct Management Presentations 271 Facilitate Site Visits 271 Provide Data Room Access 271 Distribute Final Bid Procedures Letter and Draft Definitive Agreement 272 Receive Final Bids 276 Negotiations 276 Evaluate Final Bids 277 Negotiate with Preferred Buyer(s) 277 Select Winning Bidder 277 Render Fairness Opinion 277 Receive Board Approval and Execute Definitive Agreement 278 Closing 278 Obtain Necessary Approvals 278 Financing and Closing 280 Negotiated Sale 281 Bibliography and Recommended Reading 283 Index 289  About the Authors JOSHUA ROSENBAUM is an Executive Director at UBS Investment Bank in the Global Industrial Group. He advises on, structures, and originates M&A, corporate finance, and capital markets transactions. Previously, he worked at the International Finance Corporation, the direct investment division of the World Bank. He received his AB from Harvard and his MBA with Baker Scholar honors from Harvard Business School. Rosenbaum is the coauthor of the HBS case study “OAO YUKOS Oil Company.” JOSHUA PEARL has structured and executed numer- ous leveraged loan and high yield bond financings, as well as LBOs and restructurings, for Deutsche Bank’s Leveraged Finance Group. Previously, he worked at A.G. Edwards in the Investment Banking Division. Pearl has also designed and taught corporate finance training courses. He received his BS in Business from Indiana Uni- versity’s Kelley School of Business. CONTACT THE AUTHORS Please feel free to contact Joshua Rosenbaum and Joshua Pearl with any questions, comments, or suggestions for future editions at [email protected]. xiii  Foreword ark Twain, long known for his critical views of formal education, once wisely M noted: “I never let my schooling interfere with my education.” Twain’s one-liner strikes at the core of investment banking, where deals must be lived before proper knowledge and understanding can be obtained. Hard time must be spent doing deals, with complexities in valuation, terms, and negotiations unique to every situation. The truly great firms and dealmakers have become so by developing cultures of apprenticeship that transfer knowledge and creativity from one generation to the next. The task of teaching aspiring investment bankers and finance professionals has been further complicated by the all-consuming nature of the trade, as well as its constantly evolving art and science. Therefore, for me personally, it’s exciting to see Joshua Rosenbaum and Joshua Pearl take the lead in training a new generation of investment bankers. Their work in documenting valuation and deal process in an accessible manner is a particularly important contribution as many aspects of investment banking cannot be taught, even in the world’s greatest universities and business schools. Rosenbaum and Pearl provide aspiring—and even the most seasoned—investment bankers with a unique real-world education inside Wall Street’s less formal classroom, where deals come together at real-time speed. The school of hard knocks and of learning-by-doing, which was Twain’s class- room, demands strong discipline and sound acumen in the core fundamentals of valuation. It requires applying these techniques to improve the quality of deals for all parties, so that dealmakers can avoid critical and costly mistakes, as well as unnec- essary risks. My own 35 plus years of Wall Street education has clearly demonstrated that valuation is at the core of investment banking. Any banker worth his salt must possess the ability to properly value a business in a structured and defensible manner. This logic and rationale must inspire clients and counterparties alike, while spurring strategic momentum and comprehension into the art of doing the deal. Rosenbaum and Pearl succeed in providing a systematic approach to addressing a critical issue in any M&A, IPO, or investment situation—namely, how much is a business or transaction worth. They also put forth the framework for helping approach more nuanced questions such as how much to pay for the business and how to get the deal done. Due to the lack of a comprehensive written reference material on valuation, the fundamentals and subtlety of the trade are often passed on orally from banker-to-banker on a case-by-case basis. In codifying the art and science of investment banking, the authors convert this oral history into an accessible framework by bridging the theoretical to the practical with user-friendly, step-by-step approaches to performing primary valuation methodologies. Many seasoned investment bankers commonly lament the absence of relevant and practical “how-to” materials for newcomers to the field. The reality is that most xv xvi FOREWORD financial texts on valuation and M&A are written by academics. The few books written by practitioners tend to focus on dramatic war stories and hijinks, rather than the nuts-and-bolts of the techniques used to get deals done. Rosenbaum and Pearl fill this heretofore void for practicing and aspiring investment bankers and finance professionals. Their book is designed to prove sufficiently accessible to a wide audience, including those with a limited finance background. It is true that we live in uncertain and volatile times—times that have destroyed or consumed more than a few of the most legendary Wall Street institutions. However, one thing will remain a constant in the long-term—the need for skilled finance professionals with strong technical expertise. Companies will always seek counsel from experienced and independent professionals to analyze, structure, negotiate, and close deals as they navigate the market and take advantage of value-creating opportunities. Rosenbaum and Pearl promulgate a return to the fundamentals of due diligence and the use of well-founded realistic assumptions governing growth, profitability, and approach to risk. Their work toward instilling the proper skill set and mindset in aspiring generations of Wall Street professionals will help establish a firm foundation for driving a brighter economic future. JOSEPH R. PERELLA Chairman and CEO, Perella Weinberg Partners  Acknowledgments e are deeply indebted to the numerous colleagues and peers who provided in- W valuable guidance, input, and hard work to help make this book possible. Our book could not have been completed without the sage advice and enthusi- asm of Steve Momper, Director of Darden Business Publishing at the University of Virginia. Steve believed in our book from the beginning and supported throughout the entire process. Most importantly, he introduced us to our publisher, John Wiley & Sons, Inc. Special thanks to Ryan Drook, Joseph Meisner, Michael Lanzarone, Joseph Bress, Benjamin Hochberg, James Paris, and Peter M. Goodson for their insightful editorial contributions. As top-notch professionals in investment banking and private equity, their expertise and practical guidance proved invaluable. Many thanks to Eric Leicht, Greg Pryor, Steven Sherman, Mark Gordon, Jennifer DiNucci, and Ante Vucic for their exhaustive work in assisting with the legal nuances of our book. As partners at the nation’s leading corporate law firms, their oversight helped ensure the accuracy and timeliness of the content. We’d like to thank the outstanding team at Wiley. Bill Falloon, our acquisition editor, was always accessible and the consummate professional. He never wavered in his vision and support, and provided strong leadership throughout the entire process. Joan O’Neil, our publisher, impressed upon us the capabilities of the Wiley franchise and championed our book both internally and externally. Alla Spivak, our marketing coordinator, helped us realize our vision through her creativity and foresight. Meg Freeborn, Mary Daniello, and Brigitte Coulton (of Aptara), our production team, facilitated a smooth editorial process. Skyler Balbus, our associate editor, worked diligently to ensure all the ancillary details were addressed. We also want to express immeasurable gratitude to our families and friends for their encouragement, support, and sacrifice during the weekends and holidays that ordinarily would have been dedicated to them. This book could not have been completed without the efforts and reviews of the following individuals: Mark Adler, Piper Jaffray Kenneth Ahern, University of Michigan, Ross School of Business Marc Auerbach, Standard & Poor’s/Leveraged Commentary & Data Carliss Baldwin, Harvard Business School Kyle Barker, UBS Investment Bank Ronnie Barnes, Royal Bank of Scotland Joshua Becker, Stockwell Capital Joseph Bress, The Carlyle Group xvii xviii ACKNOWLEDGMENTS Thomas Cole, HSBC Securities Aswath Damodaran, New York University, Stern School of Business Thomas Davidoff, University of California Berkeley, Haas School of Business Victor Delaglio, Deutsche Bank Jennifer Fonner DiNucci, Cooley Godward Kronish LLP Wojciech Domanski, MidOcean Partners Ryan Drook, Deutsche Bank Chris Falk, Florida State University – Panama City Heiko Freitag, GSO Capital Partners Mark Funk, EVP & CFO, Mobile Mini, Inc. Andrew Gladston, UBS Investment Bank Peter D. Goodson, University of California Berkeley, Haas School of Business and Columbia Business School Peter M. Goodson, Fortress Investment Group Mark Gordon, Wachtell, Lipton, Rosen & Katz Gary Gray, Pennsylvania State University, Smeal School of Business David Haeberle, Indiana University, Kelley School of Business John Haynor, UBS Investment Bank Milwood Hobbs, Goldman Sachs Benjamin Hochberg, Lee Equity Partners, LLC Alec Hufnagel, Kelso & Company Jon Hugo, Deutsche Bank Roger Ibbotson, Yale School of Management Cedric Jarrett, Deutsche Bank John Joliet, UBS Investment Bank Tamir Kaloti, Deutsche Bank Michael Kamras, Credit Suisse Kenneth Kim, State University of New York at Buffalo, School of Management Eric Klar, MNC Partners, LLC Kenneth Kloner, UBS Investment Bank Philip Konnikov, UBS Investment Bank Alex Lajoux, National Association of Corporate Directors, Coauthor of “The Art of M&A” Series Ian Lampl Michael Lanzarone, CFA, Barclays Capital Eu-Han Lee, Indus Capital Advisors (HK) Ltd. Franky Lee, Deutsche Bank Eric Leicht, White & Case LLP Jay Lurie, Macquarie Capital Acknowledgments xix David Mayhew, Deutsche Bank Coley McMenamin, Banc of America Securities Joseph Meisner, UBS Investment Bank Steve Momper, University of Virginia, Darden Business Publishing Kirk Murphy, Benchmark Capital Joshua Neren Paul Pai, Deutsche Bank James Paris Dan Park, Deutsche Bank Gregory Pryor, White & Case LLP David Ross, Deutsche Bank Ashish Rughwani, Dominus Capital David Sanford, UBS Investment Bank Arnold Schneider, Georgia Tech College of Management Mustafa Singaporewalla Steven Sherman, Shearman & Sterling LLP Andrew Shogan Emma Smith, Deutsche Bank David Spalding, Dartmouth College Andrew Steinerman, JP Morgan Matthew Thomson Robb Tretter, Bracewell & Giuliani LLP John Tripodoro, Cahill Gordon & Reindel LLP Ante Vucic, Wachtell, Lipton, Rosen & Katz Jack Whalen, Kensico Capital  Supplemental Materials VALUATION MODELS The model templates (and completed versions) for the valuation methodologies discussed in this book are available in Microsoft Excel format at www.wiley.com/go/investmentbanking—password:wiley09. They will be updated for new ac- counting standards, as appropriate. The completed models match the input and output pages for the respective valuation methodologies. The company names and financial data in the models are completely illustrative. The website contains the following files: Model Templates
Comparable Companies Template.xls
Precedent Transactions Template.xls
DCF Analysis Template.xls
LBO Analysis Template.xls Completed Models
Comparable Companies Completed.xls
Precedent Transactions Completed.xls
DCF Analysis Completed.xls
LBO Analysis Completed.xls Note: When opening the models in Microsoft Excel, please ensure that you perform the following procedure: in the main toolbar select Tools, select Options, select the “Calculation” tab, select Manual, select Iteration, and set “Maximum iterations:” to 1000 (also see Chapter 3, Exhibit 3.30). The model templates on the website are formatted with yellow shading and blue font to denote manual input cells. Black font denotes formula cells. In the text, however, gray shading is used to denote manual input cells, where possible. For Chapter 5: LBO Analysis, please reference the electronic version to view manual input and formula cells. xxi xxii SUPPLEMENTAL MATERIALS INSTRUCTOR TEACHING AIDS To accompany the chapters, we have included a test bank of over 300 questions and answers for classroom and other instructional use. The test bank can be accessed by instructors in Microsoft Word format at www.wiley.com/go/investmentbanking. The test bank is also available in interactive format to facilitate online testing. The website includes the following files:
Chapter 1 Comparable Companies Analysis Q&A.doc
Chapter 2 Precedent Transactions Analysis Q&A.doc
Chapter 3 Discounted Cash Flow Analysis Q&A.doc
Chapter 4 Leveraged Buyouts Q&A.doc
Chapter 5 Leveraged Buyout Analysis Q&A.doc
Chapter 6 M&A Sale Process Q&A.doc Investment Banking  Introduction n the constantly evolving world of finance, a solid technical foundation is an I essential tool for success. Due to the fast-paced nature of this world, however, no one has been able to take the time to properly codify the lifeblood of the corporate financier’s work—namely, valuation. We have responded to this need by writing the book that we wish had existed when we were trying to break into Wall Street. Investment Banking: Valuation, Leveraged Buyouts, and Mergers & Acquisitions is a highly accessible and authoritative book written by investment bankers that explains how to perform the valuation work at the core of the financial world. This book fills a noticeable gap in contemporary finance literature, which tends to focus on theory rather than practical application. In the aftermath of the subprime mortgage crisis and ensuing credit crunch, the world of finance is returning to the fundamentals of valuation and critical due dili- gence for mergers & acquisitions (M&A), capital markets, and investment opportu- nities. This involves the use of more realistic assumptions governing approach to risk as well as a wide range of valuation drivers, such as expected financial performance, discount rates, multiples, leverage levels, and financing terms. While valuation has always involved a great deal of “art” in addition to time-tested “science,” the artistry is perpetually evolving in accordance with market developments and conditions. In this sense, our book is particularly topical—in addition to detailing the technical fundamentals behind valuation, we infuse practical judgment skills and perspective to help guide the science. The genesis for this book stemmed from our personal experiences as students seeking to break into Wall Street. As we both independently went through the rigorous process of interviewing for associate and analyst positions at investment banks and other financial firms, we realized that our classroom experience was a step removed from how valuation and financial analysis is performed in real world situations. This was particularly evident during the technical portion of the interviews, which is often the differentiator for recruiters trying to select among dozens of qualified candidates. Faced with this reality, we searched in vain for a practical how-to guide on the primary valuation methodologies used on Wall Street. At a loss, we resorted to compiling bits and pieces from various sources and ad hoc conversations with friends and contacts already working in investment banking. Needless to say, we didn’t feel as prepared as we would have liked. While we were fortunate enough to secure job offers, the process left a deep impression on us. In fact, we continued to refine the comprehensive preparatory materials we had created as students, which served as the foundation for this book. Once on Wall Street, we both went through mandatory training consisting of crash courses on finance and accounting, which sought to teach us the skill set 1 2 INTRODUCTION necessary to become effective investment bankers. Months into the job, however, even the limitations of this training were revealed. Actual client situations and deal complexities, combined with evolving market conditions, accounting guidelines, and technologies stretched our knowledge base and skills. In these situations, we were forced to consult with senior colleagues for guidance, but often the demands of the job left no one accessible in a timely manner. Given these realities, it is difficult to overstate how helpful a reliable handbook based on years of “best practices” and deal experience would have been. Consequently, we believe this book will prove invaluable to those individuals seeking or beginning careers on Wall Street—from students at undergraduate univer- sities and graduate schools to “career changers” looking to break into finance. For working professionals, this book is also designed to serve as an important reference material. Our experience has demonstrated that given the highly specialized nature of many finance jobs, there are noticeable gaps in skill sets that need to be addressed. Furthermore, many professionals seek to continuously brush up on their skills as well as broaden and refine their knowledge base. This book will also be highly bene- ficial for trainers and trainees at Wall Street firms, both within the context of formal training programs and informal on-the-job training. Our editorial contributors from private equity firms and hedge funds have also identified the need for a practical valuation handbook for their investment profes- sionals and key portfolio company executives. Many of these professionals come from a consulting or operational background and do not have a finance pedigree. Furthermore, the vast majority of buy-side investment firms do not have in-house training programs and rely heavily upon on-the-job training. This book will serve as a helpful reference guide for individuals joining, or seeking jobs at, these institutions. This book also provides essential tools for professionals at corporations, in- cluding members of business development, finance, and treasury departments. These specialists are responsible for corporate finance, valuation, and transaction-related deliverables on a daily basis. They also work with investment bankers on various M&A transactions (including leveraged buyouts (LBOs) and related financings), as well as initial public offerings (IPOs), restructurings, and other capital markets trans- actions. Similarly, this book is intended to provide greater context for the legions of attorneys, consultants, and accountants focused on M&A, corporate finance, and other transaction advisory services. Given the increasing globalization of the financial world, this book is designed to be sufficiently universal for use outside of North America. Our work on cross- border transactions—including in rapidly developing markets such as Asia, Latin America, Russia, and India—has revealed a tremendous appetite for skilled re- sources throughout the globe. Therefore, this book fulfills an important need as a valuable training material and reliable handbook for finance professionals in these markets. STRUCTURE OF THE BOOK This book focuses on the primary valuation methodologies currently used on Wall Street, namely comparable companies analysis, precedent transactions analysis, dis- counted cash flow analysis, and leveraged buyout analysis. These methodologies are Introduction 3 used to determine valuation for public and private companies within the context of M&A transactions, LBOs, IPOs, restructurings, and investment decisions. They also form the cornerstone for valuing companies on a standalone basis, including an assessment of whether a given public company is overvalued or undervalued. Using a step-by-step, how-to approach for each methodology, we build a chronological knowledge base and define key terms, financial concepts, and processes throughout the book. We also provide context for the various valuation methodologies through a comprehensive overview of the fundamentals of LBOs and an organized M&A sale process, including key participants, financing sources and terms, strategies, mile- stones, and legal and marketing documentation. This body of work builds on our combined experience on a multitude of trans- actions, as well as input received from numerous investment bankers, investment professionals at private equity firms and hedge funds, attorneys, corporate execu- tives, peer authors, and university professors. By drawing upon our own transaction and classroom experience, as well as that of a broad network of professional and professorial sources, we bridge the gap between academia and industry as it relates to the practical application of finance theory. The resulting product is accessible to a wide audience—including those with a limited finance background—as well as suffi- ciently detailed and comprehensive to serve as a primary reference tool and training guide for finance professionals. This book is organized into three primary parts, as summarized below. Part One: Valuation (Chapters 1–3) Part One focuses on the three most commonly used methodologies that serve as the core of a comprehensive valuation toolset—comparable companies analysis (Chapter 1), precedent transactions analysis (Chapter 2), and discounted cash flow analysis (Chapter 3). Each of these chapters employs a user-friendly, how-to approach to performing the given valuation methodology while defining key terms, detailing various calculations, and explaining advanced financial concepts. At the end of each chapter, we use our step-by-step approach to deter- mine a valuation range for an illustrative target company, ValueCo Corporation (“ValueCo”), in accordance with the given methodology. The Base Case set of fi- nancials for ValueCo that forms the basis for our valuation work throughout the book is provided in Exhibits I.I to I.III. In addition, all of the valuation models and output pages used in this book are accessible in electronic format on our website, www.wiley.com/go/investmentbanking. Chapter 1: Comparable Companies Analysis Chapter 1 provides an overview of comparable companies analysis (“comparable companies” or “trading comps”), one of the primary methodologies used for valuing a given focus company, division, business, or collection of assets (“target”). Comparable companies provides a market benchmark against which a banker can establish valuation for a private company or analyze the value of a public company at a given point in time. It has a broad range of applications, most notably for various M&A situations, IPOs, restructurings, and investment decisions. The foundation for trading comps is built upon the premise that similar compa- nies provide a highly relevant reference point for valuing a given target as they 4 INTRODUCTION share key business and financial characteristics, performance drivers, and risks. Therefore, valuation parameters can be established for the target by determin- ing its relative positioning among peer companies. The core of this analysis in- volves selecting a universe of comparable companies for the target. These peer companies are benchmarked against one another and the target based on various financial statistics and ratios. Trading multiples—which utilize a measure of value in the numerator and an operating metric in the denominator—are then calculated for the universe. These multiples provide a basis for extrapolating a valuation range for the target. Chapter 2: Precedent Transactions Analysis Chapter 2 focuses on precedent transactions analysis (“precedent transactions” or “transaction comps”) which, like comparable companies, employs a multiples-based approach to derive an implied valuation range for a target. Precedent transactions is premised on multiples paid for comparable companies in prior transactions. It has a broad range of applications, most notably to help determine a potential sale price range for a company, or part thereof, in an M&A or restructuring transaction. The selection of an appropriate universe of comparable acquisitions is the foun- dation for performing precedent transactions. The best comparable acquisitions typ- ically involve companies similar to the target on a fundamental level. As a general rule, the most recent transactions (i.e., those that have occurred within the previous two to three years) are the most relevant as they likely took place under similar market conditions to the contemplated transaction. Potential buyers and sellers look closely at the multiples that have been paid for comparable acquisitions. As a result, bankers and investment professionals are expected to know the transaction multiples for their sector focus areas. Chapter 3: Discounted Cash Flow Analysis Chapter 3 discusses discounted cash flow analysis (“DCF analysis” or the “DCF”), a fundamental valuation methodology broadly used by investment bankers, corporate officers, academics, investors, and other finance professionals. The DCF has a wide range of applications, including val- uation for various M&A situations, IPOs, restructurings, and investment decisions. It is premised on the principle that a target’s value can be derived from the present value of its projected free cash flow (FCF). A company’s projected FCF is derived from a variety of assumptions and judgments about its expected future financial performance, including sales growth rates, profit margins, capital expenditures, and net working capital requirements. The valuation implied for a target by a DCF is also known as its intrinsic value, as opposed to its market value, which is the value ascribed by the market at a given point in time. Therefore, a DCF serves as an important alternative to market-based valuation techniques such as comparable companies and precedent transactions, which can be distorted by a number of factors, including market aberrations (e.g., the post-subprime credit crunch). As such, a DCF plays a valuable role as a check on the prevailing market valuation for a publicly traded company. A DCF is also critical when there are limited (or no) “pure play” peer companies or comparable acquisitions. Introduction 5 Part Two: Leveraged Buyouts (Chapters 4 & 5) Part Two focuses on leveraged buyouts, which comprised a large part of the capital markets and M&A landscape in the mid-2000s. This was due to the proliferation of private investment vehicles (e.g., private equity firms and hedge funds) and their considerable pools of capital, as well as structured credit vehicles (e.g., collateralized debt obligations). We begin with a discussion in Chapter 4 of the fundamentals of LBOs, including an overview of key participants, characteristics of a strong LBO candidate, economics of an LBO, exit strategies, and key financing sources and terms. Once this framework is established, we apply our step-by-step how-to approach in Chapter 5 to construct a comprehensive LBO model and perform an LBO analysis for ValueCo. LBO analysis is a core tool used by bankers and private equity professionals alike to determine financing structure and valuation for leveraged buyouts. Chapter 4: Leveraged Buyouts Chapter 4 provides an overview of the fundamen- tals of leveraged buyouts. An LBO is the acquisition of a target using debt to finance a large portion of the purchase price. The remaining portion of the purchase price is funded with an equity contribution by a financial sponsor (“sponsor”). In this chapter, we provide an overview of the economics of LBOs and how they are used to generate returns for sponsors. We also dedicate a significant portion of Chapter 4 to a discussion of LBO financing sources, particularly the various debt instruments and their terms and conditions. LBOs are used by sponsors to acquire a broad range of businesses, including both public and private companies, as well as their divisions and subsidiaries. Generally speaking, companies with stable and predictable cash flows as well as substantial assets represent attractive LBO candidates. However, sponsors tend to be flexible in- vestors provided the expected returns on the investment meet required thresholds. In an LBO, the disproportionately high level of debt incurred by the target is supported by its projected FCF and asset base, which enables the sponsor to contribute a small equity investment relative to the purchase price. This, in turn, enables the sponsor to realize an acceptable return on its equity investment upon exit, typically through a sale or IPO of the target. Chapter 5: LBO Analysis Chapter 5 removes the mystery surrounding LBO analysis, the core analytical tool used to assess financing structure, investment returns, and valuation in leveraged buyout scenarios. These same techniques can also be used to assess refinancing opportunities and restructuring alternatives for corporate issuers. LBO analysis is a more complex methodology than those previously discussed as it requires specialized knowledge of financial modeling, leveraged debt capital markets, M&A, and accounting. At the center of LBO analysis is a financial model, which is constructed with the flexibility to analyze a given target under multiple financing structures and operating scenarios. As with the methodologies discussed in Part One, LBO analysis is an essential component of a comprehensive valuation toolset. On the debt financing side, LBO analysis is used to help craft a viable financing structure for the target on the basis of its cash flow generation, debt repayment, credit statistics, and investment returns over the projection period. Sponsors work closely with financing providers (e.g., 6 INTRODUCTION investment banks) to determine the preferred financing structure for a particular transaction. In an M&A advisory context, LBO analysis provides the basis for de- termining an implied valuation range for a given target in a potential LBO sale based on achieving acceptable returns. Part Three: Mergers & Acquisitions (Chapter 6) Part Three focuses on the key process points and stages for running an effective M&A sale process, the medium whereby companies are bought and sold in the marketplace. This discussion serves to provide greater context for the topics discussed earlier in the book as theoretical valuation methodologies are tested based on what a buyer will actually pay for a business or collection of assets. We also describe how valuation analysis is used to frame the seller’s price expectations, set guidelines for the range of acceptable bids, evaluate offers received, and, ultimately, guide negotiations of the final purchase price. Chapter 6: M&A Sale Process The sale of a company, division, business, or collec- tion of assets is a major event for its owners (shareholders), management, employees, and other stakeholders. It is an intense, time-consuming process with high stakes, usually spanning several months. Consequently, the seller typically hires an invest- ment bank (“sell-side advisor”) and its team of trained professionals to ensure that key objectives are met—namely an optimal mix of value maximization, speed of execution, and certainty of completion, among other deal-specific considerations. Prospective buyers also often hire an investment bank (“buy-side advisor”) to per- form valuation work, interface with the seller, and conduct negotiations, among other critical tasks. The sell-side advisor is responsible for identifying the seller’s priorities from the onset and crafts a tailored sale process accordingly. From an analytical perspective, a sell-side assignment requires a comprehensive valuation of the target using those methodologies discussed in this book. Perhaps the most basic decision, however, relates to whether to run a broad or targeted auction, or pursue a negotiated sale. Generally, an auction requires more upfront organization, marketing, process points, and resources than a negotiated sale with a single party. Consequently, Chapter 6 focuses primarily on the auction process. VALUECO SUMMARY FINANCIAL INFORMATION Exhibits I.I through I.III display the historical and projected financial information for ValueCo. These financials—as well as the various valuation multiples, financ- ing terms, and other financial statistics discussed throughout the book—are purely illustrative and designed to represent normalized economic and market conditions. Introduction 7 EXHIBIT I.I ValueCo Summary Historical Operating Data ($ in millions) ValueCo Summary Historical Operating Data Fiscal Year Ending December 31 LTM 2005A 2006A 2007A 9/30/2008A Sales $780.0 $850.0 $925.0 $977.8 % growth NA 9.0% 8.8% NA Cost of Goods Sold 471.9 512.1 555.0 586.7 Gross Profit $308.1 $337.9 $370.0 $391.1 % margin 39.5% 39.8% 40.0% 40.0% Selling, General & Administrative 198.9 214.6 231.3 244.4 EBITDA $109.2 $123.3 $138.8 $146.7 % margin 14.0% 14.5% 15.0% 15.0% Depreciation & Amortization 15.6 17.0 18.5 19.6 EBIT $93.6 $106.3 $120.3 $127.1 % margin 12.0% 12.5% 13.0% 13.0% Capital Expenditures 15.0 1 8.0 18.5 1 9.6 % sales 1.9% 2.1% 2.0% 2.0% Note: For modeling purposes (e.g., DCF analysis and LBO analysis), D&A is broken out separately from COGS & SG&A as its own line item. EXHIBIT I.II ValueCo Summary Projected Operating Data ($ in millions) ValueCo Summary Projected Operating Data Fiscal Year Ending December 31 2008E 2009E 2010E 2011E 2012E 2013E Sales $1,000.0 $1,080.0 $1,144.8 $1,190.6 $1,226.3 $1,263.1 % growth 8.1% 8.0% 6.0% 4.0% 3.0% 3.0% Cost of Goods Sold 600.0 648.0 686.9 714.4 735.8 757.9 Gross Profit $400.0 $432.0 $457.9 $476.2 $490.5 $505.2 % margin 40.0% 40.0% 40.0% 40.0% 40.0% 40.0% Selling, General & Administrative 250.0 270.0 286.2 297.6 306.6 315.8 EBITDA $150.0 $162.0 $171.7 $178.6 $183.9 $189.5 % margin 15.0% 15.0% 15.0% 15.0% 15.0% 15.0% Depreciation & Amortization 20.0 21.6 22.9 23.8 24.5 25.3 EBIT $130.0 $140.4 $148.8 $154.8 $159.4 $164.2 % margin 13.0% 13.0% 13.0% 13.0% 13.0% 13.0% Capital Expenditures 20.0 21.6 22.9 23.8 24.5 25.3 % sales 2.0% 2.0% 2.0% 2.0% 2.0% 2.0% 8 INTRODUCTION EXHIBIT I.III ValueCo Summary Historical Balance Sheet Data ($ in millions) ValueCo Summary Historical Balance Sheet Data Fiscal Year Ending December 31 As of FYE 2005A 2006A 2007A 9/30/2008A 2008E Cash and Cash Equivalents $22.6 $11.9 $14.0 $7.9 $25.0 Accounts Receivable 123.2 141.1 152.6 161.3 165.0 Inventories 94.6 104.0 115.6 122.2 125.0 Prepaid and Other Current Assets 7.1 8.5 9.3 9.8 10.0 Total Current Assets $247.5 $265.5 $291.5 $301.3 $325.0 Property, Plant and Equipment, net 649.0 650.0 650.0 650.0 650.0 Goodwill and Intangible Assets 175.0 175.0 175.0 175.0 175.0 Other Assets 75.0 75.0 75.0 75.0 75.0 Total Assets $1,146.5 $1,165.5 $1,191.5 $1,201.3 $1,225.0 Accounts Payable 65.2 66.0 69.4 73.3 75.0 Accrued Liabilities 69.9 83.2 92.5 97.8 100.0 Other Current Liabilities 15.6 20.4 23.1 24.4 25.0 Total Current Liabilities $150.7 $169.6 $185.0 $195.6 $200.0 Total Debt 450.0 400.0 350.0 300.0 300.0 Other Long-Term Liabilities 25.0 25.0 25.0 25.0 25.0 Total Liabilities $625.7 $594.6 $560.0 $520.6 $525.0 Noncontrolling Interest - - - - - Shareholders' Equity 520.8 570.9 631.5 680.7 700.0 Total Liabilities and Equity $1,146.5 $1,165.5 $1,191.5 $1,201.3 $1,225.0  PART One Valuation  CHAPTER 1 Comparable Companies Analysis omparable companies analysis (“comparable companies” or “trading comps”) C is one of the primary methodologies used for valuing a given focus company, division, business, or collection of assets (“target”). It provides a market benchmark against which a banker can establish valuation for a private company or analyze the value of a public company at a given point in time. Comparable companies has a broad range of applications, most notably for various mergers & acquisitions (M&A) situations, initial public offerings (IPOs), restructurings, and investment decisions. The foundation for trading comps is built upon the premise that similar compa- nies provide a highly relevant reference point for valuing a given target due to the fact that they share key business and financial characteristics, performance drivers, and risks. Therefore, the banker can establish valuation parameters for the target by determining its relative positioning among peer companies. The core of this analysis involves selecting a universe of comparable companies for the target (“comparables universe”). These peer companies are benchmarked against one another and the target based on various financial statistics and ratios. Trading multiples are then cal- culated for the universe, which serve as the basis for extrapolating a valuation range for the target. This valuation range is calculated by applying the selected multiples to the target’s relevant financial statistics. While valuation metrics may vary by sector, this chapter focuses on the most widely used trading multiples. These multiples—such as enterprise value-to-earnings before interest, taxes, depreciation, and amortization (EV/EBITDA) and price-to- earnings (P/E)—utilize a measure of value in the numerator and a financial statistic in the denominator. While P/E is the most broadly recognized in circles outside Wall Street, multiples based on enterprise value are widely used by bankers because they are independent of capital structure and other factors unrelated to business operations (e.g., differences in tax regimes and certain accounting policies). Comparable companies analysis is designed to reflect “current” valuation based on prevailing market conditions and sentiment. As such, in many cases it is more relevant than intrinsic valuation analysis, such as discounted cash flow analysis (see Chapter 3). At the same time, market trading levels may be subject to periods of irrational investor sentiment that skew valuation either too high or too low. Furthermore, no two companies are exactly the same, so assigning a valuation based on the trading characteristics of similar companies may fail to accurately capture a given company’s true value. 11 12 VALUATION As a result, trading comps should be used in conjunction with the other valuation methodologies discussed in this book. A material disconnect between the derived valuation ranges from the various methodologies might be an indication that key assumptions or calculations need to be revisited. Therefore, when performing trading comps (or any other valuation/financial analysis exercise), it is imperative to diligently footnote key sources and assumptions both for review and defense of conclusions. This chapter provides a highly practical, step-by-step approach to performing trading comps consistent with how this valuation methodology is performed in real world applications (see Exhibit 1.1). Once this framework is established, we walk through an illustrative comparable companies analysis using our target company, ValueCo (see Introduction for reference). EXHIBIT 1.1 Comparable Companies Analysis Steps Step I. Select the Universe of Comparable Companies Step II. Locate the Necessary Financial Information Step III. Spread Key Statistics, Ratios, and Trading Multiples Step IV. Benchmark the Comparable Companies Step V. Determine Valuation SUMMARY OF COMPARABLE COMPANIES ANALYSIS STEPS
Step I. Select the Universe of Comparable Companies. The selection of a uni- verse of comparable companies for the target is the foundation for performing trading comps. While this exercise can be fairly simple and intuitive for com- panies in certain sectors, it can prove challenging for others whose peers are not readily apparent. To identify companies with similar business and financial characteristics, it is first necessary to gain a sound understanding of the target. As a starting point, the banker typically consults with peers or senior col- leagues to see if a relevant set of comparable companies already exists inter- nally. If beginning from scratch, the banker casts a broad net to review as many potential comparable companies as possible. This broader group is eventually narrowed, and then typically further refined to a subset of “closest compara- bles.” A survey of the target’s public competitors is generally a good place to start identifying potential comparable companies.
Step II. Locate the Necessary Financial Information. Once the initial compara- bles universe is determined, the banker locates the financial information nec- essary to analyze the selected comparable companies and calculate (“spread”1 ) key financial statistics, ratios, and trading multiples (see Step III). The primary data for calculating these metrics is compiled from various sources, including a 1 The notion of “spreading” refers to performing calculations in a spreadsheet program such as Microsoft Excel. Comparable Companies Analysis 13 company’s SEC filings,2 consensus research estimates, equity research reports, and press releases, as well as financial information services.
Step III. Spread Key Statistics, Ratios, and Trading Multiples. The banker is now prepared to spread key statistics, ratios, and trading multiples for the comparables universe. This involves calculating market valuation measures such as enterprise value and equity value, as well as key income statement items, such as EBITDA and net income. A variety of ratios and other metrics measuring profitability, growth, returns, and credit strength are also calculated at this stage. Selected financial statistics are then used to calculate trading multiples for the comparables. As part of this process, the banker needs to employ various financial con- cepts and techniques, including the calculation of last twelve months (LTM)3 financial statistics, calendarization of company financials, and adjustments for non-recurring items. These calculations are imperative for measuring the com- parables accurately on both an absolute and relative basis (see Step IV).
Step IV. Benchmark the Comparable Companies. The next level of analysis requires an in-depth examination of the comparable companies in order to determine the target’s relative ranking and closest comparables. To assist in this task, the banker typically lays out the calculated financial statistics and ratios for the comparable companies (as calculated in Step III) alongside those of the target in spreadsheet form for easy comparison (see Exhibits 1.53 and 1.54). This exercise is known as “benchmarking.” Benchmarking serves to determine the relative strength of the comparable companies versus one another and the target. The similarities and discrepancies in size, growth rates, margins, and leverage, for example, among the compa- rables and the target are closely examined. This analysis provides the basis for establishing the target’s relative ranking as well as determining those compa- nies most appropriate for framing its valuation. The trading multiples are also laid out in a spreadsheet form for benchmarking purposes (see Exhibits 1.2 and 1.55). At this point, it may become apparent that certain outliers need to be eliminated or that the comparables should be further tiered (e.g., on the basis of size, sub-sector, or ranging from closest to peripheral).
Step V. Determine Valuation. The trading multiples of the comparable compa- nies serve as the basis for deriving a valuation range for the target. The banker typically begins by using the means and medians for the relevant trading mul- tiples (e.g., EV/EBITDA) as the basis for extrapolating an initial range. The high and low multiples for the comparables universe provide further guidance in terms of a potential ceiling or floor. The key to arriving at the tightest, most appropriate range, however, is to rely upon the multiples of the closest com- parables as guideposts. Consequently, only a few carefully selected companies 2 The Securities and Exchange Commission (SEC) is a federal agency created by the Securities Exchange Act of 1934 that regulates the U.S. securities industry. SEC filings can be located online at www.sec.gov. 3 The sum of the prior four quarters of a company’s financial performance, also known as trailing twelve months (TTM).  EXHIBIT 1.2 Comparable Companies Analysis—Trading Multiples Output Page 14 ValueCo Corporation Comparable Companies Analysis ($ in millions, except per share data) Current % of Enterprise Value / LTM Total Price / LT Share 52-wk. Equity Enterprise LTM 2008E 2009E LTM 2008E 2009E LTM 2008E 2009E EBITDA Debt / LTM 2008E 2009E EPS Company Ticker Price High Value Value Sales Sales Sales EBITDA EBITDA EBITDA EBIT EBIT EBIT Margin EBITDA EPS EPS EPS Growth Tier I: Large-Cap Vucic Brands VUC $70.00 83% $8,829 $14,712 1.7x 1.6x 1.4x 8.5x 7.8x 7.2x 10.0x 9.3x 8.5x 20% 3.2x 14.6x 13.6x 12.5x 16% Pearl Corp. PRL 22.00 81% 8,850 11,323 0.9x 0.8x 0.8x 7.0x 6.7x 6.3x 8.4x 8.0x 7.4x 13% 2.3x 12.7x 12.1x 11.3x 13% Spalding Co. SLD 57.00 76% 7,781 8,369 1.0x 1.0x 0.9x 7.4x 7.1x 6.5x 8.6x 8.3x 7.6x 14% 0.9x 14.0x 13.4x 12.3x 14% Leicht & Co. LCT 85.00 82% 7,456 9,673 1.2x 1.1x 1.1x 7.6x 7.1x 6.7x 9.5x 8.9x 8.4x 16% 1.9x 14.2x 13.3x 12.5x 11% Drook Corp. DRK 78.25 74% 5,034 6,161 0.9x 0.9x 0.8x 7.0x 6.6x 6.2x 8.4x 7.9x 7.4x 13% 1.9x 12.4x 11.7x 11.0x 10% Mean 1.1x 1.1x 1.0x 7.5x 7.1x 6.6x 9.0x 8.5x 7.9x 15% 2.0x 13.6x 12.8x 11.9x 13% Median 1.0x 1.0x 0.9x 7.4x 7.1x 6.5x 8.6x 8.3x 7.6x 14% 1.9x 14.0x 13.3x 12.3x 13% Tier II: Mid-Cap Goodson Corp. GDS $44.00 79% $4,368 $5,534 0.9x 0.9x 0.9x 7.0x 6.8x 6.6x 9.0x 8.9x 8.6x 13% 1.6x 13.7x 13.5x 13.1x 13% The DiNucci Group TDG 29.85 71% 3,772 5,202 0.8x 0.8x 0.7x 6.7x 6.4x 6.1x 11.5x 11.0x 10.4x 12% 2.4x 17.5x 17.1x 16.1x 15% Pryor, Inc. PRI 42.80 78% 3,484 4,764 1.1x 1.1x 1.0x 7.3x 6.9x 6.4x 9.4x 8.9x 8.3x 16% 2.4x 13.4x 12.7x 11.8x 14% Adler Industries ADL 47.00 82% 2,600 3,149 0.8x 0.8x 0.7x 6.7x 6.3x 5.9x 9.7x 9.2x 8.6x 12% 1.2x 15.2x 14.4x 13.4x 11% Lanzarone International LNZ 28.50 81% 1,750 2,139 0.9x 0.9x 0.8x 7.2x 6.7x 6.3x 8.5x 8.0x 7.4x 13% 1.7x 13.3x 12.5x 11.6x 15% Mean 0.9x 0.9x 0.8x 6.9x 6.6x 6.3x 9.6x 9.2x 8.7x 13% 1.9x 14.6x 14.0x 13.2x 14% Median 0.9x 0.9x 0.8x 7.0x 6.7x 6.3x 9.4x 8.9x 8.6x 13% 1.7x 13.7x 13.5x 13.1x 14% Tier III: Small-Cap Lajoux Global LJX $15.00 83% $1,050 $1,650 0.9x 0.9x 0.8x 7.1x 6.8x 6.4x 8.3x 8.0x 7.5x 13% 3.1x 12.6x 12.1x 11.3x 13% Momper Corp. MOMP 20.00 80% 1,000 1,500 1.1x 1.0x 0.9x 7.0x 6.7x 6.3x 8.6x 8.1x 7.5x 15% 2.6x 11.8x 11.1x 10.0x 15% McMenamin & Co. MCM 16.50 78% 630 705 1.2x 1.2x 1.1x 7.3x 7.1x 6.6x 10.1x 9.8x 9.1x 17% 2.6x 19.9x 19.3x 17.9x 14% Trip Co. TRIP 11.25 78% 321 441 0.9x 0.9x 0.8x 6.7x 6.5x 6.1x 9.1x 8.7x 8.2x 14% 2.1x 15.6x 15.0x 14.0x 12% Paris Industries PRS 10.25 73% 156 192 0.5x 0.5x 0.5x 5.5x 5.3x 5.0x 9.1x 8.9x 8.3x 10% 3.8x 14.3x 14.0x 13.1x 10% Mean 0.9x 0.9x 0.8x 6.7x 6.5x 6.0x 9.0x 8.7x 8.1x 14% 2.8x 14.8x 14.3x 13.3x 13% Median 0.9x 0.9x 0.8x 7.0x 6.7x 6.3x 9.1x 8.7x 8.2x 14% 2.6x 14.3x 14.0x 13.1x 13% Overall Mean 1.0x 1.0x 0.9x 7.0x 6.7x 6.3x 9.2x 8.8x 8.2x 14% 2.3x 14.3x 13.7x 12.8x 13% Median 0.9x 0.9x 0.8x 7.0x 6.7x 6.3x 9.1x 8.9x 8.3x 13% 2.3x 14.0x 13.4x 12.5x 13% High 1.7x 1.6x 1.4x 8.5x 7.8x 7.2x 11.5x 11.0x 10.4x 20% 3.8x 19.9x 19.3x 17.9x 16% Low 0.5x 0.5x 0.5x 5.5x 5.3x 5.0x 8.3x 7.9x 7.4x 10% 0.9x 11.8x 11.1x 10.0x 10% Source: Company filings, Bloomberg, Consensus Estimates Note: Last twelve months data based on September 30, 2008. Estimated annual financial data based on a calendar year. Comparable Companies Analysis 15 may serve as the ultimate basis for valuation, with the broader group serving as additional reference points. As this process involves as much “art” as “science,” senior bankers are typically consulted for guidance on the final decision. The chosen range is then applied to the target’s relevant financial statistics to produce an implied valuation range. STEP I. SELECT THE UNIVERSE OF COMPARABLE COMPANIES The selection of a universe of comparable companies for the target is the foundation for performing trading comps. In order to identify companies with similar business and financial characteristics, it is first necessary to gain a sound understanding of the target. At its base, the methodology for determining comparable companies is relatively intuitive. Companies in the same sector (or, preferably, “sub-sector”) with similar size tend to serve as good comparables. While this can be a fairly simple exercise for companies in certain sectors, it may prove challenging for others whose peers are not readily apparent. For a target with no clear, publicly traded comparables, the banker seeks compa- nies outside the target’s core sector that share business and financial characteristics on some fundamental level. For example, a medium-sized manufacturer of residen- tial windows may have limited or no truly direct publicly traded peers in terms of products, namely companies that produce windows. If the universe is expanded to include companies that manufacture building products, serve homebuilders, or have exposure to the housing cycle, however, the probability of locating companies with similar business drivers is increased. In this case, the list of potential comparables could be expanded to include manufacturers of related building products such as decking, roofing, siding, doors, and cabinets. Study the Target The process of learning the in-depth “story” of the target should be exhaustive as this information is essential for making decisions regarding the selection of appropriate comparable companies. Toward this end, the banker is encouraged to read and study as much company- and sector-specific material as possible. The actual selection of comparable companies should only begin once this research is completed. For targets that are public registrants,4 annual (10-K) and quarterly (10-Q) SEC filings, consensus research estimates, equity and fixed income research re- ports, press releases, earnings call transcripts, investor presentations,5 and corporate 4 Public or publicly traded companies refer to those listed on a public stock exchange where their shares can be traded. Public filers (“public registrants”), however, may include privately held companies that are issuers of public debt securities and, therefore, subject to SEC disclo- sure requirements. 5 Presentations at investment conferences or regular performance reports, typically posted on a company’s corporate website. Investor presentations may also be released for significant M&A events or as part of Regulation FD requirements. They are typically posted on the company’s corporate website under “Investor Relations” and filed in an 8-K. 16 VALUATION websites provide key business and financial information. Private companies present a greater challenge as the banker is forced to rely upon sources such as corporate websites, sector research reports, news runs, and trade journals for basic company data. Public competitors’ SEC filings, research reports, and investor presentations may also serve as helpful sources of information on private companies. In an orga- nized M&A sale process6 for a private company, however, the banker is provided with detailed business and financial information on the target (see Chapter 6). Identify Key Characteristics of the Target for Comparison Purposes A simple framework for studying the target and selecting comparable companies is shown in Exhibit 1.3. This framework, while by no means exhaustive, is designed to determine commonality with other companies by profiling and comparing key business and financial characteristics. EXHIBIT 1.3 Business and Financial Profile Framework Business Profile Financial Profile
Sector
Size
Products and Services
Profitability
Customers and End Markets
Growth Profile
Distribution Channels
Return on Investment
Geography
Credit Profile Business Profile Companies that share core business characteristics tend to serve as good compa- rables. These core traits include sector, products and services, customers and end markets, distribution channels, and geography. Sector Sector refers to the industry or markets in which a company operates (e.g., chemicals, consumer products, healthcare, industrials, and technology). A company’s sector can be further divided into sub-sectors, which facilitates the identification of the target’s closest comparable. Within the industrials sector, for example, there are numerous sub-sectors, such as aerospace and defense, automotive, building products, metals and mining, and paper and packaging. For companies with distinct business divisions, the segmenting of comparable companies by sub-sector may be critical for valuation. A company’s sector conveys a great deal about its key drivers, risks, and op- portunities. For example, a cyclical sector such as oil & gas will have dramatically different earnings volatility than consumer staples. On the other hand, cyclical or highly fragmented sectors may present growth opportunities that are unavailable to companies in more stable or consolidated sectors. The proper identification and 6 A process through which a target is marketed to prospective buyers, typically run by an investment banking firm. See Chapter 6: M&A Sale Process for additional information. Comparable Companies Analysis 17 classification of the target’s sector and sub-sector is an essential step toward locating comparable companies. Products and Services A company’s products and services are at the core of its business model. Accord- ingly, companies that produce similar products or provide similar services typically serve as good comparables. Products are commodities or value-added goods that a company creates, produces, or refines. Examples of products include computers, lumber, oil, prescription drugs, and steel. Services are acts or functions performed by one entity for the benefit of another. Examples of common services include banking, installation, lodging, logistics, and transportation. Many companies provide both products and services to their customers, while others offer one or the other. Sim- ilarly, some companies offer a diversified product and/or service mix, while others are more focused. Customers and End Markets Customers A company’s customers refer to the purchasers of its products and ser- vices. Companies with a similar customer base tend to share similar opportunities and risks. For example, companies supplying automobile manufacturers abide by certain manufacturing and distribution requirements, and are subject to the automo- bile purchasing cycles and trends. The quantity and diversity of a company’s customers are also important. Some companies serve a broad customer base while others may target a specialized or niche market. While it is generally positive to have low customer concentration from a risk management perspective, it is also beneficial to have a stable customer core to provide visibility and comfort regarding future revenues. End Markets A company’s end markets refer to the broad underlying markets into which it sells its products and services. For example, a plastics manufacturer may sell into several end markets, including automotive, construction, consumer products, medical devices, and packaging. End markets need to be distinguished from customers. For example, a company may sell into the housing end market, but to retailers or suppliers as opposed to homebuilders. A company’s performance is generally tied to economic and other factors that affect its end markets. A company that sells products into the housing end market is susceptible to macroeconomic factors that affect the overall housing cycle, such as interest rates and unemployment levels. Therefore, companies that sell products and services into the same end markets generally share a similar performance outlook, which is important for determining appropriate comparable companies. Distribution Channels Distribution channels are the avenues through which a company sells its products and services to the end user. As such, they are a key driver of operating strategy, performance, and, ultimately, value. Companies that sell primarily to the whole- sale channel, for example, often have significantly different organizational and cost structures than those selling directly to retailers or end users. Selling to a superstore 18 VALUATION or value retailer requires a physical infrastructure, sales force, and logistics that may be unnecessary for serving the professional or wholesale channels. Some companies sell at several levels of the distribution chain, such as wholesale, retail, and direct-to-customer. A flooring manufacturer, for example, may distribute its products through selected wholesale distributors and retailers, as well as directly to homebuilders and end users. Geography Companies that are based in (and sell to) different regions of the world often differ substantially in terms of fundamental business drivers and characteristics. These may include growth rates, macroeconomic environment, competitive dynamics, path(s)- to-market, organizational and cost structure, and potential opportunities and risks. Such differences—which result from local demographics, economic drivers, regula- tory regimes, consumer buying patterns and preferences, and cultural norms—can vary greatly from country to country and, particularly, from continent to continent. Consequently, there are often valuation disparities for similar companies in different global regions or jurisdictions.7 Therefore, in determining comparable companies, bankers tend to group U.S.-based (or focused) companies in a separate category from European- or Asian-based companies even if their basic business models are the same. For example, a banker seeking comparable companies for a U.S. retailer would focus primarily on U.S. companies with relevant foreign companies providing periph- eral guidance. This geographic grouping is slightly less applicable for truly global industries such as oil and aluminum, for example, where domicile is less indica- tive than global commodity prices and market conditions. Even in these instances, however, valuation disparities by geography are often evident. Financial Profile Key financial characteristics must also be examined both as a means of understanding the target and identifying the best comparable companies. Size Size is typically measured in terms of market valuation (e.g., equity value and en- terprise value), as well as key financial statistics (e.g., sales, gross profit, EBITDA, EBIT, and net income). Companies of similar size in a given sector are more likely to have similar multiples than companies with significant size discrepancies. This reflects the fact that companies of similar size are also likely to be analogous in other respects (e.g., economies of scale, purchasing power, pricing leverage, customers, growth prospects, and the trading liquidity of their shares in the stock market). Consequently, differences in size often map to differences in valuation. Hence, the comparables are often tiered based on size categories. For example, companies with under $5 billion in equity value (or enterprise value, sales) may be placed in one group and those with greater than $5 billion in a separate group. This tiering, of course, assumes a sufficient number of comparables to justify organizing the universe into sub-groups. 7 Other factors, such as the local capital markets conditions, including volume, liquidity, trans- parency, shareholder base, and investor perceptions, as well as political risk, also contribute to these disparities. Comparable Companies Analysis 19 Profitability A company’s profitability measures its ability to convert sales into profit. Profitability ratios (“margins”) employ a measure of profit in the numerator, such as gross profit, EBITDA, EBIT, or net income, and sales in the denominator.8 As a general rule, for companies in the same sector, higher profit margins translate into higher valuations, all else being equal. Consequently, determining a company’s relative profitability versus its peers’ is a core component of the benchmarking analysis (see Step IV). Growth Profile A company’s growth profile, as determined by its historical and estimated future financial performance, is an important driver of valuation. Equity investors reward high growth companies with higher trading multiples than slower growing peers. They also discern whether the growth is primarily organic or acquisition-driven, with the former generally viewed as preferable. In assessing a company’s growth profile, historical and estimated future growth rates for various financial statistics (e.g., sales, EBITDA, and earnings per share (EPS)) are examined at selected intervals. For mature public companies, EPS growth rates are typically more meaningful. For early stage or emerging companies with little or no earnings, however, sales or EBITDA growth trends may be more relevant. Return on Investment Return on investment (ROI) measures a company’s ability to provide earnings (or returns) to its capital providers. ROI ratios employ a measure of profitability (e.g., EBIT, NOPAT,9 or net income) in the numerator and a measure of capital (e.g., invested capital, shareholders’ equity, or total assets) in the denominator. The most commonly used ROI metrics are return on invested capital (ROIC), return on equity (ROE), and return on assets (ROA). Dividend yield, which measures the dividend payment that a company’s shareholders receive for each share owned, is another type of return metric. Credit Profile A company’s credit profile refers to its creditworthiness as a borrower. It is typically measured by metrics relating to a company’s overall debt level (“leverage”) as well as its ability to make interest payments (“coverage”), and reflects key company- and sector-specific benefits and risks. Moody’s Investors Service (Moody’s), Stan- dard & Poor’s (S&P), and Fitch Ratings (Fitch) are the three primary indepen- dent credit rating agencies that provide formal assessments of a company’s credit profile. 8 Depending on the sector, profitability may be measured on a per unit basis (e.g., per ton or pound). 9 Net operating profit after taxes, also known as tax-effected EBIT or earnings before interest after taxes (EBIAT). 20 VALUATION Screen for Comparable Companies Once the target’s basic business and financial characteristics are researched and understood, the banker uses various resources to screen for potential comparable companies. At the initial stage, the focus is on identifying companies with a similar business profile. While basic financial information (e.g., sales, enterprise value, or equity value) should be assessed early on, more detailed financial benchmarking is performed in Step IV. Investment banks generally have established lists of comparable companies by sector containing relevant multiples and other financial data, which are updated on a quarterly basis and for appropriate company-specific actions. Often, however, the banker needs to start from scratch. In these cases, an examination of the target’s public competitors is usually the best place to begin. Competitors generally share key business and financial characteristics and are susceptible to similar opportunities and risks. Public companies typically discuss their primary competitors in their 10- Ks, annual proxy statement (DEF14A),10 and, potentially, in investor presentations. Furthermore, equity research reports, especially those known as initiating cover- age,11 often explicitly list the research analyst’s views on the target’s comparables and/or primary competitors. For private targets, public competitors’ 10-Ks, proxy statements, investor presentations, research reports, and broader industry reports are often helpful sources. An additional source for locating comparables is the proxy statement for a relatively recent M&A transaction in the sector (“merger proxy”),12 as it contains excerpts from a fairness opinion. As the name connotes, a fairness opinion opines on the “fairness” of the purchase price and deal terms offered by the acquirer from a financial perspective (see Chapter 6). The fairness opinion is supported by a detailed overview of the methodologies used to perform a valuation of the target, typically including comparable companies, precedent transactions, DCF analysis, and LBO analysis, if applicable.13 The trading comps excerpt from the fairness opinion generally provides a list of the comparable companies used to value the M&A target as well as the selected range of multiples used in the valuation analysis. The banker may also screen for companies that operate in the target’s sector using SIC or NAICS codes.14 Subscription financial information services, such as those offered by Capital IQ, FactSet, and Thomson Reuters, provide comprehensive 10 A company’s annual proxy statement typically provides a suggested peer group of companies that is used for benchmarking purposes. 11 An initiating coverage equity research report refers to the first report published by an equity research analyst beginning coverage on a particular company. This report often provides a comprehensive business description, sector analysis, and commentary. 12 A solicitation of shareholder votes in a business combination initially filed under SEC Form PREM14A (preliminary merger proxy statement) and then DEFM14A (definitive merger proxy statement). 13 Not all companies are LBO candidates. See Chapter 4: Leveraged Buyouts for an overview of the characteristics of strong LBO candidates. 14 Standard Industrial Classification (SIC) is a system established by the U.S. government for classifying the major business operations of a company with a numeric code. Some bankers use the newer North American Industry Classification System (NAICS) codes in lieu of SIC codes. The SEC, however, still uses SIC codes. Comparable Companies Analysis 21 company databases with SIC/NAICS code information. This type of screen is typ- ically used either to establish a broad initial universe of comparables or to ensure that no potential companies have been overlooked. Sector reports published by the credit rating agencies (e.g., Moody’s, S&P, and Fitch) may also provide helpful lists of peer companies. In addition to the aforementioned, senior bankers are perhaps the most valuable resources for determining the comparables universe. Given their sector knowledge and familiarity with the target, a brief conversation is usually sufficient for them to provide the junior banker with a strong starting point. Toward the end of the process—once the junior banker has done the legwork to craft and refine a robust list of comparables—a senior banker often provides the finishing touches in terms of more nuanced additions or deletions. At this stage of the process, there may be sufficient information to eliminate certain companies from the group or tier the selected companies by size, business focus, or geography, for example. STEP II. LOCATE THE NECESSARY FINANCIAL INFORMATION This section provides an overview of the relevant sources for locating the necessary financial information to calculate key financial statistics, ratios, and multiples for the selected comparable companies (see Step III). The most common sources for public company financial data are SEC filings (such as 10-Ks, 10-Qs, and 8-Ks), as well as earnings announcements, investor presentations, equity research reports, consensus estimates, press releases, and selected financial information services. A summary list of