Valuing Target Companies

There are several widely employed methods for valuing a potential M&A target; it is not uncommon for acquirers and investment banks to employ all of them when evaluating the attractiveness of a merger.

• Discounted Cash Flow (DCF) Analysis
• Comparable Company Analysis
• Comparable Transaction Analysis

Discounted Cash Flow (DCF) Analysis

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.

1. 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.
2. 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).
3. The analyst will then apply the selected valuation metrics to the target and its “comps.”
4. 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.
5. 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.

1. 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.
2. Just like in a comparable company analysis, the analyst will identify valuation metrics.
3. 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.