This is a derivative of the Gordon Growth approach to valuing a company, where an acquirer may discount free cash flows to the firm (FCFF) to value a potential target.
- FCFF is important because it incorporates contributions of all suppliers of capital - both debt and equity.
- DCF analysis attempts to determine the intrinsic value of the firm (i.e. the net present value of expected future cash flows).
- By breaking down the cash flows, DCF analysis allows for an analyst to estimate the potential value created by synergies.
- DCF analysis can be challenging because valuation relies on a number of estimates and assumptions that might not be fully known.
- Candidates should review the steps of a DCF valuation and practice them in preparation for the exam. This is also relevant to the Equity sessions.
Comparable Company Analysis
The analyst will evaluate a target within the context of a group of relevant peer firms.
- The analyst must compile a list of comparable companies; the list may go beyond just firms in the target's industry, but include other companies of similar size and similar capital structure.
- The analyst must then select the appropriate equity and/or enterprise valuation metrics (note: enterprise metrics sum the value of debt and equity less cash and marketable securities).
- The analyst will then apply the selected valuation metrics to the target and its "comps."
- The analyst will then calculate the takeover premium (per share), which is the excess of the merger price per share over the pre-merger market price per share of equity divided by the pre-merger price per share.
- The analyst will then evaluate the takeover premium within the context of the comparable company valuations to determine a possible acquisition price.
Comparable Transaction Analysis
This method allows for the direct estimation of a target's value by observing prices from recent acquisitions.
- The analyst identifies transactions that are comparable for the target in question. In this method, industry similar transactions are preferred.
- For example, if an analyst is looking at a potential software company merger, he/she would not review recent bank acquisition prices.
- Just like in a comparable company analysis, the analyst will identify valuation metrics.
- The analyst will then apply the valuation metrics to the target firm.
- For example, if an analyst is looking at a potential software company merger, he/she would not review recent bank acquisition prices.
This method is very attractive for evaluating M&A actions, but it can be very difficult to find truly comparable transactions and a number of adjustments may need to be made to the "comparable" transactions used in the analysis to make them relevant to the target in question.
