Manual UBS PDF

STRICTLY CONFIDENTIAL
Valuation Handbook
A UBS guide
August 2009
Valuation handbook 2009 protected.doc
Table of contents
SECTION 1 Introduction ______________________________________________________________ 1
1.1 Introduction ______________________________________________________ 2
1.2 Principal valuation methodologies ____________________________________ 3
1.3 Pros and cons of valuation methodologies _____________________________ 5
1.4 General principles to consider _______________________________________ 8
1.5 Capital structure adjustments________________________________________ 8
1.6 ROCE vs. ROE ____________________________________________________ 10
1.7 Enterprise value (“EV”) vs. equity value_______________________________ 10
1.8 Effect of gearing on valuation ______________________________________ 11
1.9 Valuation process_________________________________________________ 11
1.10 Tips for success __________________________________________________ 12
SECTION 2 Comparable company analysis ____________________________________________ 13

2.1 Introduction _____________________________________________________ 14
2.2 Defining the numerator: enterprise value _____________________________ 21
2.3 Defining the denominator _________________________________________ 34
2.4 Pro forma adjustments for acquisitions, disposals and other corporate
transactions _____________________________________________________ 38
2.5 Some additional consideration for multiples based valuations ____________ 38
2.6 Data sources_____________________________________________________ 39
2.7 How to check efficiently ___________________________________________ 39
2.8 Common errors __________________________________________________ 40
2.9 Tips for success __________________________________________________ 40
SECTION 3 Precedent transaction analysis ____________________________________________ 41

3.1 Introduction _____________________________________________________ 42
3.2 Why do we use precedent multiples? ________________________________ 42
3.3 Premium for control ______________________________________________ 42
3.4 Choosing transactions_____________________________________________ 43
3.5 Key metrics______________________________________________________ 43
3.6 Adjustments _____________________________________________________ 44
3.7 Link to UBS model ________________________________________________ 44
3.8 Drawbacks of methodology ________________________________________ 44
3.9 Data sources_____________________________________________________ 44
3.11 Common errors __________________________________________________ 45
3.12 Tips for success __________________________________________________ 45
SECTION 4 Discounted cash flow ____________________________________________________ 47

4.1 Introduction to DCF concepts_______________________________________ 48
4.2 Free cash flow ___________________________________________________ 50
4.3 Terminal value ___________________________________________________ 54
4.4 The discount rate—Weighted Average Cost of Capital (WACC) __________ 57
Table of contents
4.5 How to discount _________________________________________________ 63

4.6 Additional things that you need to know for a DCF ____________________ 64
4.8 Data sources_____________________________________________________ 67
4.10 Common errors __________________________________________________ 68
4.11 Tips for success __________________________________________________ 68
4.12 Example of UBS model ____________________________________________ 68
SECTION 5 Leveraged buy-out (LBO) _________________________________________________ 72

5.1 Overview________________________________________________________ 73
5.2 LBO returns _____________________________________________________ 74
5.3 Understanding the components of return_____________________________ 74
5.4 Required returns _________________________________________________ 75
5.5 Management participation and impact on institutional returns ___________ 76
5.6 Typical LBO structure and components of financing ____________________ 76
5.7 LBO Modelling ___________________________________________________ 80
5.9 Data sources_____________________________________________________ 84
5.11 Common errors __________________________________________________ 84
5.12 Tips for success __________________________________________________ 85
5.13 Example of UBS model ____________________________________________ 85
SECTION 6 Alternative valuation methods ____________________________________________ 88

6.1 Sum of the parts analysis (SOTP) ____________________________________ 89
6.2 Economic Value Added (EVA)_______________________________________ 93
6.3 Dividend discount model (DDM) ____________________________________ 99
6.4 Appraisal Value (AV) ______________________________________________ 99
6.5 Special cases_____________________________________________________ 99
APPENDIX A Comps & Precedents adjustments ________________________________________ 100

A.1. Adjustments ____________________________________________________ 101
APPENDIX B Glossary _______________________________________________________________ 104
APPENDIX C Further reading _________________________________________________________ 108
SECTION 1
Introduction
1
Introduction
1.1 Introduction
This book is intended as a reference guide for IBD executives. It encompasses best practice, practical
examples, advice and generally adopted methodologies that all IBD teams can use as part of their valuation
analysis. It does not cover in-depth theoretical or academic discussion underlying valuation techniques but
rather seeks to point out the key pros and cons of the various methodologies available to us. In addition to
this document, UBS Equity Research has a team dedicated to analysing the latest developments in accounting
and valuation. Various materials are available from them in the “Valuation & Accounting” section of
researchweb, and they may be contacted (on a no-names basis) for advice as to some of the issues raised in
this document.
At UBS we approach valuation in a number of ways. Whilst these methodologies are all useful in their own
right, ultimately valuation is at least as much of an art as a science and it is important to have a proper
qualitative overlay to analysis presented both internally and to clients. Specifically, it is critical to have a full
understanding of the business being valued in order to exercise judgement in drawing conclusions from
quantitative analysis.
Nevertheless, a rigorous quantitative approach must underlie every valuation exercise we do. It is particularly
important to remember that valuations rely on forward-looking perspectives (rather than historical) and the
date of valuation is key as benchmarks or standards which are accepted as a “given” may well become
rapidly outdated.
Valuations can be categorised as follows:
 Trading valuation
– reflects the theoretical value of one share as part of a listed entity
 Transaction valuation
– reflects the value an acquirer can derive from controlling a company
 Fundamental valuation
– reflects the net present value of the cash flows of the business
The chart overleaf lists the “standard” methodologies which are used under each of the headings above and
illustrates how this is typically laid out as a valuation summary in client presentations, using a “football field”
chart. Please note that not all of these methodologies are applicable in every scenario:
SECTION 1: Introduction 2
Methodology EV 1 (GBPm)
Current price 2 57.3
12-month VWAP 50.9
52-week trading range 45.2 57.7

Trading
Analyst price targets 50.1 63.2
Comparable companies 3 55.6 62.6
Trading sum-of-the-parts (SoTP) 4 55.8 62.8
6-month VWAP plus 30–40% premium 63.4 66.4

Transaction
Precedent transactions 5 68.4 74.5
Take-out SOTP 4 66.0 72.5
Leveraged buyout (LBO) 6 60.8 63.4

Fundamental
Discounted cash flow (DCF) 7 67.4 69.2
Notes:
1 Net debt, minorities, pension obligations and other liabilities of GBP23.3m
2 As at close of 24 December 2008
3 8.0–9.0x 2008E EV/EBITDA (EBITDA GBP6.96m)
4 Based on geographic split
5 10.5–11.5x LTM EV/EBITDA (EBITDA GBP6.52m)
6 Base case IRR of c. 20–25% and exit multiple of 9.0x EV/EBITDA
7 Assuming a WACC of 8.2%, a terminal growth rate of 2.0% and an exit multiple of 8.0x EV/EBITDA
1.2 Principal valuation methodologies

Set out below are some of the key features of the principal valuation methodologies which are described in
detail in the relevant chapters.
1.2.1 Comparable company analysis (trading valuation)—Chapter 2

Objective: Compare the trading and operating performance of a company to that of its peers.
This methodology determines how the market has capitalised the earnings and cash flows of the company
and similar companies. We also analyse other parameters such as book value, leverage and margins. We
compare these ratios to the company's performance and/or use them to impute a market value for
the company.
Key points to note:
 Comparability is key, both in terms of identity of relevant peers and in treatment of financial information
across different companies
– be aware of the result from applying the multiple, e.g. applying a P/E multiple results in market
capitalisation and cannot be compared with the enterprise value obtained by applying an
EV/EBITDA multiple
 Resulting analysis does not include a control premium or a value for synergies
 Interpretation of data requires familiarity with the industry and the companies involved
 The market is not always efficient; small capitalisation and thinly traded stocks may not trade actively and
the share price therefore may not reflect fundamental value
1.2.2 Precedent transaction analysis (transaction valuation)—Chapter 3

Objective: Determine the value offered in past acquisitions of similar companies.
This methodology determines the pricing of past transactions as compared to a company’s financial
performance and unaffected market value.
Key points to note:
 Interpretation of data requires familiarity with the industry and the companies involved as there will be
very specific circumstances surrounding each transaction
 Analysis is typically based on historical data and is not forward looking
 Control premium percentages should be applied to equity values rather than enterprise values
 It should be noted that differences in the forecasts used by the buyer and seller (for instance, as a result of
a buyer taking a hair-cut to management forecasts) can result in different multiples depending on whose
perspective the multiple is calculated from (i.e. the buyer may believe it is paying a lower multiple due to
more aggressive or synergised forecasts)
1.2.3 Discounted cash flow analysis (fundamental valuation)—Chapter 4

Objective: Calculate NPV of cash flows.
Specifically, this methodology discounts the unlevered, after-tax projected free cash flow at a company's
weighted average cost of capital to obtain an economic present value of assets. We subtract debt and other
enterprise value adjustments from the present value of cash flows to derive the equity value. Sensitivities are
used to demonstrate the impact of changes in the key underlying assumptions.
Key points to note:
 Need realistic five- to ten-year projected financial statements
 Sales growth rate, margins, terminal multiples, discount rates and perpetual growth rate are key to value
 Capital structure affects value only through its impact on WACC
 DCF captures the full theoretical value of a company—it would be illogical to then apply a
control premium
 Very sensitive to terminal value, which can be quite subjective to calculate and therefore
should be sensitised
1.2.4 LBO (transaction valuation)—Chapter 5

Objective: Determine the returns available to the providers of equity under a leveraged capital structure,
assuming an eventual exit at an assumed valuation.
This methodology models a company's financial performance under a leveraged capital structure. We assume
the transaction occurs in today's borrowing environment and determine the maximum initial debt a company
can realistically repay in a timely manner. We calculate the Internal Rate of Return (“IRR”) to the equity
provider with an exit after 3 or 4 years at an assumed exit multiple. The output is sensitised to a variety of
inputs including different operating and business environment scenarios.
Key points to note:
 LBO analysis determines a relevant valuation for private equity acquirers.
 It is also relevant for strategic acquirers as it shows what competing private equity acquirers can pay.
 Sales growth rates, margins, exit multiples and interest rates are key to value
1.2.5 Other valuation methods—Chapter 6

There are numerous additional valuation methodologies which are used to supplement the 4 key techniques
outlined above. Different valuation exercises require different approaches and it is important to tailor your
approach in selecting the appropriate methodology to use. Below we highlight a number of methodologies
which are found in our analysis with varying frequency.
Sum of the Parts (“SOTP”)
A SOTP approach is taken when valuing a company which has numerous divisions which, if standalone
entities, would be valued differently. A SOTP valuation can be done either on a trading basis (by reference to
comparable listed companies), on a transaction (“break-up”) basis (by reference to precedent transaction
multiples) or on a fundamental basis (by calculating the NPV of cash flows of each separate part). The
valuations of the individual parts are added together, offset by corporate adjustments (e.g. central costs,
dissynergies created by operating divisions separately), to obtain the implied enterprise value of the company.
Economic Value Added (“EVA”)
EVA is a theoretical valuation methodology which compares the returns a company generates on its capital
against its cost of capital (which represents the economic cost of the capital employed in generating such
returns). To the extent that the returns generated exceed the cost of capital, value is “created” and we can
calculate a valuation by taking a net present value of the projected value creation over a time horizon.
Adjusted Present Value (“APV”)
The APV methodology is a variant of the DCF. It is used to calculate the net present value of a company or
project assuming it were financed entirely by equity and then adds the net present value of the effect of
using debt in the capital structure (costs/benefits, including tax shield). The APV valuation method can be
particularly effective in valuing companies with changing capital structures or extremely high growth.
Dividend Discount Model (“DDM”)
DDM is most commonly used when capital requirements are prescribed by a regulatory body for a particular
industry (e.g. banks and insurance companies) or for companies with a stable dividend stream. This approach
assumes that the return generated by a company above the required level to maintain capital ratios is paid
out to shareholders as a dividend. Such dividends are then valued into perpetuity at a cost of equity to obtain
the theoretical net present value of the equity.
Appraisal Value (“AV”)
Appraisal Value is the key methodology for the valuation of life insurance and pensions companies. It is the
intrinsic valuation methodology similar to a DCF or DDM but based on industry-specific metrics like
Embedded Value (“EV”) and Value of New Business (“VNB”).
1.3 Pros and cons of valuation methodologies

1.3.1 Comparing valuation methodologies
Clients are accustomed to seeing valuation presentations which utilise the four principal methodologies. This
reflects the need both to triangulate to a “fair” valuation range and the practical applications of our
valuation methodologies. For example, if we are asked to value a subsidiary for a potential divestment, we
need to look at a number of possible scenarios:
 Multiples for comparable quoted companies (divestment through a demerger or IPO)
 Multiples of precedent transactions in the sector (divestment through a sale to a strategic or
financial purchaser)
 LBO (divestment through a sale to financial purchaser)
 DCF (theoretical value of cash flows to the owner of the company)
Each of these methodologies could result in a different valuation range and requires appropriate qualitative
overlay to judge the likelihood of any given outcome for our client.
For example, in an industry with significant overcapacity, there might well be significant synergies with a
trade buyer, who ought to be able to pay good price.
On the other hand, there may be few likely buyers but favourable equity market conditions which might
make an IPO not only possible but the means of achieving best value.
A DCF valuation is often used as a cross-check for other valuation methods. However, on some occasions, it can
be the most (or indeed the only) appropriate method to use—for example in the case of a project with finite
cash flows, or a wasting asset such as a mine or a pharmaceutical patent. In addition, the reliance placed to a
DCF valuation may increase if there is a lack of comparable transactions or companies (for example, when
Eurotunnel was floated, the bankers working on that deal had no real relevant comparable companies and so
based most of their analysis on DCF methodologies). DCF is also useful for companies seeking to evaluate
potential acquisitions and particularly whether the price they might pay is justified by all of the cash flows of the
deal (including synergies, additional costs incurred etc) when discounted at a specific hurdle rate.
Method Pros Cons

Comparable  Market efficiency should ensure that  Truly comparable companies are
quoted trading values reflect industry trends, rare and differences are difficult to
companies business risk, market growth, etc account for
analysis  Values obtained should be a reliable  Results can be distorted by stock
indicator of the value of the company market sentiment or fluctuations
as a listed entity  Stocks with a small capitalisation, low
 Possible to take into account liquidity in the market and/or limited
Relative valuation methods
expectations of future performance broker coverage may not fully reflect

 Well understood methodology and appropriate value in their share prices
primary driver of most public company
analyst valuations
Precedent  Reflects value that purchasers have  Past transactions are rarely directly
transactions been prepared to pay for control of comparable either due to company
analysis “similar” assets specific factors or the fact that
 “Real” benchmark in the sense that acquisitions happened at a different
past transactions were successfully point in the cycle
completed at certain prices  Public data on past transactions can be
 Indicates a range for premia offered incomplete, non-existent or misleading
(for quoted companies only)  Typically based on historic financial
 Trends, such as consolidating information for target companies—
acquisitions, foreign purchasers, or full analysis around expected future
financial purchases may become clear performance is required
Discounted  Reflects “fundamental” value of a  Valuation is highly sensitive to

cash flow company’s cash flows underlying assumptions for cash flows,
analysis  Less influenced by public market terminal value and discount rate
(“DCF”) conditions which can be volatile  Terminal value often represents a
 Forward-looking cash flow based significant proportion of total value
analysis, less affected by  Values obtained can vary over a
accounting rules wide range and thus may be of
 Can be used when there are no limited usefulness
comparable transactions or multiples  Involves forecasting future
data or if entity is not profit making in performance, which is
the short term inherently subjective
 Good communication tool: clearly  Often viewed as subject to
Absolute valuation methods
identifies business and financial “manipulation” of assumptions and

value drivers therefore less reliable
 May be particularly useful for projects
with finite cash flows or wasting assets,
such as mines
 Synergy values can be built in by
modelling their cash flows
 Allows a valuation of different
components of a business
 A reverse DCF can also be used to
calculate the implicit assumptions used
by the market in arriving at a current
trading price
Leveraged  Provides a valuation that is independent  Standalone LBO will underestimate

buy-out of stock and M&A markets strategic sale value by ignoring
analysis  Determines value that a private equity synergies with acquirer
(“LBO”) firm is theoretically able to pay  Value obtained is sensitive to
projections, aggressiveness of
operating assumptions and views on
exit multiple
1.4 General principles to consider
1.4.1 Price vs. value

 There is a difference between price and value. Value can be derived from the analysis undertaken with an
appropriate qualitative overlay as described in this handbook. Price, however, is the amount of money a
buyer is actually willing to pay for any asset. As we often see in negotiations, the two quite often
lie apart!
 In practice, the "ceiling" price that an acquirer may be prepared to pay for an asset is often assessed by
reference to the impact of the acquisition on the acquirer from multiple perspectives of EPS enhancement,
return on investment (compared to cost of capital or a specified hurdle rate) and value creation (typically
calculated as the value of synergies net of costs to achieve and any premium paid to effect the acquisition)
 Acquirers typically use these reference points to justify the price paid in transactions. However, they do
not always reflect underlying “value” as they rely on numerous external factors:
– an acquisition funded by debt will be EPS accretive if the P/E of the acquired equity is lower than the
P/E of acquisition debt (calculated as the inverse of the post-tax interest cost). This is typically the case
in normal credit markets except for exceptionally highly-rated companies
– an acquisition funded by equity will be EPS accretive if the target’s P/E is lower than the acquiror’s
– an acquisition will be value enhancing if its post-tax return on investment is in excess of the reference
cost of capital and this does not necessarily correlate with EPS enhancement
1.4.2 Trading value vs. transaction value

We most commonly undertake valuations to find:
 Trading (stock market investment) value: the value of a company as if it were publicly listed;
effectively the price of a single share multiplied by the number of shares in issue
 Transaction value (assuming a change of control): the value of buying an entire company or a
controlling stake in it
 Value of a “strategic stake”: the value of a large but non-controlling stake
1.4.3 Control premium

This represents the difference between trading value and transaction value of the equity of the business.
It reflects the value that a buyer can extract by owning and controlling the company and its cash flows.
1.4.4 Ensuring a consistent approach (numerator vs. denominator)

Regardless of the methodology, it is critical that the denominator and the numerator of the calculation are
fundamentally consistent with one another. For example when using multiples with enterprise value as the
numerator (reflecting the market value of the capital employed in the business, including both equity and
debt) the denominator should encapsulate the return to all of the providers of such capital (e.g. EBITDA or
EBIT – a profit measure before deducting interest, or the return to debt providers). Equally when using
multiples based on market value (reflecting the value of the equity capital) the denominator should
encapsulate an equity return. As such it is meaningless to show a multiple of EV/net income or equity
value/EBITDA as the output will not reflect the capital structure of the company.
This principle of consistency holds true for all types of adjustments such as pension deficits or leases both in
the context of valuation multiples and also in calculating returns to capital providers (i.e. ROCE, ROE etc).
1.5 Capital structure adjustments

The principle of consistency means that we need to be sure what is equity and what is debt in the capital
structure of the company being valued. It can sometimes be more difficult to establish this if the company
has instruments or securities which combine features of both debt and equity (“hybrids”). One general
principle in determining whether a given instrument is equity or debt is to establish the order of priority of
claim on the company’s cash flows (i) in a "normal" going concern situation, and (ii) in extremis, for example
in a liquidation scenario. Equity typically has a subordinate claim on cash flows (i.e. dividends are only paid
out after interest has been paid to debt providers) and debt has a senior claim.
1.5.1 Debt
Debt should be included in the capital structure at its market value. In the majority of cases this will simply be
equal to book value shown on the balance sheet, but for companies with long dated bonds that were issued
in a different interest rate environment, or for companies in financial distress, an adjustment to market value
should be made.
1.5.2 Existence of convertible securities, warrants and options

We need to consider the likelihood of conversion into equity. For example, if a company’s shares are trading
at 100p and the conversion price is 150p, the convertible is out of the money (“OTM”) and should be treated
as debt. However, if the share price/valuation is much closer to the conversion price, there may be a case for
arguing that we should treat the instrument as if it has converted into equity. Alternatively, if a quoted
market value is available for such an instrument, this should reflect the fair value of the instrument as either
debt or equity as appropriate albeit without factoring in a change of control.
1.5.3 Preference shares

Regular preference shares without equity features would typically be included in the capital structure at their
market value. If the preference shares are listed, this value may be observable in the market. If not, it can be
derived by discounting back future preference dividends at a rate representing the yield on similar
instruments which are listed. Preference shares with votes attached may well have an increased value relative
to non-voting preference shares.
Preference shares if convertible into ordinary equity may also be considered in the same way as a convertible
bond. Equally there may be a case for treating non-convertible preference shares as equity if they are
perpetual or have a feature allowing the issuer to defer interest payments.
Ultimately, judgements need to be made on a case by case basis depending on the facts of the situation.
1.5.4 Other debt-like liabilities

We also need to consider liabilities which may not appear on the face of the balance sheet; e.g.:
 Off-balance sheet structures where the share of attributable net assets is consolidated but not the share
of debt (e.g. a joint venture where the debt is not consolidated)
 Contingent liabilities (e.g. warranty claims on sales of businesses, environmental, litigation) which may be
near to crystallising
 Deferred payments (e.g. on acquisitions with earn-out formulas) that may crystallise
 Pension deficits which may have to be made whole in the event of a change of control or wind-up
1.5.5 Leases
Companies frequently have a choice as to whether to own or lease assets used in its business. If the asset is
owned, this is reflected by the debt or equity on its balance sheet which has been raised to purchase the
asset and through the depreciation in its P&L. Alternatively, if a company operates with a number of leased
assets, it will have lower debt but a lease charge flowing through the P&L. To compare two such companies
(asset owner vs. lessee) we need to adjust the balance sheet, capitalising the rents, thereby reflecting a truer
picture of the capital structure of the businesses.
1.5.6 Minority interests

If a company has a subsidiary which it does not 100% own and is material to the group, it is best to value
such a subsidiary as a stand-alone entity, and then attribute the pro-rata share of its value to the parent
group (rather than simply taking the book value of such minority interests). We should remember that, when
a group has a partly owned subsidiary, it does not have direct access to the cash flows and assets, usually
does not have unfettered rights of management control, and there may be restrictions on its ability to sell the
stake. While a controlling stake of 60% should have a value higher than 60 stakes of 1% each, the above
factors need to be taken into account in the valuation of the 60% stake attributable to the group.
Alternatively, where less information is readily available, consider applying a P/E multiple to the total minority
interest in the P&L. This is likely to be more accurate than book value.
1.6 ROCE vs. ROE

In valuing a company, it is helpful to consider the returns that it makes and delivers to its capital providers.
This can be compared against returns generated by similar companies and is also a means of benchmarking
whether a business plan is realistic or aspirational. Ultimately, these returns can, in theory, be compared with
the company’s cost of capital and assessed to determine whether the company “creates value”. The two
return metrics typically referenced are return on capital employed (“ROCE”, sometimes referred to as Return
on Invested Capital (“ROIC”)) and return on equity (“ROE”). Both are referenced to book value of capital and
so the results must be considered carefully, particularly if there are accounting impacts on book value. As
such, they must be cross-referenced with other benchmarking and valuation methodologies to ensure that
they do not generate a skewed result.
ROCE is the return a business generates on its total capital employed. Capital will include all sources of
funding (shareholders funds + debt). To be consistent with this the return should be taken prior to interest
(the return to lenders) and can be shown pre or post tax:
EBIT ÷ (average shareholders funds + net debt) = ROCE pre tax
(EBIT x (1-tax rate)) ÷ (average shareholders funds + net debt) = ROCE post tax
It is a measure of the profit earned by the business irrespective of the capital structure.
ROE is the return a business generates only on its equity capital. It is impacted by the level of debt but is
normally higher than ROCE (companies typically generate greater returns on their equity than the interest
rate they pay on their debt).
Net income ÷ average shareholders’ funds = ROE
The DuPont formula, also known as the strategic profit model, is a common way to break down the ROE into
three components: profit margin, asset turnover and equity multiplier.
ROE = (Net profit ÷ sales) * (sales ÷ assets) * (assets ÷ equity)
This analysis allows identifying where superior return is derived from by comparison with companies in similar
industries or between industries. Certain industries will rely on high profit margins (e.g. fashion), others on
high asset turnover (e.g. retailers), whilst others on high leverage (financials).
The best way to analyse debt is to look at the historical trend in debt financing compared to the trend in ROE
to see whether a company has maintained a level of ROE by increasing its debt. This could indicate that a
company is compensating for declining profit margins and increased asset efficiency with more debt to
maintain the same level of shareholder return.
When calculating both ROCE and ROE it is usually more accurate to calculate an average denominator for the
calculation to reflect changes during the year in which the relevant return is generated. Also ensure the
numerator and denominator treat minority interest consistently, i.e. either net income and equity including
minority interests or excluding it.
1.7 Enterprise value (“EV”) vs. equity value

Enterprise value represents the total value of a business/enterprise to all providers of capital (debt,
minorities, preference, equity).
Equity value represents the value to the providers of equity, after net debt, minorities and preference shares
have been deducted.
This concept is critical to valuation in terms of ensuring that we adjust for capital structure (see section 2.2 for
a detailed discussion of EV).
1.8 Effect of gearing on valuation

Two companies with the same EV can appear to be valued very differently, if we do not take into account
their capital structures.
Consider the following example:
A B
Low debt High debt
Market cap 90 50
Net debt 10 50
EV 100 100
The EV is the same, so, if the companies generate the same EBITDA, the EV/EBITDA multiples will be the
same. However, if you use an equity value multiple, you get a very different picture. This needs to be taken
into account when comparing P/E multiples across companies.
A B
Low debt High debt
EBITDA 20 20
D&A (5.0) (5.0)
EBIT 15.0 15.0
Interest (1.0) (5.0)
PBT 14.0 10.0
Tax @ 30% (4.2) (3.0)
Net income 9.8 7.0
EV/EBITDA 5.0x 5.0x

P/E 9.2x 7.1x
Note that company B pays less tax due to the tax shield on its debt.
 EV multiples (e.g. EV/EBITDA) for companies with identical operations will be the same regardless of
capital structure
 Equity multiples (e.g. P/E or RoE) do not take account of the level of debt in the business, and
consequently will result in different equity values for identically operating businesses. Furthermore, the
two companies will have different earnings due to the level of interest and tax shield on this interest, and
thus the equity multiples will differ. Additionally, the multiples will be more susceptible to distortion as a
result of accounting differences (e.g. depreciation policy)
Returns are most often measured by RoE and ROCE. The former measures the return on the shareholders’
funds only. In order to take debt into account, ROCE is used, which measures the return on the total capital
employed, the sum of shareholders’ funds and net debt (see Section 1.6 for detailed discussion).
1.9 Valuation process

A comprehensive valuation exercise requires a consistent set of steps:
 Thorough understanding of the business to be valued
 Understand where appropriate adjustments may be necessary e.g.
– non-recurring items
– pro forma adjustments to reflect recent changes such as acquisitions or disposals
– quantification of change in cost structure under new ownership (if business is being sold)
 Production of pro-forma profits/cash flows
1.9.1 Quantitative factors

As emphasised earlier, at the heart of any valuation is a rigorous mathematical framework and it is essential
to define the required parameters and inputs accurately:
 Comparable companies (relevant population)
 Comparable transactions and appropriate premia
 DCF data (cash flows, WACC, terminal value)
 LBO (cash flows, terminal value, capital structure, required rates of return etc)
The valuations do not take account of qualitative factors unless assumptions reflect such factors (e.g.
increased competition in the industry leading to lower margins over time).
1.9.2 Qualitative factors

To the extent that qualitative factors have not been reflected in the profits, cash flows or other assumptions
in the mathematical framework, the numerical output must be considered in the appropriate context when
presenting a valuation range to clients. Such qualitative factors can include:
 Quality and likely future performance of the business relative to comparable quoted companies and
precedent transactions
 Strategic value to an investor
 IPO market conditions and likely impact on IPO valuation
 Number, type (trade or financial sponsor) and mindset of potential purchasers
 Importance of incumbent management to valuation
 Likely availability of debt financing for potential purchasers
 Contingent and other liabilities to the extent not captured in the mathematical framework
1.9.3 Exercise of judgement in triangulating for the “right” answer

 In determining advice in respect of a “fair valuation”, the quantitative and qualitative factors must be
drawn together to come to a “view”
 Typically we “triangulate” to the most appropriate answer placing different weightings on the various
factors to be considered
 As such, a series of judgments have to be made which can shade valuations up or down
 This process may include running the evaluation of multiple scenarios in order to understand possible
outcomes (e.g. expected, pessimistic or optimistic scenarios), sensitivity analysis, and/or reliance on mere
“gut feel”, based on experience
 Often a process of “trial and error”, sense checking and group discussions are needed in order to finalise
our advice
1.10 Tips for success

Each section in this handbook points you to specific common errors and tips for success but if you want to
produce high quality analysis, adopt the following principles and you can’t go too wrong:
 Source and tag everything so there is a clear audit trail
 Check and re-check
 Ask yourself the difficult questions (and find answers!) before someone else does
 Ensure consistency between methodologies, data sources and within calculations
 Triangulate
 Do not be satisfied with output that looks odd
SECTION 2
Comparable company analysis

2
SECTION 2: Comparable company analysis 13

Comparable company analysis

2.1 Introduction
This analysis is used to compare the trading and operating performance of a company being valued to that of
its peers. The economic rationale underlying this method is the theory of efficient markets which infers that
similar assets should have a comparable value (i.e. should trade at similar multiples). Specifically, we seek to
understand how the market has capitalised the earnings and cash flows of similar companies and to analyse
other parameters such as operating ratios, book value, leverage and margins in order to put the analysis in
context. This context allows us to determine the level of comparability between companies and the relevance
of applying a given multiple to the company being valued.
Comparable company analysis is very well understood and largely relied on by equity investors and analysts as
a primary valuation tool. It has the advantage of using market-derived data which should ensure that trading
values reflect the very latest information on industry trends, business risk, market growth whilst taking into
account estimates of future performance. The main drawback is that truly comparable companies are rare
and differences can be difficult to account for.
When using comparable company analysis, it is vital to remember the principle of consistency and to adjust
financial inputs so that they are shown on a pre-exceptional basis.
2.1.1 Benchmarking
Benchmarking is used to compare performance against peers and “absolute standards”. Once a company’s
performance has been classified against its peers, we are able to place it in context and apply appropriate
valuation metrics.
Different industries use different valuation metrics and value drivers to benchmark the performance of
companies against one another. Below are some of the most common measures used:
 Key performance indicators including growth, margins and returns
 Valuation multiples including EV/Sales, EV/EBITDA, EV/EBITA, P/E and EV/FCF
The table below shows typical output from a comparable company analysis. Remember that benchmarking
can be sector-specific and it is important to consider more specific operational metrics where data is available.
EV 1/(EBITDA- Revenue EBITDA

(Dec Y/E) Price % of Market Enterprise EV1/revenue EV 1/EBITDA Capex) P/E growth margin
10-Apr-09 52-week value value CY 08 CY 09 CY 08 CY 09 CY 08 CY 09 CY 08 CY 09 CY 08 CY 09 CY 08 CY 09
Company name (€) high (%) (€bn) (€bn) 1 (x) (x) (x) (x) (x) (x) (x) (x) (%) (%) (%) (%)
Centrica PLC 2.5 75 13.0 15.5 0.7 0.6 5.7 4.8 7.6 5.5 12.7 9.8 30.6 1.0 11.5 13.5
Cez A.S. 29.8 57 16.0 18.9 2.7 2.6 5.6 5.4 11.4 8.8 9.1 8.3 4.1 7.4 49.5 47.4
Drax Group PLC 5.9 62 2.0 2.3 1.2 1.5 4.0 5.7 4.9 7.9 5.4 8.0 40.5 (20.0) 29.1 25.8
Electricite de France S.A. 31.4 44 57.1 131.4 2.0 2.0 8.8 7.5 24.2 nm 13.4 11.7 7.8 4.2 23.2 26.1
Energias de Portugal S.A. 2.8 66 10.2 28.1 2.0 2.3 9.0 8.5 nm 45.9 9.2 11.3 26.2 (10.4) 22.5 26.6
EnBW AG 36.2 67 9.5 16.9 1.0 0.9 6.8 6.5 13.6 13.7 10.5 8.3 10.8 9.2 15.3 14.6
Endesa S.A. 15.3 53 16.2 36.4 1.6 1.8 5.0 5.3 4.5 12.3 7.1 6.7 28.8 (9.7) 31.8 33.4
Enel S.p.A. 3.9 53 24.0 89.0 1.5 1.5 6.5 5.9 13.4 11.2 4.7 6.5 13.1 (3.8) 22.4 25.5
E.ON AG 23.1 50 44.0 92.8 1.0 1.1 10.6 6.7 nm 24.0 47.0 8.0 25.6 (1.8) 9.8 15.9
Gas Natural SDG S.A. 11.0 32 9.9 15.0 1.1 1.3 5.9 5.8 10.3 40.9 4.7 6.4 34.1 (14.2) 18.5 22.1
GDF Suez 23.8 53 52.3 98.4 1.2 1.2 7.3 7.0 33.4 32.2 11.0 9.6 11.9 (3.8) 16.2 17.7
Iberdrola S.A. 5.7 58 27.8 64.2 2.5 2.5 9.8 8.5 18.9 11.9 11.3 10.2 5.0 3.5 26.1 28.9
International Power PLC 2.5 50 3.8 11.2 2.9 2.9 9.1 7.7 11.9 8.8 7.9 7.5 28.4 (0.6) 32.1 38.1
RWE AG 55.9 64 31.4 47.4 1.0 1.0 5.7 5.4 12.3 13.1 11.4 8.3 15.2 (1.1) 17.0 18.0
Scottish & Southern PLC 11.6 68 10.7 15.6 0.9 0.9 8.9 8.0 23.5 17.9 10.2 9.4 8.8 0.9 10.1 11.1
Mean 1.6 1.6 7.2 6.6 (11.8) 18.1 11.7 8.7 19.4 (2.6) 22.3 24.3
Median 1.2 1.5 6.8 6.5 12.1 12.7 10.2 8.3 15.2 (1.1) 22.4 25.5
Source: Company fillings and consensus estimates
Notes:
1 Enterprise value = fully diluted market value + debt outstanding – cash; assumes in-the-money convertibles are equity
2 “nm” denotes EV/revenues multiples greater than 10x or negative, EV/EBITDA multiples greater than 50x or negative and P/E multiples greater than 50x or negative

2.1.2 Value drivers
2.1.2.1 Growth
Growth is often seen by equity markets as a key driver of valuation. As such we compare sales, profitability
and cash flow growth of comparable companies. Benchmarking a company’s growth relative to industry
peers is a key input in determining relative performance. Typically we consider compound annual growth
rates (“CAGRs”) for a period of 3–5 years or more, in order to eliminate year on year inconsistencies and to
capture medium term trends.
The formula for calculating CAGR is as follows:
(Year “n” value ÷ Year 1 value) ^ (1 / n) – 1
2.1.2.2 Margin
The ratio of profits to revenues for a company or business segment shows how much of each dollar of
revenue generated by the company is translated into profits. Margins will vary from company to company,
and certain ranges can be expected from industry to industry, as similar business constraints exist depending
on both structural (e.g. ability to charge higher prices) and asset ownership distinctions (e.g. asset ownership
vs. operating leases). Key ratios are EBITDA and EBIT margins although where leases or rental expenses form
a significant part of the capital structure, EBITDAR margins should also be compared. High margins
sometimes attract a higher valuation multiple because they indicate a high quality, robust business that will
be sustainable in a downturn, but this logic does not always follow, e.g. a low margin might mean an
opportunity to cut costs and achieve high profit growth, therefore justifying a high current valuation multiple.
2.1.2.3 Return
ROCE and ROE are both measuring returns of a company. ROCE gives a sense on how well a company is
using its money to generate returns and ROE reveals how much profit a company generates with the money
shareholders have invested (see section 1.6 for formula). It should be noted though that these measures are
subject to the various accounting policies of the company, and therefore subject to manipulation.
Cross sector comparison is not meaningful given that asset intensity can vary significantly. For example, an
aircraft manufacturer needs more assets than a software company. However, whatever industry the company
is in, it must strive for a ROCE (with capital marked to market) in excess of the targeted return, often
WACC—otherwise the company is theoretically destroying rather than creating wealth.
Similarly, the ROE should not be used to compare companies in different businesses. It is normally lower in
capital intensive businesses. The comparison can also be distorted by different financial structures: a more
heavily indebted company would have a higher ROE for example, as illustrated in the formula in section 1.6.
A clear example of this occurs when companies engage in a sale and leaseback of assets (most often
property). They are able to return the capital raised by selling the assets. This reduces shareholders funds,
increasing ROE. However, the company then faces additional fixed costs which both reduce profit and
increase operational gearing.
2.1.2.4 Sector specific value drivers

Below we list some examples of value drivers used in different sectors/industries:
Healthcare
Hospitals
 Revenues or EBITDAR/number of beds, maintenance capex/sales (measures how much the company needs
to spend to keep their operations running)
Biotech
 Technology value: calculated as “market value less cash” and shows how strongly investors believe in the
pipeline products of the company
Consumer products and retail

 Revenues or EBITDA/plant or factory (in agriculture, typically calculated as Revenues or EBITDA/hectare),
revenues/employee, sales/EBITDAR, sales densities, like-for-like growth

Infrastructure
 EBITDAR/fleet: measures the return the company generates on the fleet employed (at either substitution
or replacement cost)
Energy
Integrated companies and/or E&P (Exploration and Production)
 Total production measured in millions or thousands of barrels of oil equivalent ("boe"), 1P reserves
(mmboe), 2P reserves (mmboe), Reserve life (production over reserves, years), Production growth, F&D
(Finding and development) costs (US$/boe), Total replacement costs (US$/boe), RRR (Reserve replacement
ratio) as % (both shown as incl. and excl. acquisitions/disposals), EV/DACF (applicable to integrateds)
Leisure
Gaming
 Offline = admissions, spend per head
 Online = active customers, new active customers, yield per active customer, cost per customer acquisition
Hotels
 Occupancy, ARR (average room rate), RevPAR (revenue per available room, a function of occupancy and
room rate)
Cruise
 Occupancy, net revenue per diem (pricing per actual berth day sold), net yield (net revenue per available
berth day, a figure similar to RevPAR in that it takes into account price and utilisation)
Restaurants
 Like for like sales, spend per head and roll-out of new restaurants
Pubs
 Beer volumes, wet sales per head, food spend per head, rental income from pub tenants
Theme parks
 Visitors, average admission price, in–park revenue per capita
Travel
 Capacity (i.e. holiday packages on offer), load factor (a measure of how efficiently the airline capacity is
used), average spend per package and average cost per package
Fitness
 New member sales, attrition %, average member sales, membership income per head, secondary spend
per head
2.1.3 Valuation multiples
2.1.3.1 Why do we look at different multiples?

Evaluating simply one type of multiple (e.g. EV/EBITDA) will not necessarily capture the whole picture. For
example, differences in capital structure, growth rate, cash flow generation, capital intensity etc may not be
fully reflected in such a “two-dimensional” analysis. In order to come up with a more considered view, we
factor in many multiples across the capital structure and over a number of time periods. There are a wide
range of multiples available including capacity measures (for example EV/number of beds for hospitals) and
other industry specific measures. Multiples can also be applied to cash flow metrics and this is becoming ever
more popular amongst equity analysts given an increasing focus on the ability of a company to generate
sufficient cash flow to fund itself.
Overleaf we analyse the most commonly used multiples.

2.1.3.2 EV/sales
This a valuation measure that compares the enterprise value of a company to the company's sales. It gives
investors an idea of how much it costs to buy the company's sales.
Pros
– the least susceptible to accounting differences as revenue is not easy to manipulate or distort
– particularly relevant in cyclical, distressed and high growth industries or start up companies (e.g.
technology) where near term profits may not reflect the true measure of a business’s potential
– usually not as volatile as other multiples
Cons
– it can be a crude measure that does give an indication about the profitability of a company
– does not capture differences in cost structures across companies
2.1.3.3 EV/EBITDA
EV/EBITDA is the most commonly used multiple as it is unaffected by a company's capital structure. It
compares the total value of a business including debt capital, to earnings before interest, tax and D&A and
avoids problems of different accounting policies for depreciation and amortisation.
Pros
– EBITDA is often seen as a “proxy” for cash flow
– useful comparing firms with different degrees of leverage
– is not distorted by situations where capex is historically at a different level to that forecast
– less susceptible to distortions as a result of accounting differences (compared to P/E)
Cons
– there are industries which experience differing levels of capital intensity (high capex/working capital
requirements) and EV/EBITDA multiples do not capture such features
– EV/EBITDA may give misleading answers when comparing companies from different jurisdictions as it
does not pick up differences in tax rates
2.1.3.4 EV/EBITA and EV/EBITDAR

EV/EBITA can be more comparable than EV/EBITDA where capital intensity differs as it captures some degree
of capex through stripping out depreciation (i.e. implicitly making the assumption that depreciation is equal
to maintenance capex) but it can be affected by differences in depreciation accounting policies.
EV/EBITDAR is typically used where leases or rental expenses are material and form part of the
capital structure.
It is advisable to use EBITA (or EBITDA) rather than EBIT because goodwill amortisation and amortisation of
purchased intangibles is purely an accounting measure and not a cost to the business. Other forms of
amortisation will have to be considered on a case-by-case basis. For example, in the film and television
industry, programming amortisation is arguably a regular business cost which should therefore be deducted
from EBITA even though it features in the P&L as intangible amortisation.
2.1.3.5 Price/Earnings (“P/E”)

Historically, P/E has been a key driver of equity valuation as it shows how much investors are willing to pay
per dollar of earnings. It is calculated by dividing the current share price of the company by the earnings
per share (“EPS”).
Pros
– most commonly used valuation method
– earnings encompasses all factors within the P&L which affect the return achieved by shareholders

Cons
– different companies in the same sector may have different accounting policies/rules, which may distort
earnings after tax and lessen comparability of P/E across companies
– one-off expenses or income may suppress or increase earnings, distorting your view of the company’s
long-term profitability. It is therefore important to adjust earnings for any non-recurring,
extraordinary items
– a company’s leverage (amount of debt) can affect earnings but is not a driver of the
long-term profitability
– earnings can be negative even for companies which have positive value, in which case P/E is
meaningless
– can be difficult to ensure comparable number of shares are used (e.g. basic/diluted, year-end/average)
2.1.3.6 EV/FCF or EV/OpFCF

These multiples are becoming increasingly popular as a valuation input as they capture many of the features
which undermine the comparability of other multiples such as Capex and working capital requirements.
When these two items are particularly important in terms of value, it is important to compare the EV to the
FCF to ensure those are taken into account.
Free cash flow is the cash left for a company to spend at its discretion (reinvest, payout as dividends, pay
debt, etc). It's a purer measure of strength than net earnings, which are easily manipulated. The numbers to
calculate FCF are found on the cash flow statement (a more detailed calculation is provided in Section 4):
FCF = Cash from operations – capital expenditures (property, plant and equipment)
Pros
– cash flow is harder to manipulate than earnings
– reliance on cash flow rather than earnings handles the problem of differences in the quality of
reported earnings
– ultimately, a business is worth the cash it generates rather than the profits it reports under a particular
set of accounting rules
Cons
– cash flow can sometimes be more volatile depending on the industry and the cycle
– do not benefit from the accruals concept used by accountants in producing the P&L which matches
the timing of revenues and costs
It is important to try to strip out growth capex (e.g. one off expenditure on a new factory) in order to get to a
sustainable figure for FCF.
2.1.3.7 Price to book multiple (“P/B”)

This ratio is used to compare a stock's market value to its book value. It is calculated by dividing the current
closing price of the stock by the latest quarter's book value per share. This ratio is also known as the
"price-equity ratio."
P/B Ratio: Stock Price / Shareholders Equity per share
Pros
– book value is theoretically more stable than earnings, so it may be more useful when earnings are
volatile or negative
– does not reflect the role of intangible economic assets such as human capital

Cons
– should only be used in asset-heavy industries (e.g. real estate or banking)
– can be misleading when there are significant differences in the asset size of the company because in
some cases the company’s business model dictates the size of its asset base (e.g. outsourcing)
– different accounting conventions can obscure the true value; inflation and technological change can
cause the book and market value of assets to differ significantly
In some industries, intangible assets are excluded from shareholders equity in order to arrive at P/B. This in
particular excludes the impact of goodwill arising from acquisitions.
P/B will be more useful to the extent that assets are subject to regular revaluations, for example in the real
estate industry.
2.1.3.8 EV/Capital employed

EV/Capital employed reflects the premium or discount that the market applies to a company’s capital. As
such it is a measure of whether a company is seen to be creating value. It can be a good valuation metric as it
captures the whole capital structure but can be affected by accounting which impacts the level of the
denominator, and hence needs to be treated with care.
Capital employed is usually represented as total assets less current liabilities, or non-current assets plus
working capital. It is the sum of sources of long-term funds.
Capital employed = Shareholders funds + Gross debt
Pros
– reflects the value that investors attribute to the total capital invested in the company – in theory
capturing the return that the company is able to generate
– useful for sectors where tangible assets are key
Cons
– depends on accounting policies, which can distort the true value of the assets
2.1.3.9 EV/Capacity measures

These are a useful cross-check but in some industries can be the principal yard-stick. Reference can be made
to the below multiples per sector:
Mining
 EV/Resource: EV divided by Mineral Resources (typically Measured & Indicated) in terms of contained
metal (for base & precious metals) or tons of ore (coal, iron ore)
 EV/Reserves: EV divided by Mineral Reserves (Proven & Probable) in terms of contained metal (for base &
precious metals) or tons of ore (coal, iron ore)
 EV/Production: EV divided by target production capacity (typically only used for comparing development
projects and optional to include capex)
 P/NAV: Price over broker net asset value to assess valuation premium (for all gold, silver and platinum
companies) or discount (again mostly for development companies)
Paper and Packaging

 EV per tonne: EV divided by capacity volume measured in tonnes
Infrastructure
 EV/Fleet: EV divided by the value of the fleet (at substitution or replacement cost)
Telecoms
 EV per line or POP

Energy
Integrated and/or E&P (Exploration and Production)
 EV/Reserves (shown in US$/bbl), NAV per share, Share price premium/(discount) to NAV, EV/DACF
R&M (Refining and Marketing)
 EV/Capacity (refining capacity in US$/bbl)
 EV/Complexity barrels (in US$/bbl): Complexity barrel calculated by multiplying capacity (bpd) by Nelson
complexity index and divided by 1 million
OFS (Oilfield services)
 EV/backlog
Valuations by reference to such measures of production capacity effectively assume that certain “normal”
profit margins on the relevant operations can be obtained.
2.1.3.10 Importance of looking at value over the economic cycle

It should be noted that comparable companies analysis (and any multiples-based valuation) is based on
current market valuations at the time the analysis is performed. Therefore, when using comparable company
analysis in order to assess long term or future value (e.g. for calculating exit values for LBOs or terminal values
for DCFs), it is extremely important to ensure that the multiple reflects the longer-term expected multiple at
that time. This is particularly important in cyclical industries where valuation multiples can change
substantially over time.
The standard way of adjusting longer-term multiples is to calculate the average multiple at a number of
points in time over at least one, but ideally more economic cycles.
Analysis of EV/EBITDA multiples over last economic cycle (example)
10
8
Average = 7.6
6
EV/EBITDA (x)
0
2003 2004 2005 2006 2007 2008 2009
EV/EBITDA multiples for each year can be calculated as the EV at year-end divided by the following year’s
EBITDA, or the EV at the mid-year divided by the average of the current and following year’s EBITDA, in either
case it is important to footnote the methodology used.
This should then be supplemented with qualitative information regarding the current stage of the cycle, and
whether there are any exceptional events in past cycles which skew the results. All judgements of this type
should be flagged at the highest level of your deal team given the significant impact on value they have.

2.2 Defining the numerator: enterprise value
2.2.1 Key components of enterprise value

Enterprise value (EV) is the value of the underlying business operations, or otherwise expressed, the total
value of a business/enterprise to all providers of capital, not just the providers of equity.
EV is the aggregate value of all the various claims on enterprise profits and cash flows. These are
 Equity value
 Net debt
 Minority interests
 Pension deficits
 Off-balance sheet items
 Other, case-specific items
EV = equity value + net debt + minority interests + pension deficit

+ off-balance sheet items + other debt-like items
Below we consider each of these items in turn
Enterprise value calculation—illustrative output
Off-
balance
sheet Non-core
items assets
(inc.
Pension
associate)
deficit
Minority
interests Total
enterprise
Net debt value
Core
enterprise
Equity value
Value
2.2.2 Equity value

Equity value represents the value to the providers of equity, after the values of debt, minorities and
preference shares have been deducted. For listed companies, the equity value can be observed as the market
capitalisation reflecting the price investors are willing to pay for a share of the company.
In calculating the fully diluted equity value of the company options, warrants and convertible debt or
convertible preferred shares must be considered. Fully diluted equity value considers the worst case scenario
for investors, assuming all potentially dilutive securities are converted.

2.2.2.1 Options and warrants

Share options and warrants are dilutive only when their exercise price is less than the current market price of
the stock. If this is the case, they are said to be “in the money” (“ITM”) as opposed to “out of the money”.
(“OTM”) if the strike price is above the current market value. Dilutive share options and warrants theoretically
increase the number of common shares outstanding. This increase is typically calculated using the
treasury method.
This method is generally accepted as capturing the dilutive effect of ITM options and warrants as it accounts
for the hypothetical cash generated by the exercise of options and/or warrants. It assumes that the
hypothetical proceeds that a company receives from an ITM option exercise are used to repurchase common
shares in the market. The net new shares that are potentially created is calculated by taking the number of
shares that the ITM options purchase, then subtracting the number of common shares that the company can
purchase from the market with the option proceeds. The net new shares are added to the basic shares
outstanding to get the fully diluted shares which are used to calculate the fully diluted equity value.
Example:
Current share price US$50
Shares outstanding 400m
Options/warrants outstanding 10m
Exercise price US$25
Proceeds from conversion 10 x US$25 = US$250m
Stock buyback (at premium) US$250/US$50 = 5m
Diluted Shares 400 + 10 – 5 = 405m
If it is a question of calculating the value of the options outstanding rather than a diluted number of shares,
two other methodologies are used:
Intrinsic value method: intrinsic value is the amount by which the option is in the money. It is the amount
that the option owner would receive if the option were exercised. An option has zero intrinsic value if it is at
the money or out of the money regardless of whether it is a call or a put
Intrinsic value in options is the in-the-money portion of the option's premium. For example, if a call option’s
strike price is US$15 and the underlying stock's market price is at US$25, then the intrinsic value of the call
option is US$10. An option is usually never worth less than what an option holder can receive if the option
is exercised.
Fair value method: Fair value of all stock options (in the money and out of the money) is calculated using
the Black-Scholes formula or a similar method. This takes into account a number of factors as well as
intrinsic value.
2.2.2.2 Convertibles and preference shares

When a company has a convertible bond or preference share outstanding. It is important to ascribe the right
treatment (debt vs. equity) in calculating the fully diluted equity value. As with options and warrants, the
treatment depends on whether a convertible or preference share is ITM or OTM and on the nature of the
instrument in question.
2.2.2.2.1 Accounting for convertibles

On issue, the value of a convertible is split between debt and equity. The debt component is calculated based
on an appropriate discount rate for a similar, non-convertible instrument. The equity component is calculated
as the remainder of total instrument value.
Each year the interest expense on the debt component is equal to the discount rate, multiplied by the
carrying value of the liability on the balance sheet. The interest expense will exceed the coupon paid (as the
coupon on a convertible is lower than on an equivalent straight debt instrument as investors receive
remuneration through the value of the conversion option), and therefore the difference is added to the
liability. At maturity the liability will equal 100% of the convertible value. On conversion, the liability is
extinguished by an issue of shares at the conversion price.

Illustrative accounting treatment

Amount issued: 100
Term 5 yrs
Coupon 2.5%
Discount rate on comparable bond (all-in) 7.91%
Cost of similar non-convertible bond (PV) 78.3
At yr yr yr yr yr
issue 1 2 3 4 5 Calculation
Balance sheet
Equity
Option value 21.7 21.7 21.7 21.7 21.7 21.7 Equal to issue price less price of comparable
non-convertible bond
P&L cum impact (3.7) (7.7) (12.0) (16.6) (21.7) Cumulative accrued interest
Net equity impact 21.7 18.0 14.0 9.7 5.0 0.0 Option value less accrued interest
Liabilities
Beginning of year 78.3 82.0 86.0 90.3 95.0 Price of comparable non-convertible bond
Accrued interest 3.7 4.0 4.3 4.6 5.0 Difference between interest expense and
coupon paid
End of year 78.3 82.0 86.0 90.3 95.0 100.0 Sum of beginning of year plus accrued
interest
Income statement/cash flow

Coupon paid 2.5 2.5 2.5 2.5 2.5 Coupon paid each year
Accrued interest 3.7 4.0 4.3 4.6 5.0 Difference between interest expense and
coupon paid
Interest expense 6.2 6.5 6.8 7.1 7.5 Interest payable on comparable
non-convertible bond x opening liability
2.2.2.2.2 Non mandatory vs. mandatory convertibles

Optional convertibles
The majority of convertibles are optionally convertible i.e. the owner can choose whether or not to convert.
Change of Control Events
In the context of M&A, convertible bond investors frequently have the right to put the bonds at par (“investor
put following change of control”). This should be factored into enterprise value (or use of cash resources) in
analysing potential M&A situations – it is particularly relevant when a target company’s bonds are trading
significantly below par.
Mandatory convertibles
A mandatory convertible automatically converts in to the underlying security on a specified date. These
securities provide investors with higher yields to compensate holders for the mandatory conversion structure
and have a fixed conversion date and a variable conversion rate.
For valuation purposes, a mandatory convertible should normally be considered as equity (see following
section), although the terms of the instrument should be checked to ensure this is consistent with treatment
on change of control, etc. Rating agencies generally ascribe high equity content to mandatory structures (i.e.
up to 100%).

2.2.2.2.3 Convertible as equity

If the convertible is in the money it should be treated and thought of as equity. Taking into account the rule
of consistency of numerator and denominator, this requires certain treatment in both EV and P&L terms.
For equity value calculation

 Calculate the implied number of shares (NOSH) to be issued assuming the bond converts using the
conversion ratio
 Exclude the convertible from the net debt calculation
Effect on dilution of EPS:

Remember that the calculation of the basic EPS is net income available to common shareholders divided by
current number of shares outstanding. In the case of dilutive EPS, if there are dilutive securities
(e.g. convertible bonds) then adjust for the following:
 Calculate the implied net earnings as if the convertible were fully converted at the beginning of the year,
by adding back to earnings the convertible after tax interest expense
 Add the number of shares assuming full conversion to the existing number of shares
Example of EPS with convertible debt:

During 2008, Company A reported net income of US$115,600 and had 200,000 shares of common stock
outstanding for the entire year. During 2007, Company A issued 600, US$1,000 par, 7% bonds for
US$600,000 (issued at par). Each of these bonds is convertible to 100 shares of common stock. The tax rate
is 40%. Compute the 2008 basic and diluted EPS.
Answer:
Step 1: Compute 2008 basic EPS
basic EPS = US$115,600 = 0.58
200,000
Step 2: Calculate diluted EPS:

 Compute the increase in common stock outstanding if the convertible debt is converted to common stock
at the beginning of 2008
shares issuable for debt conversion = (600) (100) = 60,000 shares
 If the convertible debt is considered converted to common stock at the beginning of 2008, then there
would be no interest expense related to the convertible debt. Therefore, it is necessary to increase
Company’s A after-tax net income for the after-tax effect of the decrease in interest expense
increase in income = ((600) (US$1,000) (0.07)) (1 – 0.40) = US$25,200
 Compute diluted EPS as if the convertible debt were common stock
diluted EPS = net income + convert interest (1 – t)
wt. Avg. shares + convertible debt shares
diluted EPS = US$115,600 + US$25,200 = US$0.54
200,000 + 60,000
 Check to make sure that diluted EPS is less than basic EPS. (US$0.54 < US$0.58). If diluted EPS is more
than the basic EPS, the convertible bonds are antidilutive and should not be treated as common stock in
computing diluted EPS
2.2.2.2.4 Convertible as debt

If the convertible is out of the money it should be treated and thought of as debt. In this scenario, typically
no adjustments are required and the convertible is included in net debt at book value unless it is trading at
a discount.

2.2.3 Net debt

Net debt included in EV calculations generally refers to interest bearing capital owed to third parties. It
includes all long and short term interest bearing debt finance (including bank loans, bank overdrafts, bonds
and capitalised finance leases) but does not include liabilities which are not interest-bearing such as trade
payables, accruals, tax creditors and non-debt deemed provisions. Wherever possible, debt instruments
should be included at their market value.
Net debt is stated net of cash balances and marketable securities (generally investments included under
current assets that are readily realisable). If there is a minimum level of operational cash which is needed for
the running of the business, this is typically excluded from the calculation on the basis that this is not a capital
item, but effectively an asset of the core business.
Net debt = short-term + long-term interest-bearing liabilities—cash and cash equivalents

(marketable securities)
If valuing a subsidiary company (from its own perspective), intercompany debt should be included as a form
of debt. From a group perspective, the same intercompany debt should be eliminated as the parent would
have both "balance receivable" and "balance payable" in its consolidated accounts.
2.2.3.1 Preference shares

A company’s preference shareholders have priority over its ordinary shareholders when it distributes profit.
The preference dividend is usually a stated amount per share which is fixed at the time of issuance.
Preference shares should be considered as subordinated debt and included in the net debt calculation.
However, if a preference share is convertible, it should be treated in the same way as a convertible bond, as
described in section 2.2.2.2. There also may be a case for considering preference shares to be equity if
perpetual and with dividend deferral features.
2.2.4 Minority interests

Another financing claim to be included in enterprise value is minority interest that reflects any third party
ownership in a parent company’s subsidiary. Minority interest arises as the parent company fully consolidates
a subsidiary but does not own 100% of the subsidiary’s shares. This means that minority shareholders
provide part of the company’s overall capital, and part of the income of the subsidiary is attributable to
minority shareholders. As a consequence, part of the total derived enterprise value will accrue to
minority shareholders. In order to compare with fully consolidated profit figures, the value of the minority
ownership must be included in EV.
The valuation of minority stakes can be done with varying degrees of sophistication. The more complex and
comprehensive approaches are probably only justified where the subsidiary is significant relative to the parent
and the size of the minority stake is material.
Book value
 The balance sheet value of minority interests represents the minorities’ share of reported net assets in the
balance sheet, except for goodwill which only relates to the parent shareholders. This amount is unlikely
to be a good proxy for the fair value of minorities given that book value primarily reflects a historical cost
measurement basis and does not account for intangible assets
Price to book or P/E multiples

 Applying the group P/B or P/E multiple to the minority earnings is better than simply taking book value but
does not account for the relevance of the group multiple to the subsidiary (i.e. the subsidiary could be in a
different jurisdiction, or in the case of a conglomerate, in a different industry from other wholly-owned
group companies)
 Applying appropriate peer group P/B or P/E multiples to the minority earnings is likely to yield a more
accurate result

Full valuation analysis

 Minority interests can be valued using a detailed analysis of the value of subsidiaries which are not wholly
owned. In practice such an approach can be very difficult to implement given the lack of disclosure often
related to minority interests which are often related to unlisted subsidiaries
Quoted market price

 If the subsidiary that includes the minority shareholding is listed then the actual market value of the
minorities can be identified and included in the enterprise value calculations
In valuing minorities it is important to consider the impact of the majority control on the position of other
shareholders. Apart from the quoted market price approach above, all the others implicitly assume that the
minority value would be some proportionate share of the total value based upon the percentage
shareholding. This may not be the case and a discount may be warranted when applying a valuation multiple
to allow for situations where the majority shareholders may be claiming more than their share of value by
transfer into other wholly owned group companies.
2.2.5 Pensions
Pension schemes can be divided into two broad types: Defined Benefit and Defined Contribution schemes.
Defined benefit (“DB”) schemes were very common in industrial companies in the UK and the US until
companies realised that they were bearing all of the risk relating to the performance of the assets in the
pension scheme (as the liabilities are fixed relative to the salaries of retirees). More recently, defined
contribution (“DC”) schemes have become the norm whereby the employee bears the risk of asset
performance but the company makes fixed contributions to its employees’ schemes.
2.2.5.1 Defined contribution schemes

A DC scheme is a plan providing an individual account for each participant, who will receive benefits based
solely on the amount contributed to the scheme and the returns on assets in which the scheme invests. The
contributions are invested, for example in the stock market, and the returns on the investment (which may be
positive or negative) are credited to the individual's account. On retirement, the member's account is used to
provide retirement benefits, often through the purchase of an annuity which provides a regular income.
Under a defined contribution scheme, the employer pays a specified amount into an employee’s scheme each
year. Since this amount is known and there is no further risk associated with the payment from the
company’s perspective, accounting for such schemes is fairly simple. On the P&L, the amount of the
contribution would be recorded as an operating expense (typically under selling, general and administrative
expense) in the period the employee earns the benefit. On the balance sheet, if the contribution is paid in the
same period as the employee earns the benefit, no entries are necessary.
If benefits earned in one period are paid in the next, the company will have to record a liability for the
amount they owe the employee until it is paid. This amount will also typically be recorded in the P&L under
accrued salary or other accrued expenses. Either way, since the amount is known and that amount is
recorded on the P&L and (if necessary) the balance sheet or EV, no adjustments are necessary.
2.2.5.2 Defined benefit schemes

Under a DB scheme, the sponsoring company promises to make periodic payments to the employee after
retirement, typically expressed as a percentage of their final salary. Unlike a DC scheme, the employer
typically invests funds itself in order to meet this future obligation and assumes the risk and rewards
associated with the scheme assets and liabilities. A company’s defined benefit pension obligations are
calculated separately for each scheme it operates. A pension scheme is governed by trustees whose role is to
safeguard the benefits of the scheme members. The trustees are also responsible for negotiating both
ongoing and deficit catch up contributions with the company on behalf of the scheme members.
Accounting for DB schemes is much more complicated than DC schemes, because the employer must
estimate the value today of the future obligations made to its employees. To estimate this value, the
company must make assumptions concerning the discount rate to use to calculate the present value of the
future obligations, the expected increase in employee compensation, how long employees will work before
they retire, how many will quit or be fired and how long they will live after they retire. A company with a DB
scheme usually sponsors a pension fund, which is a portfolio of financial securities managed to generate
income and principal growth necessary to fund future pension obligations. The amount the company reports
on its balance sheet (the “accounting liability”) is the net amount: the difference between the value of the
assets (the pension fund) and the present value of the future pension liability.

2.2.5.3 Funded and unfunded schemes

To fund the post-employment benefits inherent in DB schemes the company can meet its pension obligations
out of operational cash flow on a “pay as you go” basis (unfunded schemes) or save up for future liabilities
by investing in pension assets (funded scheme).
A funded scheme is one in which all liabilities are funded in advance. Contributions from participants and
earnings on investments provide cash to cover the scheme’s expected liabilities. In a funded defined benefit
arrangement, the company and pension trustees must agree upon the contributions that the company must
make to ensure that the pension fund will meet future payment obligations. DC schemes are by definition,
funded, but the “guarantee” made to employees is different from a DB scheme in that the employer
commits to making contributions during the employee’s working life rather than promising fixed future
payments on retirement.
In an unfunded DB scheme, no assets are set aside and the benefits are paid for by the employer or other
pension sponsor as and when they need to be paid. Pension arrangements provided by the state in most
countries in the world are unfunded, with benefits paid directly from current workers' contributions and
taxes. This method of financing is known as Pay-as-you-go. In other words, a pension scheme funded out of
the employer's current income whenever funds are required by retiring employees or beneficiaries, rather
than out of money put aside on a regular basis regardless of current need.
2.2.5.4 Pensions and enterprise value

For the calculation of enterprise value, DB obligations are viewed as a “debt-like” item; in other words, a loan
provided by employees to the company to be repaid upon retirement. In addition, as the pension liabilities
are recorded at present value, there is an implied annual interest cost. This, together with the long term
nature of pensions, makes us treat these obligations as financing in nature. An unfunded pension liability is
included in enterprise value whereas for funded DB schemes, it is the difference between pension liabilities
and pension assets. This difference is called a scheme’s surplus (or over-funding) if the assets exceed the
obligation, and a deficit (or under-funding) if not. This deficit can vary depending on whether accounting or
actuarial estimates of the liability are used.
We typically consider that the pension deficit should be included in enterprise value on a post-tax basis (note
that a pension surplus is typically not taken into account). In many jurisdictions, companies receive a tax
deduction for contributing cash to their funded defined benefit schemes. Therefore the burden of a pension
deficit is effectively the gross amount reduced by the marginal tax rate. Where the deficit is a present value,
the tax saving is also on the same basis. The tax saving will be recognised as a deferred tax asset in the
company’s balance sheet.
2.2.5.4.1 Accounting vs. actuarial differences

In a funded DB scheme, the pension deficit calculated by reference to the accounting liability can differ
significantly from the deficit as calculated by an actuary given the use of different assumptions. For example,
in the UK under IAS 19, accounting liabilities are calculated by using a discount rate derived from the yield on
AA rated corporate bonds whereas the actuarial liability is typically calculated by adding a fixed percentage to
underlying gilt rates.
Companies and pension trustees use actuarial calculations in setting contribution rates and these are often
subject to considerable negotiation. Given that contributions will be reflected in a company’s future P&L and
cash flow statement (depending on type of contribution – service costs versus deficit catch-up), arguably the
actuarial figures are more appropriate for use in valuation. However, given that accounting liabilities are
readily available (unlike actuarial figures), they are typically used in valuation exercises. It is important to
recognise the potential for differences here and consider whether to make adjustments in cases where there
is a significant difference.

2.2.5.5 Pensions and P&L

Treating pensions as debt for the purpose of enterprise value also means that only the operating items
related to pensions should be included as part of EBIT for multiples and estimates of enterprise free cash
flow (FCF).
Under IAS 19 the main gains and losses recognised in the P&L related to pensions are
i) service coost: the value of the pension rights earned by employees during the period
ii) interest accretion on the gross pension obligation: the effect of unwinding the effect of stating the
liability on a discounted, present value basis
iii) expected return on the gross pension scheme assets: an estimate of the long-term expected return
on the different components of the pension fund. For bonds, this is relatively simple, being the bond
yield, but for equities and other assets such as investments in property and hedge funds it is a more
difficult assessment of risky asset returns and in particular an estimate of the equity risk premium.
Typically, interest costs and the expected return on pension assets are treated as ‘financing in nature’, and
hence these should be included as part of net financing income rather than operating income and added
back to EBITDA or EBITA where a pension deficit has been included in EV. The service costs, reflecting the
value of pension rights earned by employees in a particular accounting period, are a genuine operating
expense to be included in EBITDA, EBIT and estimates of FCF when used for comparison with
pension-adjusted EV.
The challenge for analysts and investors is that under IFRS, companies have the discretion to present all
pension P&L items as either financing or operating. Therefore, key performance metrics such as EBIT margins
can be affected by the treatment of the expected return on assets and interest costs on the pension liability.
2.2.5.6 Country differences

France
Subscribing to the State-controlled Pension Scheme is mandatory in France, and contributed to by both
employees and employers. Private pensions schemes are comparatively rare, and as a result the sole accounting
treatment of this item is a cost against profit in each period. There are no adjustments needed to EV.
Germany
There are different kinds of pension schemes in Germany:
 Traditional system of fully unfunded pensions schemes on balance sheet (i.e. pensions to be paid out of
future cash flow and provisions are included in EV as debt)
 On balance sheet financing with certain pension assets (also on balance sheet), defined benefit set up, but
only the funding gap should be included which will be disclosed in the notes
 Total removal of pension obligations to an external pension scheme (usually non recourse to the actual
corporation), defined benefit set up, pension obligation should not be relevant for debt calculation
(depending on recourse/non recourse)
In recent years, corporations have been moving to defined contribution schemes (managed by insurance
companies etc) to remove the increasing pension provisions from the BS and solve the issue, however there
are still “old” pensions on the BS.
Italy
Italian regulations (introduced in 2007) require companies to provide an entitlement for their employees by
way of a payment expensed annually. This payment is called "Trattamento di Fine Rapporto" (Severance
Treatment), or TFR. Contributions to fund the TFR are deducted from the employee's salary each month.
Employees of large companies (50+ employees) can:
(i) elect to receive the TFR-portion of their compensation in a single instalment, as severance payment, when
they leave the company for any reason (voluntary change of employer, redundancy, retirement). The
company is obliged to transfer the TFR payments received from the employee to the Italian Social Security
system, which, once the employment is terminated, will pay the accrued TFR amount to the employee;

(ii) not make any election, in which case the TFR-portion of their compensation is contributed by default into
external certified pension funds, which operate as defined contribution schemes. Once the employee retires,
he will receive from the fund an annuity integrating the regular, State-controlled pension payments
In both cases, current TFR-related payments are already included in the cash personnel cost of the company, and
therefore fully reflected in the company’s EBITDA. The pension liability is not on the balance sheet of the company
but instead is reported on the balance sheet of either the Italian Social Security or the external funds. As a result,
no adjustment to the calculation of the company’s EV is required to reflect the post-2007 TFR schemes.
However, prior to January 2007, TFR’s sole purpose was to fund a severance payment. The TFR-portion of
compensation was retained by the company, which had the obligation to pay the entire accrued TFR amount
to its employees upon termination of employment. As a result, the TFR was a non-cash item, that created an
unfunded liability on the company's balance sheet. The TFR provision related to pre-2007 schemes is still
present on the balance sheet of Italian companies. As severance payments are made over time, the size of the
TFR provision is gradually decreasing. Nonetheless, the pre-2007 TFR provision should be added to the
company's EV. This value is clearly reported on the balance sheet, under both IFRS and Italian GAAP.
Spain
Corporate pension assets in Spain are externally managed by a specialised company to provide its
beneficiaries with a greater guarantee of efficiency and security. As a result of such external management
and the fact that companies do not bear the cost or risk of the pension schemes, no pension adjustment
typically needs to be incorporated when valuing a company in Spain.
US
Over the years, US companies with defined benefit schemes have moved to defined contribution schemes.
However, substantial legacy defined benefit schemes remain in some sectors and large unfunded positions
when market headwinds prevail (e.g. steel, coal, auto, airlines). In addition, companies operating in the
US offer post-retirement health benefits. These also have a defined benefit character. Thus the total defined
benefit obligations of a company include defined benefit pension schemes and other post employment
benefits (OPEB).
Defined Benefit Schemes & OPEB
Per US GAAP, the P&L includes pension income/costs that are unrelated to current period operations. Both
the P&L and balance sheet are sensitive to actuarial assumptions, many of which are not disclosed.
Furthermore, the figures reported on the balance sheet rarely convey the actual funding level. In fact, the
balance sheet may show a net surplus or pension asset while the pension is actually in deficit.
Adjustments to EV and EBIT/EBITDA should be effected with data coming from the footnotes:
– add tax-adjusted “funded status” to EV
– add to EBIT/EBITDA the entire Periodic Pension Charge except for Service Cost (which should not be
backed-out)
UK
In the UK, DB schemes have historically been common although these have largely been closed to new
members. DC schemes are now the norm for new employees and some companies are even converting
existing DB schemes to DC schemes.
Under IAS 19, the net pension liability arising from DB schemes (i.e. the deficit) will appear on the balance
sheet net of deferred tax and should be added to enterprise value. The pension footnote will provide
information on pension financing costs which should be added back to EBITDA or EBIT as described in
section 2.2.5.5.
It is important to note that the accounting deficit may differ materially from the actuarial deficit. The latter is
the basis on which the trustees and the company agree a schedule of future contributions to make up the
deficit. Such contributions are not captured in the P&L (they are accounted through the cash flow statement)
and so it may be necessary to make a further adjustment to EV, for example by adding the NPV of agreed
future deficit contributions. This should be reviewed on a case by case basis.

2.2.6 Leases
It is important to consider the effect of leases on valuation in order to compare two companies who may
choose to operate their businesses with different levels of asset ownership vs. leases. A lease is a contract
between two parties: one party (lessee) has right to use an asset which is owned by another (lessor) for a
fixed or indefinite period of time, whereby the lessee obtains exclusive possession of the property in return
for paying the lessor a fixed or determinable payment. The lessor retains the legal ownership of the asset.
There are two types of leases:
Operating leases
An operating lease is usually signed for a period considerably shorter than the useful life of the asset and the
present value of lease payments are generally lower than the actual price of the asset. At the end of the life
of the lease, the physical possession of the property reverts back to the lessor, who can either offer to sell it
to the lessee or lease it to somebody else. Under an operating lease, the lessee may have the option to cancel
the lease and return equipment to the lessor, before the expiry of lease agreement although this option is
likely to carry additional cost for the lessee. Thus the ownership of the asset resides with the lessor, with the
lessee bearing little or no risk if the asset becomes obsolete. An example of operating leases could be retail
businesses which lease rather than own their shops or aircraft companies which lease their planes. Under an
operating lease, the lessor may also provide services relating to the asset, such as maintenance, or operations.
In accounting terms, an operating lease is considered to be the same as renting an asset:
 The lessee simply has to record the payments it makes under the lease agreement as an expense in the
P&L (and vice versa for the lessor) when they occur. There is no recognition of any asset or obligation to
make payments under the lease in the financial statements of the lessee
 The lease payments are operating expenses which are tax deductible. Thus, although lease payments
reduce income, they also provide a tax benefit
 The lessor continues to recognise the asset on its balance sheet and depreciate as normal. It does not
recognise any future cash to be received as a receivable, and simply records the income in the P&L as
it occurs
Finance or capital leases

A finance or capital lease generally lasts for the life of the asset, with the present value of lease payments
almost equivalent to the price of the asset. A finance lease generally cannot be cancelled, and the lease can
be renewed at the end of its life. In a lot of cases, the lessor is not obligated to pay insurance and taxes on
the asset, leaving these obligations up to the lessee; as a result the lessee reduces the lease payments, leading
to what are called net leases. A finance lease imposes substantial risk on the shoulders of the lessee. A
finance lease is deemed to be the equivalent of the lessee buying an asset outright from the lessor. However,
in a lease situation, legally ownership is never passed and the asset never legally belongs to the lessee.
For valuation purposes, finance leases are treated as debt and corresponding lease payments as interest.
2.2.6.1 Effect of leases on Expenses, Income and Taxes

Finance leases are treated similarly to assets that are bought by the firm; hence the firm can claim
depreciation on the asset and an imputed interest payment on the lease as tax deductions instead of the
lease payment itself. The imputed interest payment is calculated by splitting the lease payment into interest
and principal.
If aggregated over a long period of time, the total tax deductions amount on imputed interest expenses and
depreciation, which comprise the tax deductible flows arising from the lease, will still be equal to the sum of
the lease payments. The only difference is in timing –– the capital lease leads to greater deductions earlier
and less later on.

2.2.6.2 Effect of leases on balance sheet

From the lessee's perspective, Operating leases are often referred to as off-balance sheet leases—the
company is obtaining benefits from using an asset in its operations which is not required to be recorded on
the balance sheet. Under a finance lease, the leased asset is shown as an asset on the balance sheet, with a
corresponding liability capturing the present value of the expected lease payments.
Accordingly, companies can switch between lease types and create the lease which gives them the desired
result in their financial statements (i.e., the lease is considered operating if the company wants to reduce its
gearing levels, so there is no requirement to record the contracted liability on the balance sheet.) Additionally,
it is possible for a lessee and a lessor to classify the same lease differently (i.e., the lessee may think it is a
finance lease whereas the lessor may qualify it as an operating lease).
Given the discretion, many firms prefer the first approach, since it hides the potential liability to the firm and
understates its headline financial leverage. While an operating lease is favourable for the lessee, it reduces the
lessor’s tax deductions in terms of depreciation, interest etc. Despite this conflict of interest, firms manage to
design lease agreements according to their requirements. The conditions for classifying operating and capital
leases apply in most countries; exceptions being France and Japan where all leases are treated as
operating leases.
By adjusting all leases as if they are treated as capital leases (i.e. by capitalising them), adjusted net
debt/EBITDAR multiples can be calculated. These are used in certain industries for the benchmarking of debt
financing capacity where leases are an important business expense.
2.2.6.3 Finance vs. operating leases, understanding the differences

Valuations generally fall into two categories
 Operating leases may not allow the asset to be virtually exhausted by the same lessee: a rental transaction
must allow an asset to be used by a series of users. The finance lease, being long-term, covers the life of
the asset
 Operating leases do not put the lessee in the position of a virtual owner: the lessee merely uses the asset
and does not have the same commitment to the asset he has in case of owned assets. Under finance
leases, only the legal ownership does not change, but for all practical purposes the lessee assumes the
risks and expenses in relation to the asset
 In an operating lease, the lessor takes asset-based risk, he is directly affected by the state, efficiency and
obsolescence of the asset. The value of the asset is important not only from the viewpoint of security of
the lessor's investment, but the value itself determines the lessor's returns. In a finance lease the lessor
takes both financial risks and asset-based risks
 In operating leases, the lessor's rate of return is dependent upon the asset value, performance, or costs
relating to the asset. The fixed lease rentals cannot give rise to an ascertainable rate of return on
investment. Therefore, the implicit rate of return in an operating lease is always a matter of probabilities
and is uncertain. Finance leases almost cover the whole life of the asset, ensuring that the lessor’s
investment is returned through fixed lease rentals over the lease period
2.2.6.4 Capitalisation of operating leases

If a company chooses to lease rather than buy assets this source of capital needs to be captured in our
valuation analysis. In calculating EV, the value of capitalised operating leases needs to be added in order to
make the invested capital base inclusive of all assets employed. Capitalising operating leases also helps reveal
true company leverage and equity risk. In addition, the commitment to make operating lease payments
should not be treated differently than having a commitment to pay interest and debt.
There are two methodologies that can be used to capitalised the operating leases. In practice, S&P uses the
NPV methodology and Moody’s uses the multiple methodology when calculating ratios for credit rating
purposes. For valuation purposes, either is acceptable, but should be consistent for each company
being valued.

Multiple methodology
The simple technique to determine the operating lease liability is the application of a multiple to the current
operating lease charge. For example, if a company has an operating lease charge of 350 in 2008, this is
multiplied by, say, 7 to obtain the amount of liability and assets (2,450) that should be on the balance sheet.
Different multiples are appropriate for different sectors, as illustrated by Moody’s methodologies for their
ratings calculations below:
Moody’s operating lease capitalisation multiples
Sector/multiple (x) Sector/multiple (x)

Aerospace/Defense 6 Media: Diversified, Paid TV & Subscription Radio 6
Automotive 6 Media: Printing & Publishing 6
Chemicals 6 Metals & Mining 5
Consumer Products 6 Natural Products Processor 6
Energy: Electricity Cooperative 6 Packaging 5
Energy: Electricity—Project Finance 6 Pharmaceuticals 5
Energy: Electricity—Non Project Finance 8 Public Utility 6
Energy: Oil & Gas—Drilling 5 Public Utility—Gas Distribution 8
Energy: Oil & Gas—Exploration & Production 6 Public Utility—Gas Transmission 8
Energy: Oil & Gas—Integrated 6 Restaurants 8
Energy: Oil & Gas—Merchant Energy 6 Retail 8
Energy: Oil & Gas—Midstream 6 Services—Business 6
Energy: Oil & Gas—Project Finance 6 Services—Consumer 6
Energy: Oil & Gas—Refining & Marketing 6 Services—Contractors 5
Energy: Oil & Gas—Services 5 Services—Processors 5
Environment 6 Services—Rental 5
Forest Products 5 Services—Towers & Satellites 5
Gaming/Lodging 8 Technology 5
Healthcare—Hospitals and Services 6 Telecommunications 5
Healthcare—Medical Devices 6 Transportation Services 6
Homebuilding 5 Airline 8
Leisure & Entertainment 8 Maritime Shipping 8
Manufacturing 6 Transportation Services—Airports & Toll Roads 6
Media: Advertising & Broadcasting 6 Wholesale Distribution 6
For consistency reasons when capitalising the operating leases, the necessary adjustments need to be made
also to the P&L. Specifically when calculating EV/EBITDA multiples, remember to add back the operating lease
expense to EBITDA so that any expenses related to leasing of assets are not included.
For the calculation of EBIT and earnings multiples, adjustments for the depreciation and the interest
component of the lease are required. The operating lease charge is typically reallocated on the P&L in a
simple way assuming 1⁄3 relates to interest and 2⁄3 to depreciation.
NPV methodology
A more sophisticated technique is to calculate the NPV of future operating leases payments. In order to
do this accurately, the future “normalised” level of lease payments is required, something that is not
always available.

2.2.7 Core versus non-core enterprise value

Although EV multiples have become a popular valuation methodology, there is frequently confusion about
the calculation of enterprise value. An important issue is the treatment of associates and investments, both in
EV and related results metrics like EBIT(DA). The question is whether these are an integral part of the parent
company’s business or reflect related activities that are not deemed to be part of the core operations of the
company. We distinguish between two types of enterprise value:
 Total enterprise value: The value of all the activities of the business. It includes the value of investments
and associates
 Core enterprise value: Total enterprise value less the value of non core assets—operations not regarded
as part of the core activities and which it is thought desirable to exclude for the purpose of calculating
valuation multiples. Non-core assets include investments, associates and joint ventures but may also
include other trading operations, which are very different in nature to the core activities of the enterprise
It is typically preferable to use core EV for comparability across similar companies, as multiples for non-core
activities such as investments and associates can be very different. We therefore generally treat
associates/joint ventures and other investments as non-core for the purpose of enterprise value multiples and
value them separately. In addition, trading operations, which are very different in nature to the core activities
of the enterprise (i.e. say a financing division which is secondary to the company’s main business purpose)
could also be treated as non-core.
However, to get meaningful multiples, there needs to be consistency between the components of enterprise
value and its related results component such as EBIT(DA). In deriving a consistent core EV multiple, we must
not only remove investments and associates from enterprise value, but also any (associated) income should be
excluded from EBIT(DA).
It is important to deduct the market value and not the book value of non-core assets like investments and
associates to get to a core enterprise value. This is relevant for all non-core assets but is particularly important
for investments in associated companies as the market value may be substantially different from (historical)
book value. If the associated company is not listed, the market value can only be estimated by, for example,
applying a price/earnings multiple to the company’s share of the profit of the associate.
Below we give a simple example of a company with total EV of €2,100m and total EBIT of €200m to illustrate
the distinction between total and core EV multiples. Assume a company has an investment in an associate
(book value €350m) and other investments (book value of €50m). Removing the market value of the
investment in the associated company (€500m) and other investment (€100m) gives a core EV of €1,500m.
This gives a core EV/EBIT multiple is only 8.6 compared with a total EV/EBIT multiple of 12.0.
Deriving EV/EBIT multiples
Enterprise value €m EBIT €m EV/EBIT multiples
Market cap 750
Net debt 1,200
Minorities 150
EV (total) 2,100 EBIT (total) 200 EV/EBIT (total) 10.5x
Associates 500 Associate income 25
Investments 100 Investment income 0
EV (core) 1,500 EBIT (core) 175 EV/EBIT (Core) 8.6x
Source: UBS

2.3 Defining the denominator
2.3.1 Calendarisation
For the purpose of deriving trading multiples, estimates are often calenderised to a common year end. This is
done to ensure consistency and enhance comparability. We often calendarise to the year end of the company
being valued or the most common year end across the universe. In case of companies with different year
ends, forecasted estimates are “calendarised”. Calendarisation is the process of prorating estimates that are
available on fiscal year basis, to derive estimates on a calendar year basis.
Consider the following example
Fiscal year end of company XYZ 30 September
Forecasted revenues for FY 2008 US$1,200m
Forecasted revenues for FY 2009 US$1,440m
Revenues for calendar year 2008 shall be determined as under:
Forecasted revenues for FY 2008 pro rated for 9 months US$1200 x 9/12 = US$900m
Add Forecasted revenues for FY 2009 pro rated for 3 months US$1,440 x 3/12 = US$360m
Forecasted revenues for calendar year 2008 (Jan–Dec 06) US$900 + US$360 = US$1,260m
Data should always be calendarised for comparison purposes and to get LTM financials.
Please note that seasonality can affect the calendarisation and for the most accurate results, this needs to be
accounted for rather than assuming that earnings and cash flows are derived equally across the year.
2.3.2 Adjusting the earnings numbers for pensions

As discussed in section 2.2.5.5 above, treating pensions as a financing claim for the purpose of enterprise
value also means that only the operating items related to pensions should be included as part of EBIT for
multiples and estimates of enterprise free cash flow (FCF). Therefore, remember to add back to EBIT(DA) the
non-operating pension related expenses, such as interest costs and expected return on pension assets. Only
the service cost is considered as a genuine operating expense (see section 2.2.5.5 for an example).
2.3.3 Adjusting the earnings numbers for leases

As discussed in section 2.2.6.4, capitalising operating leases does not only impact the balance sheet but also
the P&L. Remember that, the total lease expense is added back to EBITDA and EBIT is adjusted by 1⁄3 of leases
accounting for the depreciation of assets, and interest expense increased by 2⁄3 of leases.
2.3.4 Deferred taxes and tax losses
2.3.4.1 Marginal tax rate and effective tax rate (ETR)

The statutory tax rate is the marginal tax rate (“MTR”) in the jurisdiction in which the firm operates. Marginal
tax rates can be found in the relevant footnotes of the annual report or general accounting reports. KPMG
produces a tax rate survey for each country every year which is available on their website.
A firm's reported effective tax rate (“ETR”) is simply income tax expense divided by the taxable income.
In practise, it is very common that the effective tax rate and statutory tax rate differ. The differences are
generally the result of:
 Different tax rates across different tax jurisdictions where the company operates
 Permanent tax differences: tax credits, tax-exempt income, non-deductible expenses, and tax differences
between capital gains and operating income
 Changes in tax rates and legislation
 Deferred taxes provided on the reinvested earnings of foreign and unconsolidated domestic affiliates
 Tax holidays in some countries

Accounting standards require a disclosure reconciling the difference between reported income tax expense
and the amount based on the statutory income tax rate.
Example (US company)

(%)
Fed Statutory Rate 35.0
Adj. for Non-tax Paying S&P 500 Companies 34.5
State Income Taxes 1.6
Effect of Foreign Taxes (1.6)
Foreign Sales Corp (0.1)
Benefit of Tax-Exempt Income (0.6)
Benefit of Puerto Rico Operations (and Ireland) 0.3
Acquisition/Merger Costs 0.0
Dividend Tax Benefit (0.1)
R + D Tax Credits 0.0
Impairment Charges (0.2)
Change in Valuation Allowance (0.3)
Net Operating Losses not currently benefited (0.1)
Restructuring Charges (0.0)
Amortisation of Goodwill/Intangibles 0.0
Repatriation of Foreign Earnings 0.0
Adjustment to Prior Year Tax Liabilities (0.1)
Tax Settlements (0.3)
All Other—net (1.8)
Effective Tax Rate 32.5
2.3.4.2 When to use which tax rate?

In the event that you are seeking to normalise net income for certain non-core operations or extraordinary
items, you need to be careful to use the correct tax rate. In some instances, it will be possible to find a
disclosure of the tax impact of certain items in the notes to the financial accounts. If this is not the case, you
should take care to assess the likely tax jurisdiction which the item is subject to in assessing which rate to use
and the nature of the item in question. As a rule of thumb, general business expenses can be considered to
be subject to the effective tax rate of the business. In the case of extraordinary or one off items, specific tax
charges are likely to have been made at the marginal rate, and hence this rate should be used.
2.3.4.3 Timing vs. permanent differences

Taxable profit is computed based on taxation regulations as opposed to accounting policies and hence
taxable profit and accounting profit can differ. The difference between taxable profit and accounting profit
can be classified into:
 Permanent differences
 Timing differences
Permanent differences:
 Differences between taxable profit and accounting profit which DO NOT reverse in subsequent periods.
For example, if the tax regulations only allow deductibility of part of a given expense, the disallowed
amount would result in permanent difference (e.g. employee stock options)
 The impact: as this type of difference does not reverse in subsequent periods, their impact on the amount
of tax charged in the P&L of the current period is not measured and accounted for

Timing differences:
 Differences between taxable profit and accounting profit which arise because the period in which some
items are included in taxable profit is different to the period in which they are included in accounting
profit (e.g. capital allowances versus depreciation for fixed assets)
 Note that the total of these items in both accounting profit and taxable profit are ultimately the same, but
they occur in different periods
 The impact: this type of item will reverse in subsequent periods, but will result in differences in the tax
paid in each year
2.3.4.4 What causes deferred tax liabilities

Deferred tax is an accounting item that effectively smoothes the difference between the tax charge expected
in the accounts (based on PBT multiplied by the corporate tax rate) and what is actually payable (based on the
tax rules). It takes into account differences between when an item is recognised by tax regulations versus
accounting policies. A deferred tax difference tends to originate in one period and reverse in a future period
(or vice versa).
A deferred tax liability (“DTL”) is created when the tax expense on the P&L is greater than taxes payable on
the tax return due to temporary differences. These arise from different accounting treatments for tax and
financial reporting purposes and are expected to reverse themselves (i.e. they are temporary differences).
They result in future cash outflows when taxes are paid.
The most common cause of deferred tax is differences between depreciation and the related tax allowance in
respect of fixed assets. Other differences include: accruals, prepayments, deferred income etc.
2.3.4.5 What causes deferred tax assets

A deferred tax asset (“DTA”) is created when the tax expense on the P&L is lower than taxes payable on the
tax return due to temporary differences. Similar to deferred tax liabilities, deferred tax assets are expected to
reverse themselves through future operations and provide tax savings and therefore, are accounted for on
the balance sheet.
Warranty expenses, tax loss carryforwards and post employment benefits are the most common causes of
deferred tax assets.
If a company has an expense item (e.g. estimated warranty expense) on its financial statements that is not
deductible for tax purposes currently, a deferred tax asset will be created. This represents the future tax
savings that will result when the deduction is taken (e.g., when warranty expense is actually paid). Deferred
tax assets are adjusted for the probability that they will actually be realised in future periods. This adjustment
is made by creating or adjusting a "valuation allowance" on the balance sheet. This item serves to reduce the
DTA to reflect the probability that the DTA will not actually be realised in future periods.
2.3.4.6 How do you account for deferred taxes

In the example overleaf, we assume year 1 accounting profit before depreciation of €1,000. Depreciation is
€250 whereas the tax equivalent of depreciation amounts to €400. Assuming no other tax/accounting
differences and a tax rate of 30%, the expected tax charge is €225 ((€1000 – €250) * 30%) whereas the
actual tax charge is lower at €180 ((€1,000 – €400) * 30%). In year 2, assuming profits and depreciation
remain at year 1 levels, if the tax allowances are €100 then the actual tax payable of €270 ((€1,000 – €100) *
30%) is now higher than the expected tax charge of €225.

Example:
Year 1 Year 2
€ Taxation Accounting Taxation Accounting
Profit before depreciation/tax allowance 1,000 1,000 1,000 1,000
Depreciation/tax allowance (400) (250) (100) (250)
Profit after depreciation/tax allowance 600 750 900 750
Tax rate (%) 30 30
Actual (cash) tax charge 180 180 270 270
Total reported tax charge 225 225
Deferred tax charge/(gain) 45 (45)
Effective tax rate (before deferred tax) (%) 24 36
Effective tax rate (after deferred tax) (%) 30 30
In year 1 the difference in tax charges relates to the additional tax capital allowances charges
(€150*30% = €45) whereas in year 2 the difference is due to the smaller tax capital allowances. Deferred tax
tries to ‘smooth’ these timing differences out: in year 1 a deferred tax liability would be made for
€45 to increase the actual tax charge up to the expected amount of €225. This reflects a liability on balance
sheet as the current favourable tax allowances upfront will be offset by more tax being payable in the future.
In year 2 this deferred tax liability is reversed as the timing difference reverses resulting in a reduction in the
actual tax charge from €270 to €225.
Accounting for deferred tax means that the reported tax charge reflects the tax expected to be payable
(albeit not maybe immediately) based on accounting profits. In the above example, without providing for
deferred tax, the effective tax rates for years 1 and 2 are 24% (€180/€750) and 36% (€270/€750)
respectively. Providing for deferred tax brings these to 30% for both years (€225/€750).
2.3.4.7 What tax losses are, how they are recovered

Tax loss carry forward is the current net taxable loss that can be used to reduce taxable income (and
therefore taxes payable) in future years. Companies recognise a deferred tax asset when it expects to realise a
future tax benefit from the loss carry forward. If the company believes that, more likely than not, future
taxable income will be insufficient to allow realising the full tax benefit, it may decide to offset the gross
deferred tax asset by the so-called valuation allowance. The resulting net deferred tax asset on the balance
sheet reflects the management’s estimate of the benefit to be realised from the total amount of net
operating losses available.
2.3.4.8 Deferred taxes and valuation

Historical operating losses can be a source of value if companies can use these losses to offset future or
sometimes past taxable income. Below we set an example in order to understand this better
In its 2007 Annual Report, ArcelorMittal discloses the total amount of estimated tax losses carry forwards of
US$7,179 million, compared with US$9,019 million as per year end 2006. This amount includes
US$2,478 million of losses with set expiry dates whereas the remaining tax loss carry forwards are indefinite.
The company measures total deferred tax assets for tax loss carry forwards of US$2,373 million (33% tax rate
times the US$7,179 million tax losses). However it only recognises US$1,659 million as deferred tax assets
leaving US$714 million as unrecognised deferred tax assets.
Example:
Total deferred Recognised deferred Unrecognised deferred
US$ million Gross amount tax assets tax assets tax assets
2006 9,019 3,079 2,234 845
2007 7,179 2,373 1,659 717
Source: ArcelorMittal (annual report 2007)

The valuation allowance is based on the company’s current view of the level of taxable income of the
different entities where the tax losses reside. If the likelihood of the company being able to realise the tax loss
carry forward improves, valuation allowance is reversed to reflect the improved likelihood. This reversal
increases the total amount of tax losses available to offset future taxable income. In interpreting the amount
of recognised deferred tax assets for the purpose of valuation, we recommend using the net number of
US$1,659 million for ArcelorMittal instead of the US$2,373 million of gross deferred tax assets.
For the purposes of calculating the EV, the value of the deferred tax asset is typically treated separately and
added to the EV as a non-core asset.
The practical problem is estimating the proper value for the deferred tax asset related to tax loss carry
forwards. It theoretically requires estimating the present value of the cash tax benefits as using the book
value would overestimate the value as it does not take into account the timing of the cash benefits. Although
company disclosure should help in assessing the timing of the tax benefits, it remains a challenging exercise.
In addition, it requires estimating the discount rate where opinions vary. Although some people argue that
the risk free rate should be used as the cash payment from the government should be seen as risk free, it is
accepted that the cost of equity is generally the appropriate discount rate for cash tax benefits, because
companies must generate profits after interest cost in order to benefit from tax loss carry forwards.
A similar methodology is used when evaluating a company from a transaction point of view. A company that
offers buyers significant tax savings later should be worth more than an identical business which does not.
Key issues to keep an eye out for are whether these deferred taxes are transferable to the new owners and
extent to which ownership changes may affect the realisation of tax deferrals.
2.4 Pro forma adjustments for acquisitions, disposals and other

corporate transactions
To the extent that transactions have either taken place since publication of the most recent balance sheet or
current or prospective year figures do not include a full year’s impact of the transaction, we need to make
certain adjustments to reflect this.
Adjustment to balance sheet

The balance sheet of the acquirer needs to be adjusted to reflect the assets being acquired and the financing
for the transaction. If the transaction has not yet completed it may not be possible to do a pro forma
calculation line by line across the balance sheet. In this scenario, EV should simply be adjusted to reflect either
the debt taken on or the shares issued to finance the transaction (to the extent not already captured).
In the event of a disposal, the EV needs to be adjusted to reflect the proceeds received.
Adjustment to the P&L

The P&L items need to be adjusted for the acquired/disposed entity. Pro forma full year contribution
calculations are the most appropriate way to do this in the transaction year. Ensure that the forecasts you are
using have been published subsequent to the date of any such transaction so that they reflect it.
2.5 Some additional consideration for multiples based valuations
Company with Assume a normal level of debt, and adjust interest, taxes and earnings
abnormally high debt for appropriately. Obtain a notional value on this basis and then make an
its sector (we can adjust appropriate deduction for the additional debt, including an adjustment
the process appropriately for additional debt, including an adjustment for additional
for abnormally low debt) risk/operational gearing.
Conglomerate or If the P/E of the different subsidiaries are likely to be very different
multi-business group from each other, it may be best to allocate debt (e.g. on the basis of
capital employed) attributable to each of these and value the resultant
“post interest” earnings by reference to the appropriate multiples,
rather than valuing each subsidiary on a debt free basis and then
making an overall deduction for debt.

2.6 Data sources
2.6.1 Historic financials

Historic financials should be from the latest annual report (full financial section) or quarterly reports.
Balance Sheet information can be found in the financial section of latest report, annual or interim report. The
same can be obtained from the company website or Stock exchange website (SEC, LSE, etc). Check out
www.sec.gov for US companies or www.londonstockexchange.com for UK listed companies. Alternatively,
the investor relations section of company websites often include recent filings and can often be the fastest
way to access the data. Using analyst research for balance sheet and historic data can often be problematic
due to inaccurate or incomplete analysis—company reports should ALWAYS be used.
2.6.2 Forecasts
UBS research
For financial forecasts UBS research forecasts can be used and these are available on Research web. For
European trading companies, you can request the analyst research model and you can also find most of them
on ras (type ras in your browser) and click on Launch Model Viewer (link can be found toward the bottom
right of the web page). You should benchmark the UBS research forecasts to consensus estimates (see
below) to understand whether our analysts are bullish or bearish relative to the other analysts covering the
stock in question.
Datastream/Factset (consensus estimates)
IBES estimates (a survey of all contributing analysts who cover the stock) can be sourced from DataStream
whereas both IBES and Reuters consensus estimates can be pulled from FactSet. More info on both of these
databases can be found in the WorkSmarter handbook.
Creating consensus estimates
Consensus estimates can also be created manually by building a spreadsheet comparing the forecasts of the
credible brokers. This can be more reliable than IBES which often includes forecasts from less well-known
research houses and/or forecasts which are out of date. Be careful, in case brokers report financials using
different reporting methodologies/accounting treatments, so in this case the numbers are not directly
comparable and your consensus will not be meaningful.
2.7 How to check efficiently

 Sanity check the output. If a number seems out of line, check it
 Compare the multiples at different levels of the balance sheet/P&L against one another. Anomalies should
be investigated
 Evolution of multiples over the forecast period is a key part of the analysis—check that it makes sense.
Usually the multiple should be decreasing over time as the company grows (will not work for companies
which are shrinking or undergoing corporate change)
 Compare your results with Equity Research or FactSet front company page—make sure you know where
any differences comes from
 Check with Bloomberg, FactSet, DataStream, other databases and try and reconcile the difference (if any)
 Check the output ratios of comps on a rough estimate from Bloomberg or other sources to cross-check
data and check if they are in ‘ball park’ (Bloomberg Command: FA11 can be useful)
 Check your multiples with sector/market multiples

2.8 Common errors

 Most UK Companies share prices are quoted in pence and not pounds so be careful when calculating the
equity value
 Be careful with the units—sometimes balance sheet/notes to the accounts give the information in
‘THOUSANDS’—please divide the figure by 1,000 to get the figures in ‘Millions’ (we input all figures in
millions for our company valuation model)
– Japanese companies: I/B/E/S estimates given in JP Yen are generally in BILLIONS, please double check
and input them accordingly
– No. of shares outstanding figures from Datastream are in THOUSANDS
 Odd figures in Estimates: e.g. EBIT greater than EBITDA which is not possible. Do not use old figures
without double checking the source e.g. the comps file
 EV being less than Market cap—might be the case (if cash > debt) but double-check
 Consistency between denominator and numerator—calculation of EV should be comparable with the
profit measures used in the multiples. For example, if EV includes adjustment for pension liabilities, then
EBIT(DA) should also be adjusted
 Currency adjustments (some companies have share prices in one currency and report in another)
 Calendarisation—ensure you have sufficient forecasts to allow calendarisation of the furthest year out
 Classes of shares—include all classes of shares. Use the MSH function on Bloomberg
 Options—to be included to get the fully diluted number of shares adjustment based on the Treasury
method, assuming shares outstanding are increased by the total shares underlying options net of the
number of shares that can be bought back using the proceeds from the options being exercised
 Exceptionals—should be excluded from all comparable company analysis
 Buyback and share issuance—implied change in NOSH needs to be reflected
 Buyback—implied reduction in NOSH needs to be reflected

 Source and tag all back up to enable auditing
 Insert comments in Excel to explain where adjustments made
 Use reliable forecasts and if using forecasts from a specific broker, determine where they stand relative
to consensus
 No formulae hidden in cells. Where additional analysis is required, create a new tab and link
 Clean numbers—all P&L items should be adjusted for exceptional items
 At the net income level, exceptionals need to be POST TAX (using the marginal tax rate)
 Pro forma—P&L items need to be pro forma for transactions

SECTION 3
Precedent transaction analysis

3
SECTION 3: Precedent transaction analysis 41

Precedent transaction analysis

3.1 Introduction
Precedent transaction analysis is a methodology which compares the multiples implied by selected M&A
transactions involving companies displaying similar characteristics to the company under consideration in
order to derive an implied transaction value for that company. This analysis is useful as it attempts to quantify
the difference between a trading and transaction valuation—often referred to as a control premium.
3.2 Why do we use precedent multiples?

Precedent multiples represent an index of recent market prices paid by other acquirers and accepted by
other sellers. The multiples are “real” in the sense that past transactions were successfully completed at
certain prices.
The mathematical methodology is very similar to the comparable company analysis in Section 2 with the key
distinction that precedent transaction multiples are often based on historic or LTM figures while comparable
company analysis is forward-looking.
The output is also different due to the premium that was paid to gain control of the target company. As a
result, precedent transaction multiples tend to be higher than comparable company multiples.
3.3 Premium for control

This represents the theoretical difference between trading and transaction valuations of the equity of the
business. It can reflect a combination of:
 The fact that the owner of an entire business can manage the assets as it wishes and obtain direct access
to the cash flows, whereas a buyer of a minority interest has to rely on the board/management for the
cash flow it will obtain (via dividends)
 Because of the above, a strategic buyer of a business is able to extract synergies by combining the target
business with its own and this has a clear value to the buyer’s shareholders. (How much of the value of
these synergies is given to the vendor as part of the purchase price will be a function of the parties’
relative negotiating positions)
 Factors that are often not quantifiable in the short term (e.g. the special value to an acquirer obtaining a
strategic foothold in a new market), or “defensive” factors such as maintaining market position or
eliminating over-capacity in the buyer’s industry
 The amount needed to overcome inertia amongst shareholders and to induce them to sell
The quantum of the control premium will vary depending on the circumstances of the transaction.
 The applicable range of premia to trading multiples should be corroborated by checking precedent
transactions. A rough rule of thumb might be that transaction values are 20–50% higher than trading
values but they can be much higher or lower so please note: this is only a rule of thumb and needs
rigorous testing by comparison both with previous control premia paid in public takeovers (over
unaffected share prices) and precedent transaction multiples
 Control premia can be significantly affected by economic circumstances (e.g. if a target company is
perceived to be trading at a high multiple or is subject to takeover speculation, a buyer is likely to be wary
about paying a high premium over the trading values in a transaction)
 It is not necessarily the case that there will always be a premium for control over the trading value. An
absence of free capital markets, or regulations restricting types of potential acquirers of companies, may
all contribute to lower takeover values and control premia. Indeed, in some cases there may be no
premium for control over the trading value, or the transaction value may even be lower than the
trading value
 Some trophy companies may command transaction prices that are particularly high. This is also valid for
assets (e.g. hotels that are bought for “pleasure of ownership and not economic rationale”)

Control premium percentages should be applied to equity values rather than enterprise values. This is
because they are derived from observations of the takeover prices of real companies, which usually have at
least an element of debt in their capital structure.
Another way of looking at the situation is to bear in mind that control is actually exercised by the holders of
voting equity rather than the holders of debt, and hence the control premium should only be applied to the
value of the formers’ holding.
3.4 Choosing transactions

A database of completed precedent transactions is retained and updated by each sector team—this should
always be used as the starting point. Always submit any newly created precedent transactions analyses for
inclusion in the database of the relevant sector team.
When choosing transactions, the aim is to find deals which have similar businesses and financial
characteristics to the transaction being considered. As with the comparable company analysis,
financial/operational benchmarking is helpful. In general, it is advisable to consider the following when
selecting precedent transactions:
 Transactions in the same industry as the target business
 Transactions in the relevant geography (e.g. North West Europe, South America)
 Transaction background (e.g. strategic vs. financial buyer, domestic vs. cross-border, full auction vs.
negotiated deal, underlying market conditions)
 Transaction rationale and financial profile of the assets acquired: scale, growth, synergies, diversification
 Timing: the more recent the data, the more relevant the benchmark, particularly in cyclical industries
 Size of the deal: transactions that are similar in size to the company that is being evaluated are generally
more relevant
3.5 Key metrics

Precedent transaction analysis is normally based on historical, not forward looking, data as this is most readily
available in the majority of situations. Usually done on an LTM basis, i.e. the last twelve months financials
prior to the transaction are used (historical data only)—which means the twelve months prior to the latest
quarterly or interim earnings statement, or annual results. However, at the time of the acquisition, the value
was, in all likelihood, determined by reference to future profitability and so, whenever this data is available
(most commonly where a public company has been acquired and equity research from the time of the
acquisition is available) we should show implied forward multiples too. Bear in mind that the forecasts of the
buyer and the seller might not be the same. For example, by forecasting a lower EBITDA the seller can claim
to have sold for a higher multiple and vice versa for the buyer.
Prices paid as a multiple of net earnings and/or operating profit (EBIT or EBITDA) are typically the most useful
for a broad range of industrial companies, although as with comparable company analysis, other sector
specific multiples should be considered as appropriate. Sector-specific operational multiples (e.g. average
room rate, occupancy rate etc) are often used, in particular for transactions involving private companies when
financial information is limited.
3.5.1.1 Premium analysis

Premium analysis is usually computed for public transactions to illustrate the price paid relative to the
prevailing share price at the time of the deal. The key is to use an “unaffected share price” prior to market
rumours, announcement of a possible offer or strategic review. For the most accurate analysis, you need to
research the exact date when the rumours surfaced and calculate the premium based on the previous day’s
closing share price. This is occasionally impractical (e.g. if analysing a large number of transactions quickly)
and so a 1 month or 3 month premium can be used as a proxy.
Other common metrics considered are as follows:
 Percentage of 1-day trading price, 1-week trading price and 1-month trading price
 Percentage of 1-month VWAP price, 3-month VWAP price and 6-month VWAP price
 Other points include as percentage of 52 week high and low, broker price targets etc.

3.5.1.2 Synergies
Synergies are the financial benefits that a company expects to realise from the integration of two businesses.
There are four main sources of synergies:
 Cost synergies: result from efficiencies created through improved operating practices and greater
economies of scale, e.g. consolidated purchasing, SG&A reductions
 Revenue synergies: result from ability to generate more revenues through combination of infrastructure or
distribution network. Usually very difficult to quantify
 Capex synergies: lower investment required per unit of sales
 Financial synergies: potentially lower cost of debt due to increased earnings power
Cost synergies are normally the simplest to quantify—they are usually announced for most transactions and
typically can be found in the press releases/investor presentations. It is key to consider the multiples on a
post-synergy basis to demonstrate how the acquiring company may have justified the acquisition price. It is
also important to benchmark the level of synergies across transactions (as a percentage of sales or costs) as
this can often account for variations.
3.6 Adjustments
Please see section 2 on comparable companies which shows how to factor in various EV adjustments.
Consistency is important with all adjustments to ensure that one has a meaningful set of data.
3.7 Link to UBS model

There is a simple precedent model which is already set up and easy to use. The model can be found at:
http://nldn1633pap:8257/mandakm/European%20Standard%20Models/Forms/AllItems.htm
3.8 Drawbacks of methodology

 Past transactions are rarely directly comparable either due to company specific factors or the fact that
acquisitions occur at different points in the cycle
 It is very difficult to obtain full information regarding expected performance of the company and the
actual business plan the buyer used at the time of the acquisition
 If based on historic financial information for target companies, it will not reflect expected future
performance of targets
 Public data on past transactions can be incomplete, non-existent or misleading
– data in news stories can be misleading and should be cross-checked where possible
 Premia paid driven by the circumstances surrounding each deal
– nature (e.g. contested, hostile or friendly)
– financial buyer vs. strategic buyer
– consolidation of sector, scarcity of assets
3.9 Data sources

Finding information on M&A deals can be challenging; as a result it is always a good idea to start with
transaction announcement documents from the acquirer and/or the seller. Information on deals involving
private companies is often very limited. It is recommended to consult the appropriate sector teams for specific
sources.

+
 Transaction announcement / document
Company
 Investor presentations
sources
 Latest annual report and interim report of the target
Reliability
 Dedicated databases: SDC, Dealogic

Third party
 Broker notes issued at the time of the deal sources
 Press, mergermarket
-
Confidential information (e.g. info memo, UBS models, documents sent by clients) should not be used for
sourcing financial information.

 If a number seems out of line—double check inputs
– challenge the financials—the result is only as good as the inputs, so make sure you believe the raw
data is accurate
 Cross check with company presentation and research notes published at the time of transaction
 Cross check with trading comps
– multiples tend to be higher reflecting control premia paid
– understand why multiple is lower (scale, existing stake, timing, level of financial distress etc)
 Pro forma financials for recent acquisitions/disposals
3.11 Common errors

 Options should be calculated based on offer price and not current share price
 Accepting the company’s presentation of numbers without checking the notes
 Control premia should be applied to equity values only
 Watch out for revised synergies figures after deal has closed which can help explain the price paid
 Any special dividend paid to the target shareholders should be included in the enterprise value of the deal
 Make sure you are using enterprise value and not market value (particularly for private deals)
 Watch out for stake acquired and adjust appropriately

 Always ask the industry/sector team for information before you begin
 Important to understand each transaction selected and key drivers for price paid
 Do not forget to calendarise data to get LTM financials

Transaction multiples—illustrative output

LTM enterprise multiples LTM equity multiples LTM margins
Equity Enterprise EV/sales EV/EBIT EV/EBITDA P/E P/NAV EBIT EBITDA
Date announced Acquirer Target value (€m) value (€m) (x) (x) (x) (x) (x) (%) (%)
15-May-07 HeidelbergCement Hanson 11,641.1 13,264.1 2.20 17.2 12.1 20.1 2.9 12.8 18.2
20-Feb-07 Vulcan Materials Florida Rock 3,539.8 3,502.1 3.50 14.5 11.7 22.2 3.7 24.2 30.0
02-Mar-06 Hanson Civil & Marine 362.1 362.1 2.48 na 9.6 na na 0.0 26.0
21-Mar-03 CRH SE Johnson 208.7 208.7 0.81 12.2 7.9 12.2 na 6.6 10.3
Median 2.34 14.5 10.6 20.1 3.3 9.7 22.1

Mean 2.25 14.6 10.3 18.2 3.3 10.9 21.1
Premia paid and synergies analysis—illustrative output

Premia paid LTM
1 day prior 1 month prior Announced Synergies as % Adj.
Date announced Acquirer Target (%) (%) synergies of target sales EV/EBITDA (x)
15-May-07 HeidelbergCement Hanson 4.1 33.0 199.9 3.3 10.2
20-Feb-07 Vulcan Materials Florida Rock 44.9 45.4 38.0 3.8 10.3
Where relevant,
2-Mar-06 Hanson Civil & Marine na na 4.4 3.0 8.6 add columns with
21-Mar-03 CRH SE Johnson na na 0.0 na 7.9 operating metrics
Median 3.3 9.4
Mean 3.4 9.3
Source: Publicly available information

SECTION 4
Discounted cash flow

4

4.1 Introduction to DCF concepts
4.1.1 What does DCF value represent?

The DCF analysis estimates the net present value of projected cash flows available to the providers of capital
to the company being valued.
It is a more sophisticated approach than relative multiple valuation, aimed at capturing the intrinsic value of
the underlying business. It is particularly suitable for valuations involving:
 Predictable cash flows (e.g. utilities, infrastructure projects)
 A business with simple operational characteristics (e.g. hotels)
 Assets with finite lives (e.g. mines, oil and gas properties, royalty streams)
 Projects that will not produce revenues for some time (e.g. construction projects)
 Situations where detailed financial information is available for modelling so that we can prepare accurate
projections of turnover, operating costs and capital expenditures
 An investment which is difficult to value in other ways (e.g. a business with operating losses, a joint
venture or a “bolt-on” acquisition where cost savings are an important source of value)
A DCF analysis is only as good as the cash flow forecasts on which it is based. If we only have 3 years of
public data for example, a DCF can only ever be a crude cross-check. However, if we have a good set of
financial forecasts, DCF will become much more important as a valuation tool, particularly if the company fits
into one of the categories above.
In addition, DCF analysis is a good communication tool as it allows us to understand and model the key
drivers that will affect value.
4.1.2 Discounting projections and terminal value

There are two parts to a DCF valuation: the projected cash flows and the terminal value. The terminal value
represents the value at the point in time at which the explicit projection period ends, and its derivation is
covered in greater detail below. The cash flows for each year and the terminal value should be discounted
back to the valuation date using the following formula:
Present value = Cash flow / (1+Discount rate)t
Where t is the time period in years of the cash flow you are discounting.
SECTION 4: Discounted cash flow 48

4.1.3 Defining what to discount

The discount rate and cash flows that should be used are dependent upon the type of DCF valuation you are
seeking to undertake.
Different DCF approaches can be used as valuation tools. These different methods are essentially equivalent
and should result in the same value for equity. When performing a DCF analysis, it is important to consider
what is being valued (the enterprise or the equity), and to use cash flows and discount rates which reflect
these (i.e. for equity value you look at dividends and the cost of equity, for enterprise value you look at all
cash flows and a weighted average cost of debt and equity to reflect all sources of capital).

valuation
PV of enterprise
PV of equity cash flows
cash flows
Dividend discount Discounted enterprise

Adjusted present value
model FCF
Enterprise cash flows

 Discounted enterprise free cash flows: the most common DCF technique, based on free cash flows
(see below). Discount rate is the weighted average cost of capital (see below). Provides an estimated
enterprise value that must be adjusted to identify the implied equity value
Equity cash flows

 Dividend discount model (“DDM”): a direct equity valuation. Forecast dividends are discounted by the cost
of equity. Dividends can be forecasted directly or generated by forecasting earnings and the payout ratio
 Adjusted present value (“APV”): modified version of DDM. Focuses on all cash flows that can potentially
be distributed to equity holders discounted at the cost of equity
– APV calculates the net present value of cash flows assuming 100% equity financing and adds up the
present value of benefits/drawbacks of financing (e.g. tax shield)
– in cases where the level of gearing changes substantially over time (e.g. if an entity cannot be
re-levered at the present time, or construction projects that can sustain very different debt profiles
early on), it may be more appropriate to use a discounted equity free cash flow model that calculates
cash flows available to equity holders using a detailed schedule deducting the amortisation of existing
debt and related service costs from free cash flows and discounting by the cost of equity, thus
capturing the change in the debt profile over time
Equity cash flow DCF methodologies are discussed further in section 6. The rest of this section focuses on
DCF analysis based on enterprise cash flows although the mathematical framework is identical.
4.1.4 Real vs. nominal

It should be noted that the present value of a business should be the same whether real or nominal cash
flows are used. The discount rate should be calculated on the same basis in which the cash flows are
presented (i.e. real cash flows—use a real discount rate). In practice, nominal values are used in the vast
majority of cases. This reduces the need for additional assumptions regarding projected inflation rates.

4.2 Free cash flow
4.2.1 Definition
A business’ free cash flow represents the cash returns available for distribution to all providers of capital (i.e.
debt and equity holders). Free cash flows are calculated as the net cash flow from a business, after capital
expenditure, changes in working capital and notional cash tax (but before interest):
EBIT
Less: Notional taxes/cash taxes 1
Earnings before interest, after tax
Add: Depreciation & amortisation
Less: Investment in working capital
Less: Capital expenditure
Unlevered Free Cash Flow
Alternatively,
Net income 2
Add: Deferred taxes & other non-cash charges
(e.g. depreciation, amortisation and deferred taxes) 3
Add: After-tax interest expense
Less: Investment in working capital
Less: Capital expenditure
Unlevered Free Cash Flow
Notes:
1 Notional tax/cash tax is the total tax charge less interest relief at the marginal tax rate. Alternatively you can apply the effective tax
rate to taxable income (roughly EBIT less tax losses carried forwards) to reflect the tax charge as if there were no debt
2 Net income before preferred dividends, equity income and minority interest
3 Goodwill amortisation is only deductible for tax purposes under limited circumstances in certain countries
As you can see from the above, tax on EBIT is adjusted for in the free cash flow calculations. It is important
that this reflects to the fullest extent possible the actual tax charge on earnings, including the appropriate
deductibility of amortisation and depreciation. This is discussed in more detail below.
Conventionally, a DCF valuation is undertaken pre-synergies. This theoretically values the whole company, as
if it were controlled, and so there is no need to add a control premium. In order to assess the total theoretical
value that an acquirer might extract from the business, it may also be appropriate to prepare a DCF including
synergies. A purchaser would not be prepared to pay this higher value, as it would be paying away all its
synergies, but might be prepared to pay a value incorporating, say, half the synergies assuming the
transaction meets a predefined return within an acceptable timeframe.
4.2.2 How to develop cash flow projections
4.2.2.1 Turnover
Turnover should be broken down and modelled at an appropriate level of detail unless the mix is expected to
remain stable (e.g. by country, product group, channel of distribution).
In general, turnover can be projected by applying the assumed inflation rate and real growth rates, or
volumes and unit prices.
Research reports, client forecasts and industry surveys should be consulted to develop or confirm projections.
The relationships between turnover, market growth and market share should be considered carefully and, if
possible, modelled explicitly. It is critical to understand the basis for turnover and margin projections and to
assess their reasonableness.
Inflation rate assumptions in the market/turnover forecasts must also be checked for consistency with the
inflation rate assumptions in the DCF model and discount rate estimation (or make adjustments as appropriate).
It is particularly important that the cash flow projections be expressed in (or converted to) the same currency
for which the discount rate has been calculated. For example, if you are using a US$ risk free rate as the basis
for the WACC, the forecasts must be converted into US$ at appropriate rates (remember that the exchange
rate captures the inflation differential between currencies). Generally, it is recommended to use the currency
in which company’s cash flows are denominated.

4.2.2.2 Operating expenses

Projected operating margins should be compared against historic and competitor margins; we have to
consider whether the projected margins are reasonable for the market in question.
Operating expenses should be broken out by category if possible; determine whether each item is fixed or
variable. Depreciation should be considered separately.
In many businesses, COGS (cost of goods sold) and SG&A (selling, general and administrative) expenses can
be separated easily.
Minority interest, provisions, deferred taxes and other non-cash items should be excluded.
Corporate overheads should be included.
4.2.2.3 Depreciation and amortisation

When unavailable, depreciation can be estimated from balance sheet data as follows:
Plant and equipment (beginning of period)

+ ½ capital expenditures
Average asset life
Future values of plant and equipment on balance sheet can be projected by deducting depreciation and asset
disposals and adding capital expenditures on plant and equipment.
It should be noted that as the business’ markets mature and growth opportunities become more scarce,
depreciation and capital expenditure should converge to a 1:1 relationship, reflecting the fact that capital
expenditure is being spent to maintain, as opposed to expand, capacity.
Over the long term, a common rule of thumb is for capex to be equal to depreciation over the course of the
cycle in order to maintain returns. This effectively provides for a constant capital stock. Clearly this will be true
in aggregate for a mature industry, but care should be taken to examine the relative prospects of the
business being valued within that industry.
4.2.2.4 Cash taxes (notional)

Notional cash taxes are calculated by assuming no interest can be estimated from the P&L by taking the
existing tax charge and adding back the notional tax on interest expense at the marginal tax rate.
Notional cash taxes can also be calculated as a percentage of EBIT unless the company’s effective cash tax
rate differs substantially from the marginal tax rate, but it should be noted that an adjustment should be
made for amortisation in jurisdictions where it is not tax deductible (i.e. in most jurisdictions). Amortisation is
likely to be particularly significant in US company financial statements, where goodwill has been incurred and
is being written off.
Taxes should be reviewed carefully if the assumed rate is different from the statutory rate.
When modelling cash flows in detail, consider carefully the effects of capital expenditures on taxes—there
may be tax credits or tax shelter through accelerated depreciation. At the end of the projection period, make
a generous allowance for capital expenditure required to sustain the asset base, particularly if, in the terminal
year, capex is below depreciation.
4.2.2.5 Investment in working capital

Can be estimated roughly as a percentage of sales. However, a more detailed, yet still simple, approach
separates working capital into its components and calculates their turnover against sales or COGS, usually
expressed in days, and calculated as follows:
Stock days = Stock / Cost of Goods Sold x 365
Debtor days = Debtors / Sales x 365
Creditor days = Creditors / Cost of Goods Sold x 365

4.2.2.6 Capital expenditures

Sustaining capital expenditures (i.e. regular replacement of plant and equipment) should be considered as
well as specific planned capital expenditures for growth.
We should look at long-term average ratios of capital expenditures to sales and capital expenditures as a
percentage of fixed assets for the target and competitors.
Consider factors which can create specific capital expenditure requirements, for example capacity limits, new
technology and environmental compliance.
4.2.2.7 Asset disposals

There may be certain assets that can be sold, either immediately or in the future; e.g. investments, property,
excess capacity.
4.2.3 Dealing with affiliate income, minority interests, other income and
financial income
Equity income from associates can be problematic. Only dividend income is received—which is likely to be
less than the investing company’s share of profits, and the company’s pro-rata share of capital expenditure
and debt will not be included in the annual report or prospectus. If associates represent a large proportion of
income on value, they should be valued separately and excluded from the DCF analysis.
Minority interests should be valued separately as appropriate and deducted from the enterprise value when
estimating equity value if they have been added back to net income in calculating free cash flow.
Other income and financial income should be included in the firm’s cash flows to the extent that these
are core business activities. If this is not the case, or if there is significant variability in these items, they should
be excluded from the free cash flows and valued separately.
4.2.4 How to deal with deferred taxes and long-term accruals

Deferred taxes occur for a number of reasons, as explained in Section 2.3.4. For most companies (except for
those with very significant or irregular capital expenditure programmes) the deferred tax component of the
profit and loss account tax charge is normally relatively small and in practice, subject to a one year deferral in
payment, taxes provided in the P&L are often a reasonable estimate of notional cash taxes for DCF valuation
purposes. If deferred taxes are large, it will normally be necessary to adjust the P&L tax charge to add back
the deferred tax element. All of this is relevant only to “bottom-up” estimates of free cash flows.
Accumulated tax losses or tax credits are often valued separately rather than adjusting the projected cash
flows. The value of the tax loss or credit then becomes an adjustment to the enterprise value. This approach
may not work if the losses or credits are not expected to be recoverable over an extended period.
Accruals reflect the difference in timing between when a cost is incurred and the related cash payment is
made. These need to be carefully analysed to determine whether this timing difference can be assumed to
persist, and if so, the cash flows should be adjusted to ensure the cash payment is properly reflected in free
cash flows (assuming they are suitably material).
4.2.5 What to do with loss making or very fast growing subsidiaries and
where DCF valuation may be inappropriate
DCF valuations are only as reliable as the data on which they are based. In the case of loss-making or
fast-growing subsidiaries where there is a lesser degree of confidence regarding likely future performance
additional analysis should be undertaken.
Loss making companies which are not likely to achieve profitability in the future should be considered as if
they are being wound up; their cash flows excluded from the rest of the business and be valued on the basis
of their liquidation value (realisable proceeds net of closure and sale costs). For companies making temporary
losses, consider valuing them on the basis of their net assets, with an appropriate adjustment. Alternatively,
they may be valued on the basis of a normalised operating margin (based on the industry/sector) to derive a
theoretical profitability level, based on turnover/assets. Then amounts for risk and uncertainty should be
deducted in achieving those theoretical profitability levels (very subjective) and costs incurred in getting to
that stage including losses in the intervening period.

Fast growing subsidiaries should be valued independently of the rest of the business if possible in order to
allow analysis and sensitivity of the growth profile of that subsidiary. This should be benchmarked against
other growing companies (past and present) in that sector, and sense-checked in terms of costs of achieving
growth and winning market share.
4.2.6 How long to forecast?

In principle, cash flows should be projected until they are expected to stabilise (i.e. grow reasonably in line
with inflation or GDP, on normal margins). In practice, a 10-year projection period is common.
Projecting for a minimum of five years is recommended. Even if there is a lack of detailed cash flow
projections beyond two or three years, reasonable forecasts for the rest of the projection period, based on
general growth and margin assumptions, are Iikely to be less subject to error than the terminal value itself.
Terminal value estimates are subject to wide variation, depending on the perpetual growth rate assumption
for future cash flows; the free cash flows themselves are somewhat less difficult to forecast. Shortening the
projection period causes most of the value in the DCF valuation to be in the terminal value.
One approach to DCF modelling involves making detailed projections for, say, five years and then projecting
free cash flow using a simple growth rate assumption for the next 10 to 15 years; this minimises the effect of
errors in estimating the terminal value while making explicit the general nature of forecasts beyond the first
few years.
Long projection periods are appropriate in special cases. Examples include:
 Mines and other finite-life assets, for which cash flow projections should cover the life of the asset (i.e. no
terminal value); and
 Large projects for which there will be negative cash flows for several years (e.g. Eurotunnel)
In these cases, a projection period longer than 10 years would be appropriate.
Only certain balance sheet items need to be projected in most cases:
 Working capital movements;
 Asset disposals; and
 Capital expenditures
Projecting a balance sheet or P&L statement is not necessary to establish an enterprise value using the DCF
method. Only cash flow matters. However, it may be useful to develop balance sheet and P&L projections in
order to put the cash flow forecasts into context and to ensure sensible assumptions have been made on
capital structure and returns going forward.
4.2.7 How to create sensible assumptions for free cash flows

4.2.7.1 Forecasting cyclical companies
It is important when forecasting cash flows for a cyclical company to include at least one complete cycle. This
avoids results that are not representative of the long term value of the company that are caused by only using
cash flows during a peak or trough in the cycle. Particular care should be exercised when projecting the
terminal value cash flow. This should be representative of average cash flows across the entire cycle to ensure
there is no bias one way or the other.
4.2.7.2 Forecasting in different currencies

If a business has only a small proportion of its business in different currencies, it is customary to assume that
the cash flows from this business are converted to the valuation currency at a fixed rate. In situations where
currency exposures are more significant, it is advisable to separately value the cash flows of the business that
are generated in the different currency to allow sensitivities to be run. These cash flows should then be
converted at the expected FX rate for each year, from a credible source (e.g. UBS, Economist Intelligence
Unit, Global Insight, etc), cross-checked against forward rates.

4.3 Terminal value
4.3.1 Definitions
Terminal value is an estimate of the value of business at the end of the projection period, which is in turn
expected to be the present value of the future cash flows from that point. Conceptually, the firm is being
valued on the last day of the last year of the projection period. As with the cashflows during the projection
period, the terminal value needs to be discounted back to the valuation date.
4.3.2 How to calculate the value terminal value

There are three common ways to calculate terminal value:
 By capitalising free cash flow (as a growing perpetuity);
 By applying a multiple; and
 By capitalising free cash flow in a formula that explicitly considers the return on newly invested capital
from that point onwards in the projection period
For the first and last methods, it is necessary to project cash flows for the year after the projection period
because the formulas used are for the value of perpetuity.
4.3.2.1 Perpetual growth

The perpetual growth (or Gordon Growth) method calculates terminal value by growing the year t cash flow
by a chosen growth rate (often 2%, but which shouldn’t exceed the inflation rate in the relevant country as
this implies a continuously growing business in perpetuity). The value of this growth to infinity as at year t, is:
FCFt 1
WACC  g
Where “FCFt+1“ is the cash flow in year t+1 and “g” is the perpetual growth rate. This should be discounted
back t years to year zero.
It is important to show a sensitivity table with different assumptions for WACC and g, given their significant
impact on the terminal value, and hence overall value.
4.3.2.2 Multiple
This method assumes that the business trades in the public market or is sold at the end of the
projection period. It is often used as a cross-check to the other terminal value methods. For example, it is
helpful to know what EV/EBITDA multiple is implied by certain perpetuity assumptions and then to
cross-reference this against comparable company benchmarks to check that it is reasonable.
When using multiples it is imperative you apply the right one i.e. a current year sales multiple times year 10
sales will give the value at year 10, as will a one year forward multiple times year 11 sales. A current year
multiple times year 11 sales gives the value at year 11.
Terminal Value = Operating statistic x Multiple
If free cash flows are being capitalised, we need to be sure that adequate long-term capex is being provided.
Where the operating statistic used can be sales, EBITDA, EBIT, net income, or another measure as appropriate
for the industry. We also need to bear in mind that, by the terminal value date, many of the special attributes
of a good business may well have been averaged down by competition implying a lower multiple than might
be used today.

4.3.2.3 Value driver

This technique produces the same result as the perpetual growth method; it simply expresses the perpetual
growth method in terms of the value drivers: ROCE and growth:
NOPLATt 1  (1  g / ROCE)
Terminal value =
WACC  g
Where
 NOPLATt+1 = the normalised level of net operating profit less adjusted tax (NOPLAT) in the first year after
the explicit forecast period (see section 4.3.8 for detailed calculation of NOPLAT)
 g = the expected growth rate in NOPLAT perpetuity
 ROCE = the expected rate of return on net new investment
This formula is identical to the Gordon growth formula above in the case where ROCE is equal to WACC
(practically speaking when the return on new investments only equals the WACC), which could feasibly be
the case in mature, competitive markets where opportunities for value-creating investments are no longer
available. Hence the Gordon growth formula is used in most cases.
If you wish to assume that a company remains able to make incremental investments at above its cost of
capital in perpetuity, the above value driver formula can be used. This would be the case where a company is
assumed to have a natural advantage over its competition that will not be eroded over time.
4.3.3 Understanding the relationship between growth and investment in the

terminal year including the relationship between capital expenditure
and depreciation
In a steady state, the capex of a business would be equal to depreciation. At this level, the amount of capex
spent is equal to the fall in useful value of its assets, i.e. capacity neither expands nor contracts but is
only replaced.
If a business expands, it will need to grow its fixed asset base in order to provide capacity for expansion.
In this case, the business will spend capex in excess of the cost of maintenance and replacement of existing
capacity, hence capex will be greater than depreciation. Vice versa, if a business is contracting, its capex will
be lower than its depreciation.
In calculating a terminal value, we need to assume that the business has reached a steady state. Therefore we
typically assume that capex and depreciation are equal (or at least very close). There will usually be a trend
over time to reach this level.
4.3.4 Preparing and checking the steady state cash flow

In calculating the steady state cash flow, you should ensure that any abnormal results are normalised
(by using an average over time or simply reversing any identifiable anomalies). This should be done on a
line-by-line basis, and the result sense-checked against historic and industry-average growth rates and
margins. As per the above, you should ensure that the ratio of capex to depreciation does not imply strong
growth or contraction in the business either.
4.3.5 Preparing a steady state year for a cyclical company

The steady state year for a cyclical company should be reflective of the state of the business across an entire
business cycle in order to prevent bias. In this respect, growth rates and margins for the terminal year should
be based on average levels. Over the cycle historic analysis is often useful to corroborate the
assumptions used.

4.3.6 Sanity checking the amount of value embedded in the terminal value?
How much is too much?
The amount of value embedded in the terminal value will be a result of a number of factors, including:
 Length of the explicit projection period (longer period will lower proportion of value in terminal value);
and
 Growth rate in projection period (higher rates will raise proportion of value in terminal value)
As such, it is not possible to be precise about the proportion of value in the terminal value, except to say that
for a normal business assumed to operate in perpetuity it is likely to be 50–70% depending on the
projection period. If it is higher than this, you should extend the projection period and explicitly model a
longer time period to try to capture a higher proportion of the projections explicitly and thus
improve accuracy.
4.3.7 Understand how to back calculate the implied long-term growth rate if
you use an EBITDA multiple for the terminal value
By rearranging the Gordon growth formula, it is possible to derive the implied long term growth rate. This is
useful to sanity check the EBITDA multiple which is being used to ensure it appropriately reflects the future
prospects of the business at the end of the forecast period. The formula is as follows:
Implied growth rate = WACC – (Steady state cash flow/Terminal value (multiple-based))
4.3.8 Example terminal value calculation

Assume that we are valuing a business with the following cash flows in the first year after the
projection period (steady state cash flows):
(£m)
Turnover 1,000
Cost of goods sold (600)
Gross profit 400
SGA and overheads (275)
Operating profit 125
Share of associates 25
EBIT 150
Notional cash taxes (150 x .33) (50)
NOPLAT 100
Depreciation & amortisation 60
Capex (12)
Investment in NWC (4)
FCF 144
Additional capital expenditure to “normalise” FCF (48) 1
Normalised FCF 96
Note:
1 This adjustment assumes capex is equal to depreciation. The correct figure will depend on the circumstances of the business
being modelled

With a WACC of 10%, an assumed FCF growth rate of 2% and an assumed NOPLAT growth rate of 7%, the
terminal value (“TV”) would be as follows under the three methods:
1. Perpetual growth:
TV FCF
=
WACC  g
96
=
0.10  0.02
= 1,200
2. From EBIT multiple (say 7x):

TV = EBIT multiple
= 150 X 7
= 1,050
3. From NOPLAT (assuming r = WACC):

NOPLAT  (1  g / r)
TV =
WACC  g
100  (1  0.02 / 0.10)

=
0.10  0.02
= 1,000
4.3.9 Link to UBS model

There are both standard long form and short form DCF model templates, which will allow you to link in
financial data to automatically calculate and sensitise DCF values. Whilst these are very useful tools, their use
and outputs should be considered in the context of the discussion above to ensure that the most logical
forecasts and methodology are used. The models can be found at:
4.4 The discount rate—Weighted Average Cost of Capital (WACC)
4.4.1 Definition
The WACC is a measure of the weighted average after tax cost of all sources of capital to an entity. It can
also be thought of as the effective blended rate of return which an entity must pay to capital providers. It is
important to remember that in a typical valuation, the WACC is supposed to represent the appropriate
long term cost of capital.
4.4.2 Estimating WACC under Capital Asset Pricing Model (CAPM)

Overleaf is the standard page setting out the WACC calculation under CAPM, which is contained within the
standard DCF model.

WACC analysis
SUMMARY OF WEIGHTED AVERAGE COST OF CAPITAL CALCULATION—CAPITAL ASSET PRICING MODEL
Market risk premium (%) ¹

5.50
Cost Equity risk premium (%)

5.53 Assumed
of long-term
Levered company beta ² financing
equity 1.01 structure
Levered company 85%
cost of equity (%)
9.77
3
Risk free rate (%) WACC (%)
4.24 8.93
Levered company After tax
cost of debt (%) cost of debt (%)
5.74 4.13
15%
4
Cost Levered debt premium
150bp
of
debt
Marginal tax rate (%)

28.0
Notes:
1 Source: UBS Equity Research market risk premium derived from “forward looking” calculation using UBS forecasts across the equity market and spot prices
2 Source: observed levered Beta (Barra - local) relevered based on assumed long term financing structure
3 10-year government benchmark bond yield (Source: Bloomberg, Datastream)
4 Company credit margin at chosen financing structure
The calculations behind this page are set out below:
WACC = Weighted cost of debt + weighted cost of equity
D E
=  (Cost of debt"Kd" ) (1- T)   (Cost of equity "Ke")
D E DE
Where
 D = Debt component of capital (at market value)
 E = Equity component of capital (at market value)
 t = Marginal tax rate
Kd = (R+m ) x (1– t)
(i.e. net of tax relief)
Ke = R + (p x ß)
Where
 R = Risk free rate
 m = Interest margin (i.e. the debt risk premium)
 p = Equity risk premium
 ß = Beta for the assumed long-term gearing

The risk-free rate (R) can be taken as the yield on the applicable 10-year government bonds. It is important
to take a 10 year bond as this captures longer-term WACC.
The “debt risk premium” (m) is the premium over the yield on long-term government bonds demanded by
the market on the company’s debt. It varies widely according to the credit rating of a company, or underlying
credit strength. DCM or GSF may be able to give an indication of the likely premium for individual companies.
Alternatively check the yield on recent long term (5 years +) financings of the company in question. You
should verify that the all-in cost of debt is correct (i.e. the consistent risk free rate and margin are used).
The “equity risk premium” (p) refers to the premium demanded by equity investors on shares that have an
“average” degree of market related risk and an “average” level of gearing. For equities on major stock
exchanges, it is likely to fall between 4 and 8%.
Beta (ß) reflects the sensitivity of the stock to movements in the market. Betas are dependent upon
the gearing of a company, and when obtained from Barra, Datastream, Bloomberg and most other sources
are “geared betas” which reflect the actual level of gearing for the company concerned (i.e. reflects actual
measured co-variance between movement in the stock and the relevant index). Within normal gearing
ranges, beta can be adjusted to reflect assumed gearing levels different from the actual gearing level using
the following formula:
D
ß geared = ß ungeared x 1 + ( x (1 – t))
E
Betas and equity risk premium data are normally available only for major stock markets. It may still be
possible to use this data when the target business is in a different country, although the equity risk premium
might be higher for a developing economy or an emerging stock market than for, say, the NYSE or London
Stock Exchange (see 4.4.5.2).
Consistency of assumptions concerning interest rates, inflation rates, tax rates and the cost of capital is
important. The following points should be considered:
 The risk-free rate should normally be 2 to 6% above the assumed general long-term rate of inflation
 The currency used for projections should be the same as the currency on which WACC is based
 The assumptions about capital structure (i.e. proportions of debt and equity) and tax rates should be
reviewed carefully if the company will pay little or no tax under those assumptions
 If management provide a discount rate, the underlying assumptions should be checked. Is it after-tax? Is it
a return on equity or a return on capital? For what currency is it calculated? Is it a hurdle rate?
 An after-tax discount rate should be used with after-tax cash flows
 Turnover and costs are generally projected as nominal values (i.e. they include inflation). There are some
situations in which it is acceptable to discount real cash flows using a “real” discount rate, but using
nominal figures (i.e. which include inflation) is usually more accurate, reduces the possibility of confusion
and is often simpler
 The cost of preference shares is defined as the yield to maturity (based on the net dividend) on the
company’s preference shares, with no deduction for corporate tax
4.4.2.1 Is your WACC fully weighted?

When calculating the WACC using the above formula, it is important to ensure that all debt and equity
instruments are included. The weightings can then be adjusted accordingly, based on the market value of
these securities. Using the book values will not accurately reflect the current capital structure of the company
due to the fact that they are based on historic cost. In instances where no market value is available, book
values may, however, be the best approximation available.
Due to the fact that interest payments are deductible in most jurisdictions (although not all), you should
ensure that the WACC reflects the after tax, or effective, cost to the company. Further information regarding
the tax rate you should use is set out overleaf.
Preference shares should be included in the WACC calculation and in the capital structure weightings if they
represent a significant part of the capital structure. Their effective cost should be calculated as the yield to
maturity of the outstanding preference shares (potentially based on issuance cost if market values are
not available).

The cost of common equity can be calculated based on the CAPM as calculated above, which can be cross-
checked by calculating the implied cost of equity from a dividend discount model (see below).
There may be circumstances where it makes sense to use a different WACC in different years, for example, if
a tax regime is expected to change.
4.4.3 Which tax rate to use?
4.4.3.1 Taxation in different countries

We should bear in mind the way tax is actually levied by tax authorities.
If a UK company buys a US company, it may finance this in part with US$ debt. The debt may be
denominated in dollars, but it may be located in the UK (where it will attract relief at UK tax rates against UK
profits) or in a US sub-holding company (where it will attract relief at US tax rates).
Given all the other simplifying assumptions and simplifications in DCF modelling, it is probably not worth
worrying about the implication of this, and we should instead use the marginal tax rate in the target
jurisdiction to tax the cash flows. However, we should be aware that, if tax rates differ by a very large
amount, this can cause inaccuracies in the context of “value to the purchaser.” Indeed, in some cases,
overseas companies may be held in such a way that tax relief is obtained twice (once in the target’s and once
in the owner’s jurisdiction). It is possible to deal with such issues in the DCF modelling, and reference should
be made to tax treatment in any fairness opinions.
4.4.3.2 Investor vs. Corporate taxes

People sometimes question how the WACC should take account of the differences between corporate and
investor tax rates. This question is complicated by:
 The dividend payment system in the country in question;
 The fact that some investors (e.g. pension funds) are tax exempt; and/or
 Different tax rates amongst tax paying investors
It is usual practise to ignore the above differences in the WACC calculation, and to allow tax relief at the
corporate tax rate for debt, and no tax relief for equity funding. This makes sense if one is looking at the DCF
process from the perspective of the acquiring company. After all, it gets tax relief on servicing costs for its
borrowings, and does not get any tax relief on servicing costs for its equity (dividends).
Other arguments in favour of ignoring the taxes at the shareholder level are:
 The part of the WACC calculation that relates to the returns demanded by investors, in order to invest in
equity rather than debt, is based on historical data, and is what it is—an average
 The measured risk premium is generally computed as the pre-investor tax differential between the
risk-free rate and the overall return on equities
 The measured risk premium includes the impact on the cost of capital of investor taxes and therefore it
would be double counting to apply the effect of the tax again
 It is impossible for a public company to choose who will invest in it, e.g. to try to sell its equity only to
tax-exempt pension funds or to top-tax rate paying individuals
 The cash flows being discounted are after notional corporate taxes but before investor level taxes;
therefore the discount rate should also reflect only corporate level taxes
4.4.4 Equity risk premium

The equity risk premium (“p”)—i.e. the difference in returns expected by investors under the CAPM theory
from investing in equities, relative to the risk-free rate, has been estimated in several studies. These estimates
range from c. 4.0–8.5%. Some have used Treasury bill yields as the risk-free rate; others have used long-term
bond yields. For our purposes, we regard long rates as a better measure of the risk-free rate than short rates,
since DCF valuations are based on long-term projections. Furthermore, forward-looking measures are strongly
preferred due to their more accurate picture of current expectations.

UBS Equity Research calculates a measure of the forward-looking risk premium, which attempts to capture
investor expectations. This implied equity risk premium is derived from a discounted cash flow model, which
equates discounted future streams of earnings (cash flows) to prevailing market valuations and is primarily
used to assess risk appetite. The equilibrating factor is the discount rate, which is the sum of the risk-free rate
and the equity risk premium. Subtracting the long-term bond yield from the discount rate yields the implied
equity risk premium. This methodology has drawbacks arising from the fact that consensus forecasts are
often incomplete and/or date quickly, particularly in volatile markets, potentially giving rise to
anomalous results.
As the wide range of estimates suggests, “p” is difficult to estimate, since it is in theory a measure of the
Ievel of required—rather than actual—equity returns. Because required returns from equities cannot be easily
measured, "p" is often estimated by considering actual stock market returns over a very long period of time,
relative to either short-term or long-term government bond yields. Equity returns can be measured either as a
geometric mean (i.e. the compound average return over the period) or as an arithmetic mean of the annual
returns. There are arguments for both measurement approaches. Similarly, there are arguments both for
using short-term and for using long-term rates as the risk-free rate in this calculation; for our purposes,
long-term rates are preferable since we are attempting to measure the cost of long-term capital, and as such
will be the same as the rate used in calculating the cost of equity.
4.4.5 Beta
Betas are calculated using the following formula:
Beta (Stock) = Covariance (Expected stock return, Expected market return) / Standard deviation (Expected market return)
Forward looking betas are estimated by Barra, but in the absence of reliable data on expected returns,
historic data may be used. This can be downloaded into Excel from information services such as Datastream,
and calculated using standard Excel formulae.
The betas acquired from most public sources reflect the specific debt/(debt—equity) ratio at the time of
measurement. For comparability purposes (e.g. in WACC calculations), we may wish to make use of a beta
with a different capital structure. Note that for companies that have some level of debt, levered betas are
higher than unlevered betas because leverage amplifies the ups and downs of returns for shareholders for
any given level of business risk. Business risk with no leverage is measured by the unlevered beta or asset
beta. The equation overleaf sets out how to adjust the beta for leverage:

Example:
25 = D0 = original debt component of capital (at market value)
75 = E0 = original equity component of capital (at market value)

33% = t= marginal tax rate
1.1 = ß geared = the measured, geared volatility of the particular share

ß geared
ß ungeared =
D
1 + ( x (1 – t))
E
1.1
=
25
1 + ( x (1 – 33%))
75
= 0.90
This is in line with the idea that lower gearing yields a lower beta (because gearing compounds volatility).
Then, assuming the desired gearing was:
40 = Dt = “target” debt component of capital (at market value)
60 = Et = “target” equity component of capital (at market value)
D
ß geared = ß ungeared x 1 + ( x (1 – t))
E
40
= 0.90 x 1 + ( x (1 – 33%))
60
= 1.30
4.4.6 Capital structure

Given that debt is typically less risky than equity it is usually a cheaper source of financing, particularly when
you take into account the tax shield on interest. However, it is not the case that the optimal financing
structure is to maximise the debt component as increasing the debt burden increases the financial pressure
on the company with a lower ability to service debt and higher volatility in equity returns. As a result, the
cost of both debt and equity increase as debt accounts for a greater portion of the capital structure. In
practice, the lowest weighted average cost of capital tends to be the point at which a company’s credit rating
is just above the investment grade boundary. However, companies often target different capital structures as
a result of the need to preserve a very high credit rating (e.g. banks) or a suitability for high leverage
(e.g. infrastructure).
4.4.7 WACC reasonability

Changes in the WACC can have a very significant effect on the valuation. It is therefore very important that
you check the data used to calculate the WACC, and furthermore, also ensure that it is reasonable from a
logical perspective.
Factors we should bear in mind in considering the WACC are:
 How much debt and equity (at market value) does the company use to finance itself? An all equity
financed company should have a higher WACC, because of the absence of tax relief
 Are we using a US or UK (or other) risk-free rate?
 Are we using a “pure” WACC or one that includes a hurdle rate or one that has been loaded for risk?

4.4.8 WACC versus purchaser hurdle rate

A DCF with a “normal” WACC calculation produces a theoretical or absolute value for the business. This
does not necessarily reflect the purchaser’s hurdle rate of required return (which includes the profit potential
required). Thus, a WACC of 13% may produce a DCF value of 100. However, the purchaser may only be
prepared to buy the business for 80. This might represent a discount rate of 18%, which is the buyer’s hurdle
rate or required IRR.
4.4.9 Link to UBS model

Both the short and long form DCF models contain a template to calculate the WACC in a format that can be
used in presentations, and (as per the above link), are available at:
4.4.10 Dividend discount model as an alternative to CAPM

In addition to CAPM a number of other models exist to calculate the required return on equity. These have
been proven to increase the accuracy (reduce the standard deviation) of predictions in the real world, but the
effect is relatively small, and by introducing additional complexity the potential for errors in calculation grows.
As such, CAPM is generally used in the financial services industry as a relatively simple but accurate model. Of
the remaining methods of estimation, a dividend discount model is most commonly used as a cross-check for
CAPM. Further information on this is included in section 6.
To calculate the cost of equity from a dividend discount model, you will need to model the expected future
dividends of the business. Then, taking the current share price of the company, you can calculate the IRR that
is implied by this price and the future cash flows. This IRR is the implied cost of equity. This method does
however rely on dividend estimates being in line with market expectations and as a result can produce
inaccurate results.
4.5 How to discount
4.5.1 Understanding the financial maths for discounting

Discounting is performed via rearranging the formula used to calculate future values given a set rate of return
(as you would use to calculate your own bank interest), which is:
FVt= PV x (1+r) t
Where r is the WACC and t is the time period of the cash flow being discounted (i.e. year 1, year 2 etc)
Rearranging, the formula to discount a future value is:
PV = FVt / (1+r) t
4.5.2 Impact of seasonality

Where cash flows are assumed to fall on average in the middle of a year (as is the case with most companies
with steady sales), but reported at the end of a year, the time factor (“t”) for the first year’s cash flow should
reflect this fact, i.e. the first year will be discounted by:
PV = FV / (1+r) 0.5
All future years’ cash flows will also be considered to fall mid-year, so the timing factors will be 1.5, 2.5, 3.5
and so on.
Where a business is highly seasonal (e.g. garden furniture that is mostly sold in spring), the time factor should
be adjusted. For instance if we assume cash flows are received on average at the end of March, the discount
factors would be 0.25, 1.25, 2.25, etc.

4.5.3 Discounting to a specific deal date

If we are discounting to a June valuation date, we assume the cash flows fall on average at the end of
September and financials are reported annually, we need to adjust for these timing factors.
 The buyer will not get the benefit of any cash flows that have occurred prior to June, so these should be
excluded entirely
 The time factor for the first year and subsequent years will need to reflect the fact that we are only three
months (or 25% of a year) away from receiving the first cash flow (i.e. June to September), so would be
0.25, increasing by one for each year thereafter based on the entire reported cash flow for each
subsequent year
4.6 Additional things that you need to know for a DCF
4.6.1 DCF when a purchaser is buying a dissimilar business

Consider a utility (low beta) buying a large housebuilder (high beta). Whose WACC input (debt margin,
gearing, beta) should we use?
It is sometimes tempting to use those of the utility. This would help establish a higher value for the
housebuilder, because the WACC discount rate would be lower. What would actually happen, however, is
that some of the value in the utility would therefore be transferred into the housebuilder. In other words, the
acquisition would reduce the value of the utility’s other businesses.
It seems also wrong to evaluate the housebuilder by reference to the average WACC inputs of the enlarged
group. This is because one would again be flattering the value of the target, while ignoring the loss of value
of the purchaser.
The position is analogous to what happens with P/E ratios. If a large company has a P/E of 20x, it can
probably issue shares to buy a small lower quality business with a P/E of 10x without upsetting its own P/E.
The technical increase in EPS might even result in the price of the enlarged group’s shares going up (because
the market might still rate the enlarged business on a multiple of 20x). If, however, the two businesses were
of roughly equal size, the P/E of the enlarged business would probably trend to the average of 15x. If we
value the target at a multiple higher than 10x, there will be value transfer from acquirer to target
shareholders as the equity market will not value the enlarged business more highly simply by virtue of the
acquirer paying a high price.
By analogy, the correct way of doing DCF valuations of target businesses is normally by reference to
 The target’s debt margin (over the risk-free rate);
 The target’s gearing assuming a “normal” capital structure for its sector (this has to be done by reference
to market, not book values); and
 The target’s beta
Management may feel they can afford to pay more (or less) because of hurdle rate requirements, technical,
strategic or other unsystematic risk-type reasons (to the extent not built into the cash flows) but that should
be a separate evaluation.
If we “pollute” the DCF valuation by including attributes in the WACC calculation (such as gearing, cost of
capital etc) particular to the purchaser, we are probably mixing up the concepts of “theoretical” or
“absolute” value and value to a particular purchaser.
This is not to say, however, that we should ignore the attributes of the purchaser. For example, the target
company and sector may typically operate on a debt/equity ratio (at market values) of 50 % while the
purchaser may, for reasons of temperament, only be prepared to operate at a lower gearing level, e.g. 20 %.
This would push up the WACC the buyer applies (because there is no tax shelter on the higher equity
ingredient of the buyer’s financing)—this is in effect a voluntary additional hurdle imposed by the buyer,
limiting the buyer’s willingness to pay high prices.
It is probably best, however, to make this point explicit, rather than implicit, by summarising the results of the
valuation as:
Initial DCF value 100

Less: amount to take into account purchaser’s preferred gearing (10)
Value to purchaser 90

4.6.2 Adjustments from enterprise value to calculate equity value

When undertaking a DCF using the WACC and free cash flows, you will arrive at an answer that values the
entire business, or the enterprise value. As with comparable company and precedents analysis, if you then
wish to derive an equity value you will need to adjust for certain items (e.g. net debt, pensions etc). This
should be undertaken in an identical fashion to that explained in Section 2.2.
4.6.3 Understanding where to incorporate the value of financial investments

and loss making/very fast growing subsidiaries
As described in section 4.2.5, it is sometimes appropriate for these items to be removed from the core cash
flows used in the DCF and valued separately. If this is the case, it is important to add these value items to the
enterprise value derived for the core operations to ensure any additional realisable value is recognised.
4.6.4 Multiple scenarios/sensitivity analyses

As is evident from the model outputs shown below, sensitivity analyses are one of the key outputs from a
DCF model. Given the high dependence the overall value has on the value of the WACC and terminal
growth/exit multiples, it is essential to ensure that the impacts of changes in these items are properly
identified. Additionally it is useful to incorporate, at a minimum, sensitivities for the future growth and
margins of a business in the projected period to demonstrate the effects of increased or lessened
competition.
The overall level of sensitivity analysis you perform should be dependent upon the predictability of the
forecasts and the availability of information. Clearly, you would undertake significantly more sensitivities for a
cyclical consumer goods company than a utility with regulated prices and predictable demand.
4.6.5 Difference in value between terminal value methodologies

It is common for there to be differences between the valuations derived by the perpetual growth and
multiple-based DCF valuations. As shown in Section 4.3.8 above, under certain circumstances these should
be equivalent. Differences between these valuations can occur for a number of reasons, most commonly due
to the use of a multiple that does not adequately effect the expected reduction in value over time as
competitive advantages that currently exist disappear (thus reducing the future growth of the business and
hence its multiple). You should ensure that you are able to explain the differences between the results of
both methodologies ahead of presenting the results of a DCF and in particular to cross-reference
(i.e. understand the terminal multiple implied by a particular PGR and vice versa).
4.6.6 Using a reverse DCF to imply market assumptions

Reverse DCF analysis is a useful tool to impute the long term growth rate and/or WACC that the equity
market currently applies to a listed company. It is undertaken by calculating the terminal value assumptions
implied by the current market capitalisation of the company.
10.50
10.25
10.00
WACC (%)
9.75
9.50
9.25
9.00
1.5 1.6 1.7 1.8 1.9 2 2.1 2.2 2.3 2.4 2.5
Perpetual growth rate (%)
Value @ 50p Value @ 45p

4.6.7 Reconciliation with results of other valuation methods

DCF valuations reflect the fundamentals of a company. It is rare, however, for a company to trade at its DCF
value. This is in part due to subjectivity in developing long term projections due to imperfect information, but
is also due to the fact that there are often risks associated with businesses that are not wholly accounted for
in the WACC and cash flows (e.g., probability of realising synergies, impact of potential management
changes etc). As a result, the implied discount rate for a company given to it by the market may be higher
than that strictly implied by its DCF.
You should ensure that you are able to provide suitable reasons for any differences between methodologies
before presenting your results (e.g. company’s projections are higher than the market expects etc).
4.6.8 Difficult situations

4.6.8.1 International investments and country risk
Given that exchange rates take into account interest rate differentials, purchasers considering an offshore
acquisition need to factor this in when selecting which FX and WACC to use when evaluating such a
transaction.
There are two possible approaches to this issue. The first approach, and most common in practice, is to
discount the foreign currency cash flow using the relevant offshore discount rate and then convert the
resulting valuation into local currency at the spot exchange rate.
An alternative is to convert foreign currency future cash flows into local currency at the forward rates in the
market and discount the resulting local currency cashflows with a local currency WACC. The forward FX rate
will reflect the interest rate differential between the two currencies and reach a comparable result to the
above.
4.6.8.2 Developing markets

The risk of investing in the market in question is captured using local measures for the following:
 Risk free rate;
 Equity risk premium; and
 Debt risk premium (unless the DCF valuation is for acquisition purposes in which case it can make more
sense to add the acquirer’s credit spread to the local risk free rate)
As a result, the discount rate for an emerging market WACC can be very high as seen in the below example:
Indonesian subsidiary as at May 2009
Rate Source
US risk free rate 2.7% 10 year US treasury (Datastream)
Country risk premium 7.2% Difference between 10Yr US$ denominated
Indonesian and US Govt Bonds (Datastream)
Risk free rate 9.9%
Market risk premium 5.8% Deutsche Bank Research report
Levered beta 0.60 Average unlevered beta of peers from Barra,
adjusted for leverage
Cost of equity 13.4%
Parent cost of debt 7.4% 250bps above 10 yr US treasuries (DCM)
Country risk premium 7.2% Difference between 10Yr US$ denominated
Indonesian and US Govt Bonds (Datastream)
Pre-tax cost of debt 14.6%
Marginal tax rate 28.0% KPMG Tax Rate Survey 2008
Post-tax cost of debt 10.5%
Debt/(debt + equity) 30% Assumed long term leverage
WACC 11.2%

There is some debate around whether to include an additional country equity risk premium in the cost of
equity. As in the example above, it can be argued that this is already captured in the risk free rate and that
there is no fundamental reason why an investor in emerging market equities requires a greater spread over
the relevant risk free rate than an investor in, say, Western Europe.
If local data is not available, it is possible to add a country risk premium on top of an established (e.g. UK/US)
risk free rate and market risk premium for a benchmark country. Estimates for this are relatively scarce, but
estimates from Aswath Damodaran, a recognised finance professor are often used (see:
http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/ctryprem.html), as are Bloomberg estimates
(type “CRP”). In the event that a country risk premium is not available either, you should estimate the equity
risk premium by benchmarking against other countries for which data is available based on economic
characteristics.

The most significant challenge in undertaking DCF analysis is the requirement to have long term financial
forecasts. Whilst in many cases companies diligently forecast their financials over an extended time period,
many companies prefer to only forecast in the required level of detail for a relatively short time period. This
necessitates the use of a number of assumptions in order to perform a DCF. Additionally, you should bear in
mind that the forecasts used may have been prepared for a different purpose (e.g. to set challenging budgets
for managers), and therefore may be skewed.
DCFs are also very sensitive to the WACC, perpetual growth and exit multiple assumptions used. As a result,
any errors in these numbers are greatly magnified in the final valuation, requiring great care to be taken. The
CAPM is an equilibrium-based model that assumes that all investors are value maximisers, who look for the
optimal trade-off between risks and returns. They are price takers in an environment of perfect information
where the markets are perfectly efficient and all participants can borrow and lend as much as they like at the
same rate in order to hold identically composed portfolios of the most attractive combination of assets in the
market.
Clearly this case is never observed in reality in the presence of funding constraints, imperfect availability of
information and differing investment strategies and outlooks. Despite this the CAPM has been proven to be
reasonably accurate in practice in academic studies for relatively liquid markets (e.g. major worldwide stock
exchanges), and remains the most widely used method for predicting asset prices.
4.8 Data sources
4.8.1 Market risk premia

The most commonly used source of market risk premia is UBS Equity research, a link to which can be found
on the Global Equity Strategy page
(http://clientportal.swissbank.com/portal/index.htm?page=eqrschstratsectorstrategy). Alternatively, the
historical implied premia can be taken from Bloomberg (type “ERP”).
4.8.2 Betas
Barra betas are commonly used. The latest Barra betas are continuously updated and can be found on the
UBS shared drive, under: \\ldnroot\data\IBD\APPLICATIONS\APPS\Barra\. Barra betas are the preferred source
for betas as they are based on forward looking information from Barra’s equity model and are unlevered.
Alternatively, betas are available from Bloomberg under the security description for equity instruments, or by
typing BETA. Two types are available—the raw beta, based on historical prices, not adjusted for dividends,
etc, or the adjusted beta, calculated as (0.67 x raw beta) + (0.33 x 1). This calculation is intended to give an
estimation of future expected beta. Bloomberg betas are levered betas and hence should be unlevered based
on current leverage and relevered using the assumed long term capital structure.
Betas are also available from Datastream (data type: BETA), based on historic stock price data over the
previous 2.5 years and adjusted for outlying data. These are levered betas and hence should also be adjusted
as per the above.
Consider reviewing the R2 values for your betas. Low R2 values indicate little correlation and hence near
meaningless beta results. These are available on the Beta screen in Bloomberg, or can be calculated in Excel if
using a manual regression of historic market and share price data.


Whilst important to check all aspects of any valuation, the key aspects of a DCF should be checked in
detail, being:
 Financial profile—are the long term projections realistic?
 Terminal year—are capex and depreciation in line, is the growth and margin reflective of the long term?
 Beta—is this reflective of long-term beta for the industry?
 WACC—have comparable companies been used for benchmarking, and are the risk free rates and market
premia sensible?
 Do the multiple and perpetual growth methods produce similar outcomes? If not, why not?
4.10 Common errors

 Not adjusting the terminal year cash flow appropriately
 Incorrectly calculating the discount factor due to wrong timing (i.e. year end vs. mid year)
 Over-optimism in forecasts
 Terminal multiple—based on current multiple with no erosion to valuation over time
 Cost of Equity—use of unadjusted betas where significant differences in capital structure or markets exist
 Incorrect input of financial data from operating models
 Incorrect source for risk free rate or market risk premia (cross-check sources against each other
for accuracy)

 Sense check the output—don’t assume you have finished once you have completed the inputs
 Always reconcile the different results (from different TV methodologies) to each other and other
methodologies—be prepared to reconcile any differences
 Challenge the financials—the result is only as good as the inputs, so make sure you believe the raw data is
accurate and appropriate for the business
 Present appropriate sensitivities—e.g. provide profitability sensitivities for unpredictable businesses
 Source every assumption clearly and check multiple sources
 If the company is covered by UBS Research, request the valuation model to sense check the output
4.12 Example of UBS model

The following pages show a selection of outputs from the standard UBS DCF model, which has been set up
to provide presentations-ready print-outs. Please note in particular the sensitivities page presented. You will
be able to see the significant impact that only a small change in the key WACC, perpetual growth rate or exit
multiple assumptions has on the overall valuation. This page also reconciles the resulting valuations to EBITDA
multiples, allowing the results to be sense checked against other valuation methods.

Free cash flows—Base case

Free cash flows Stub '09E
(March y/e GBPm) 2009E -3.4 mths 2010E 2011E 2012E 2013E 2014E 2015E 2016E 2017E 2018E
EBIT 392 (113) 411 451 491 511 529 545 561 578 595
Pre-tax net EBIT synergies 0 0 0 0 0 0 0 0 0 0 0
Effective cash tax rate (%) 28% 28% 28% 28% 28% 28% 28% 28% 28% 28% 28%
– notional tax on EBIT (110) 0 (115) (126) (138) (143) (148) (152) (157) (162) (167)
NOPLAT 282 (113) 296 324 354 368 381 392 404 416 429
+ Depreciation and intangible amortisation 119 (34) 123 128 132 136 140 143 147 150 154
– Capex (including acquisition of intangibles) (214) 61 (182) (162) (148) (148) (158) (156) (160) (158) (162)
– Increase/(decrease) in net working capital (11) 3 (7) (7) (7) (7) (6) (5) (5) (6) (6)
– Increase/(decrease) in other LT assets (10) 3 (8) (6) (4) (2) (2) (2) (2) (2) (2)
+/– Net adjustments 0 0 0 0 0 0 0 0 0 0 0
Unlevered Free cash flow 167 (79) 223 277 327 347 355 372 384 400 413
Cash flow weighting 50% 50% 50% 50% 50% 50% 50% 50% 50% 50%
Years to discount (0.1) 0.2 1.2 2.2 3.2 4.2 5.2 6.2 7.2 8.2
Discount factor 101.2% 98.2% 90.2% 82.8% 76.0% 69.7% 64.0% 58.8% 53.9% 49.5%
PV of FCF (80) 219 249 271 264 247 238 226 216 205
Sum of PV of FCFs 2,054
 4
Terminal value—Base case

DCF VALUATION NORMALISATION ADJUSTMENTS TO YEAR 10 CASH FLOW
Perpetual EBITDA As stated Normalised TV
(GBPm) growth multiple (March y/e GBPm) 2018E Adj. 2018E (Yr 11)
Terminal value 6,111 5,993 EBIT 595 0 595 607
Terminal value as % of EV 59.6% 59.1% margin (%) 24.0% 24.0%
– notional tax on EBIT (167) 0 (167) (170)
Implied EBITDA multiple (x) 8.2x 8.0x NOPLAT 429 0 429 437
Implied perpetual growth rate (%) 2.0% 1.9% + Depreciation and intangible amortisation 154 0 154 157
– Capex (incl. acquisition of intangibles) (162) 0 (162) (165)
Present value: as % of depreciation (%) 105.0% 105.0%
Years 1-10 Free cash flows 2,054 2,054 – Increase/(decrease) in net working capital (6) 0 (6) (6)
Terminal value 3,027 2,968 +/– Net adjustments 0 0 0 0
Enterprise value 5,081 5,023 Free cash flow 416 0 416 423
Enterprise value to equity value bridge IMPLIED ENTRY AND EXIT MULTIPLES
Associates 0 0 Perpetual EBITDA
Net non-core assets 0 0 growth multiple
Net (debt)/cash (500) (500) EV/EBITDA (x)
Minority interest 0 0 2009E 9.9x 9.8x
Pension deficit 0 0 2010E 9.5x 9.4x
Equity value 4,581 4,523
Equity value per share (GBP) 15.27 15.08 EV/EBIT (x)
Upside/(downside) to current (%) 53% 51% 2009E 13.0x 12.8x
2010E 12.4x 12.2x
KEY ASSUMPTIONS
WACC (%) 8.9% Implied exit multiples (x)
Perpetual growth rate (%) 2.0% 2018E EBITDA 8.2x 8.0x
Exit EBITDA multiple (based on 2018E EBITDA) (x) 8.0x 2018E EBIT 10.3x 10.1x
ENTERPRISE VALUE COMPONENTS—PERPETUAL GROWTH ENTERPRISE VALUE COMPONENTS—EBITDA MULTIPLE
PV of Yrs 1-10 Cash Flow 40.4%

Terminal Value 59.6% PV of Yrs 1 40.9%
PV of Yrs 1-10 Terminal V 59.1% PV of Yrs 1-10
Terminal Value Cash Flows Terminal Value Cash Flows
60% 40% 59% 41%
 5

Perpetual growth rate sensitivities—Base case & WACC of 8.9%

ENTERPRISE VALUE (GBPm) IMPLIED SHARE PRICE (GBP)
SENSITIVITY TO PERPETUAL GROWTH RATE AND WACC
Perpetual growth rate (%) Perpetual growth rate (%)
5,081.0 1.0 1.5 2.0 2.5 3.0 5,081.0 1.0 1.5 2.0 2.5 3.0
7.9 5,370 5,639 5,953 6,325 6,772 7.9 16.23 17.13 18.18 19.42 20.91
WACC (%)
WACC (%)
8.4 4,998 5,223 5,483 5,787 6,147 8.4 14.99 15.74 16.61 17.62 18.82
8.9 4,673 4,863 5,081 5,332 5,626 8.9 13.91 14.54 15.27 16.11 17.09
9.4 4,387 4,549 4,733 4,944 5,187 9.4 12.96 13.50 14.11 14.81 15.62
9.9 4,134 4,273 4,430 4,608 4,812 9.9 12.11 12.58 13.10 13.69 14.37
SENSITIVITY TO SALES GROWTH RATE AND WACC
Change in Sales growth (%) Change in Sales growth (%)
5,081.0 (2.0) (1.0) 0.0 1.0 2.0 5,081.0 (2.0) (1.0) 0.0 1.0 2.0
WACC (%) 7.9 4,922 5,417 5,953 6,532 7,157 7.9 14.74 16.39 18.18 20.11 22.19
WACC (%)
8.4 4,551 4,999 5,483 6,006 6,571 8.4 13.50 15.00 16.61 18.35 20.24
8.9 4,233 4,641 5,081 5,557 6,070 8.9 12.44 13.80 15.27 16.86 18.57
9.4 3,957 4,331 4,733 5,169 5,638 9.4 11.52 12.77 14.11 15.56 17.13
9.9 3,716 4,060 4,430 4,830 5,261 9.9 10.72 11.87 13.10 14.43 15.87
SENSITIVITY TO EBITDA MARGIN AND WACC
Change in EBITDA margin (%) Change in EBITDA margin (%)
5,081.0 (2.0) (1.0) 0.0 1.0 2.0 5,081.0 (2.0) (1.0) 0.0 1.0 2.0
7.9 5,429 5,691 5,953 6,215 6,477 7.9 16.43 17.30 18.18 19.05 19.92
WACC (%)
WACC (%)
8.4 4,999 5,241 5,483 5,725 5,966 8.4 15.00 15.80 16.61 17.42 18.22
8.9 4,632 4,857 5,081 5,305 5,530 8.9 13.77 14.52 15.27 16.02 16.77
9.4 4,315 4,524 4,733 4,943 5,152 9.4 12.72 13.41 14.11 14.81 15.51
9.9 4,037 4,234 4,430 4,626 4,823 9.9 11.79 12.45 13.10 13.75 14.41
SENSITIVITY TO NET WORKING CAPITAL AND WACC
Change in NWC as % of sales (%) Change in NWC as % of sales (%)
5,081.0 (5.0) (2.5) 0.0 2.5 5.0 5,081.0 (5.0) (2.5) 0.0 2.5 5.0
7.9 5,987 5,970 5,953 5,936 5,919 7.9 18.29 18.23 18.18 18.12 18.06
WACC (%)
WACC (%)
8.4 5,512 5,498 5,483 5,468 5,453 8.4 16.71 16.66 16.61 16.56 16.51
8.9 5,107 5,094 5,081 5,068 5,055 8.9 15.36 15.31 15.27 15.23 15.18
9.4 4,756 4,745 4,733 4,722 4,711 9.4 14.19 14.15 14.11 14.07 14.04
9.9 4,450 4,440 4,430 4,420 4,410 9.9 13.17 13.13 13.10 13.07 13.03
SENSITIVITY TO CAPEX AND WACC
Change in Capex as % of sales (%) Change in Capex as % of sales (%)
5,081.0 (1.0) (0.5) 0.0 0.5 1.0 5,081.0 (1.0) (0.5) 0.0 0.5 1.0
7.9 6,091 6,022 5,953 5,884 5,815 7.9 18.64 18.41 18.18 17.95 17.72
WACC (%)
WACC (%)
8.4 5,618 5,551 5,483 5,415 5,348 8.4 17.06 16.84 16.61 16.38 16.16
8.9 5,214 5,147 5,081 5,015 4,948 8.9 15.71 15.49 15.27 15.05 14.83
9.4 4,864 4,799 4,733 4,668 4,603 9.4 14.55 14.33 14.11 13.89 13.68
9.9 4,558 4,494 4,430 4,366 4,302 9.9 13.53 13.31 13.10 12.89 12.67
 6
Perpetual growth rate sensitivities—Base case

ENTERPRISE VALUE SENSITIVITY — 2.0% perpetual growth rate, 8.9% WACC
Base case - DCF valuation 5,081
Sales growth (+/- 1%) 4,641 5,557
EBITDA margin (+/- 1%) 4,857 5,305
WACC (+/- 0.5%) 4,733 5,483
Perpetual growth rate (+/- 0.5%) 4,863 5,332
(0) 1,000 2,000 3,000 4,000 5,000 6,000

Enterprise value (GBPm)
IMPLIED SHARE PRICE SENSITIVITY — 2.0% perpetual growth rate, 8.9% WACC
Base case - DCF valuation 15.27
Sales growth (+/- 1%) 13.80 16.86
EBITDA margin (+/- 1%) 14.52 16.02
WACC (+/- 0.5%) 14.11 16.61
Perpetual growth rate (+/- 0.5%) 14.54 16.11
0.00 2.00 4.00 6.00 8.00 10.00 12.00 14.00 16.00 18.00 20.00
Share price (GBP)

 8

WACC analysis
SUMMARY OF WEIGHTED AVERAGE COST OF CAPITAL CALCULATION—CAPITAL ASSET PRICING MODEL
Market risk premium (%) ¹

5.50
Cost Equity risk premium (%)

5.53 Assumed
of long-term
Levered company beta ² financing
equity 1.01 structure
Levered company 85%
cost of equity (%)
9.77
3
Risk free rate (%) WACC (%)
4.24 8.93
Levered company After tax
cost of debt (%) cost of debt (%)
5.74 4.13
15%
4
Cost Levered debt premium
150bp
of
debt
Marginal tax rate (%)

28.0
Notes:
1 Source: UBS Equity Research market risk premium derived from “forward looking” calculation using UBS forecasts across the equity market and spot prices
2 Source: observed levered Beta (Barra - local) relevered based on assumed long term financing structure
3 10-year government benchmark bond yield (Source: Bloomberg, Datastream)
4 Company credit margin at chosen financing structure
Beta analysis
Beta methodology Company data 1.0
Marginal Capital structure Levered beta Unlevd.

Equity Debt tax rate D/E D/(D+E) Barra - local Bloomberg Datastream Source Selected beta
Company Currency (LCm)1 (LCm) (%) (%) (%) predicted (x) (x) (x) (x) (x) (x)
Corleone GBP 3,000 500 2 28.0 16.7 14.3 1.00 2.00 3.00 Barra - local 1.00 0.89
[Company 1] [GBP] 1,000 500 30.0 50.0 33.3 1.00 2.00 3.00 Barra - local 1.00 0.74
Mean (excluding Corleone) 50.0 33.3 1.00 2.00 3.00 1.00 0.74
Median (excluding Corleone) 50.0 33.3 1.00 2.00 3.00 1.00 0.74
Corleone (selected unlevered Beta) 0.89
WACC—SENSITIVITY ANALYSIS
Capital structure Relevered Cost of debt
D/E D/(D+E) beta Cost of equity Pre-tax Post-tax Cost of capital
(%) (%) (x) (%) (%) (%) (%)
17.6 15.0 1.01 9.77 5.74 4.13 8.93
0.0 0.0 0.89 9.15 5.74 4.13 9.15

10.0 9.1 0.96 9.50 5.74 4.13 9.01
20.0 16.7 1.02 9.86 5.74 4.13 8.90
30.0 23.1 1.09 10.21 5.74 4.13 8.81
40.0 28.6 1.15 10.56 5.74 4.13 8.73
50.0 33.3 1.21 10.92 5.74 4.13 8.65
60.0 37.5 1.28 11.27 5.74 4.13 8.59
70.0 41.2 1.34 11.62 5.74 4.13 8.54
80.0 44.4 1.41 11.98 5.74 4.13 8.49
90.0 47.4 1.47 12.33 5.74 4.13 8.45
100.0 50.0 1.54 12.68 5.74 4.13 8.41
Notes:
1 Market cap as of [•]
2 Latest reported net debt as of [•]
 17

SECTION 5
Leveraged buy-out (LBO)

5
Leveraged buy-out (LBO)

5.1 Overview
5.1.1 What is a LBO

A leveraged buy-out (LBO) is the acquisition of a target company by a financial investor (typically led by a
private equity firm, “financial sponsor” or “sponsor”), which may include the target’s own management. The
investor group acquires control of the target, financing its acquisition with a minimal amount of equity
capital. Hence the primary financing source is typically debt capital. The assets of the acquired company are
used as collateral for the debt.
5.1.2 What does a LBO valuation represent?

A LBO valuation represents the maximum price which a financial investor could pay for an asset, whilst
achieving an adequate return (usually assumed to be approximately 20–30% per annum, the range being
determined by the nature of the asset and market conditions). It is highly dependent upon the assumed
capital structure of the target company post acquisition as well as long term valuation trends.
In competitive auctions, it is often used to determine the expected realisable value for a financial investor that
any strategic bidder will have to exceed in order to win.
It should be noted that a stand-alone LBO will not reflect strategic sale value because it excludes synergies
available to an industrial acquirer and is measured on a financial return criteria rather than capturing any
strategic value premium.
Generally, given that a LBO valuation would not normally include synergies as the target remains a
stand-alone entity, and would involve quite high required returns for the providers of equity (albeit levered),
one would expect the resulting valuation to be lower than a DCF valuation for the business.
5.1.3 Role of leverage

The goal of a LBO is to use the future cash flows of the target to finance the acquisition. The greater the
borrowing power of the target, the less equity the investor group requires to make the acquisition. The actual
cash outlay of the equity investors is thereby minimised—and the potential return on that equity investment
increased—the power of leverage.
In a typical LBO, equity comprises between 30% and 40% of the enterprise value, although there are
instances when it is significantly higher, for example if debt is less readily available and lenders become more
credit risk averse or the asset has strong growth characteristics. The total amount of equity required depends
upon the acquisition price, the debt capacity of the target, and the lenders’ requirement for a minimum
equity cushion. According to S&P the average sponsor equity contributions reached their lowest levels since
the mid-90s between 2005–2007 standing at 34%.
The debt holders receive a fixed return, the interest paid on the debt. The equity holders get the excess
capital as profit. The objective of a private equity firm is typically to exit the investment after three to five
years realising, on average, an internal rate of return of 20–30% or a money multiple of 2–3x, although it will
vary case to case depending on risk.
5.1.4 Identifying LBO candidates

It should be noted that not all businesses are suitable for a LBO—if they were, there would be no publicly
traded companies! For a company to be a potential target for a LBO there are some key factors which private
equity firms look for:
 Steady and predictable cash flow: The strength and stability of cash flows is crucial in determining the
debt capacity of the business. Excessive requirements for capital expenditure will reduce debt capacity as
this will reduce cash flow available to service and retire acquisition debt. “Cash is king, the rest is just
journal entries” is a key concept
 Strong, defensible market position: LBO entities typically have a strong or leading position in their
market which increases the reliability of their cash flow. Obviously, it also helps to have a steady growth
trajectory, since growth in profitability will accelerate the repayment of the debt
SECTION 5: Leveraged buy-out (LBO) 73

 Minimal future capital requirements: The priority of a company that has been acquired through a LBO
is the payment of interest and principal payments on the new debt. All other things being equal,
companies with lower maintenance capital expenditure requirements can dedicate more cash to servicing
their debt
 Divestible assets: Unrelated or potentially non-core divisions can greatly enhance the attractiveness of a
target company, since they may be sold to raise funds for repayment of debt if required
 Strong, incentivised management team: Good management is often thought of as the single most
important factor in any LBO. A motivated and competent management group is needed to run the
company after the buy-out. In most cases, the best choice is for existing management to take an equity
interest in the company. However, new management is sometimes brought in by investors. The LBO
structure typically provides strong incentives/rewards for successful management teams which is a key
differentiator versus traditional strategic bidders
 Viable exit strategy: The private equity firm should have a strategy for exiting the business within an
appropriate timeframe, either by selling the business to a strategic buyer or by selling equity to the public
through an initial public offering. Over the past years, secondary buy-outs (i.e. a sale to another financial
investor) have been offered as viable exit strategies, however these do rely on the availability of debt
 Potential for restructuring: Significant value in a LBO can often be created through restructuring the
operations of the business (i.e. cost cutting, process efficiencies). Often divisions of large corporates have
never had a true focus on the efficiency of operations and this represents a significant opportunity to
create value for the equity investors in a LBO
 Technology: State-of-the-art technology helps ensure maximum efficiency and profitability. The nature
and requirements of the technology platform should be considered, particularly in relation to capital
expenditure requirements
 Skeletons: Any litigation problems, environmental concerns or other unresolved contingent liabilities can
be “deal-breakers” since these problems can make financing difficult to attain given the risk implied
5.2 LBO returns

A LBO valuation is defined by whether or not a private equity firm can achieve a targeted level of return.
Assumptions regarding business performance, the exit strategy, and the period between the acquisition and
the exit are critical to determining an appropriate capital structure and potential returns to equity investors.
The sponsors will generally look to create value through either some/all of the following mechanisms:
 An increase in the underlying operating and financial performance of the asset acquired, both on the
revenue and cost side
 Repayment of debt through cash flow generated while owning the asset
 Exit multiple expansion
Financial buyers, such as private equity, venture capital and mezzanine capital providers, often have required
rates of return for each investment based on the expectations of their investors. These returns are generated
primarily through the sale of the company—usually “exiting” three to five years from the date of the initial
investment—at which time the firm's investors generate their returns from the proceeds of the sale.
In general, the greater the debt (and less equity) a financial buyer can structure into a transaction, the higher
its ultimate returns. As such, the amount a financial buyer is willing to pay for a company is not only
dependent on the company's projected performance, but also constrained by the capital structure that the
buyer can impose.
5.3 Understanding the components of return
5.3.1 Entry and Exit Multiples

A LBO capitalises a company with a significant amount of debt (fixed in value) and with the balance in equity
(variable in value). Assuming a fixed or increasing enterprise value for the business, as the debt is paid down,
so the portion of the value attributable to the equity increases even if the multiple does not change. If the
initial amount of equity is relatively small then the proportionate increase in value, and therefore the return,
can be significant. The equity holders also benefit from the tax relief generated by interest payments.

The interplay between the fixed and variable financing ("leverage") and its effects can be illustrated with
an example.
yr 1 (m) yr 5 (m) CAGR (%)
EBITDA 100 150 10.7
EBITDA multiple 6x 6x
Enterprise value 600 900 10.7
Debt outstanding (300) (150)
Equity value 300 750 25.7
Though the percentage growth in firm value is relatively modest (under 11%), the investors in the equity
would have achieved 26% per annum return on their investment. Of course, the effects of leverage can work
equally dramatically in the opposite direction if the firm value decreases even modestly. The impact is
accentuated if the fall in value stems from a fall in earnings as the debt will be paid off less rapidly. As a rule
of thumb, many assume that entry multiple = exit multiple. However, financial investors are increasingly
factoring in market, sector and company specific factors when determining assumptions and further analysis
should be undertaken to support exit multiple assumptions (i.e. trading of multiples through the cycle).
5.3.2 Debt Paydown

The paydown of debt also significantly increases the returns to the equity provider, as cash flows from the
target company are used to pay down this debt. Occasionally divestments of parts of the business can be
used to enhance this, particularly if such a sale can be undertaken at a value enhancing multiple.
5.3.3 Profit Growth

Potential buyers look at the operating performance of the target company and rely on management’s ability
to improve the business (a combination of increasing revenue and decreasing cost) in order to enhance
profitability. Even if the exit multiple is unchanged, moderate profit growth can lead to very significant equity
returns even before any debt paydown.
5.3.4 Bolt on acquisitions

In addition to organic growth, businesses may also deliver value through the acquisition of new businesses.
Similar to industrial acquirers, these acquisitions might offer the opportunity to deliver synergies or enhanced
growth. Typically, acquisitions will be funded through a combination of debt (some financing structures have
specific facilities set aside for acquisitions) and equity.
Financial investors typically run LBO analyses to consider whether any acquisition is accretive or dilutive.
Where a large number of acquisitions are available at implied multiples (post synergies) below the in-price for
the original asset, substantial value can be realised. This might justify a higher price for the “seed” business
as the in-price will be reduced over time by acquiring new bolt-on acquisitions at lower prices. Alternatively,
bolt-on acquisitions may change the investment case thereby opening up new exit alternatives or enhancing
the exit multiple.
5.4 Required returns

Driving most leveraged buy-outs is the ability for equity investors to generate attractive returns. In LBOs,
returns are measured in terms of Internal Rate of Return (“IRR”) or CAGR achieved on the original
equity invested.
Generally, investors will expect a return of approximately 20–30% per annum though it can vary according to
market conditions. Returns can be generated in a wide variety of ways, but most commonly they are realised
through the eventual sale or initial public offering of the target asset.
Investors are increasingly targeting returns based on a money multiple. The multiple of money is simply
calculated as the cash returned to the investors following exit divided by the cash initially deployed by them.
Typically, investors seek minimum returns of 2x over a three-year period. In recent times, expectations have
moved to 3x albeit over a period in excess of five years.

5.5 Management participation and impact on institutional returns

Institutional equity typically takes the form of redeemable preference shares or subordinated loan notes plus
ordinary shares. Such a mix is designed to provide a non-cash running yield on the investment, to take
advantage of tax relief on interest (on the preference shares/loan notes) to the fullest extent and to allow a
tranching of the equity between the equity investors and management. Practically speaking, the full tranche
of institutional investment is referred to as "equity" as it is fully subordinated to other forms of debt with no
cash dividends received and forms a package, all the returns of which go to the equity investors.
Management equity is normally a small part of the overall equity tranche and, provided institutional equity
returns are acceptable, it can be assumed that management returns are at least as good. In practice, there
are many ways of incentivising management including giving it a “kicker” in the form of warrants, similar to
that given to mezzanine finance (in some cases), and/or a formula which gives them more of the equity the
better the value achieved for equity holders, or the faster debt is reduced. This enhanced equity is often
referred to as “sweet equity” in Europe and “sweat equity” in the US. Alternatively, management may be
given the opportunity to purchase its equity entitlement at a discount to the institutional price.
5.6 Typical LBO structure and components of financing
5.6.1 Financing sources

LBOs are typically structured using three sources or “tranches” of finance
Type of finance Description Provider
1
Senior debt Generally secured on the assets of Banks, institutional buyers,
the business and ranking ahead of CLOs
all other claims on the business in
the event of a liquidation
(exceptions apply)
2
Subordinated debt (high Subordinate to the senior debt but Institutional bond investors,
yield bonds or mezzanine ranking ahead of other claims on mezzanine funds, banks
debt) the business.
3
Equity Ordinary shares or preference LBO funds, venture
shares or subordinated loan stock capitalists, management
groups etc

5.6.2 General example of an LBO structure

Below is an example of a typical LBO structure, in a transaction that utilises the high yield bond and/or
mezzanine market. In this diagram the bank debt resides at Bidco and benefits from Targetco and subsidiaries
guarantees. In many instances however, the bank debt is eventually pushed down to the Targetco and
subsidiaries. This means that debt pushed down to i.e. the Targetco must be serviced before cash can be up
streamed (through a dividend) to Bidco.
Management Private equity
3 Equity 3 Equity/
shareholder
loan
3 New Co (equity)
1 Senior debt Mezzanine & high

Banks Bid Co 2 Bond Co/Mezz Co
yield debt
Bids for target
Existing debt
Target Co
(normally refinanced)
Guarantees & security

over assets
Subsidiaries

5.6.3 Typical features of financing

Type Description Usual covenants
Senior debt  Ordinary floating rate bank debt ranking senior to all other  Financial covenants
(first lien) financing obligations (leverage, interest
 Often includes combinations of amortising and bullet debt cover, capex limits)
(payments in kind or “PIK”) with varying maturities,  Restrictions on
typically 5 to 9 years acquisitions and
 Secured for LBOs disposals, raising of
additional finance,
payment of dividends,
change of control and
negative pledge
Second Lien  Debt that ranks below the rights of other, more senior  Closely replicate senior
debts issued against the same collateral debt covenants
 Second lien lenders can be part of the same security
agreement and vote as secured lenders equal to that of
first lien
 Usually bullet payments with longer maturities
Mezzanine debt  Subordinated to other senior secured claims  Closely replicate senior
 Usually bullet repayment with longer maturity than debt covenants
senior debt
 Return can incorporate equity type instruments,
e.g. equity warrants
High yield debt  Larger amounts than mezzanine achievable, minimum size  Limited covenants but
typically US$200 million including restrictions
 Non-investment grade traded capital market instruments on raising new debt,
 Typically 7 to 12 years maturities with bullet repayment acquisitions and
payment of dividends
 Usually fixed interest rates
Bridge finance  Short-term financing to allow rapid deal completion,  Closely replicate senior
refinanced by capital markets instruments (e.g. high debt covenants
yield debt)
 Often structured so as to convert into mezzanine finance
with increasing margins and warrants if a refinancing in
the capital markets does not occur
Vendor loan note  Financing provided by vendor, to capture further upside or  na
increase headline price
 Fully subordinated (structurally/contractually) and hence
considered as equity by the debt providers
 The loan can be secured by the shares (an equity loan) or
through a debenture
 Form part of the money that private equity
funds plough into such structures, alongside normal equity
 Typically with rolled-up interest
PIK Notes  No interest payment until company is sold or refinanced  na
 With rolled-up interest
Pure equity  Pure equity is a form of financing which gives ownership in  na
the company
 Direct participation of company’s equity

5.6.4 Key debt ratios

There are five key ratios which measure debt capacity in a LBO transaction and although each of these can be
used individually to give an indication of leverage, they should not be used exclusively to determine the
optimum debt levels. Indeed, the debt capacity of a LBO transaction is often constrained by one of the five
drivers hitting its “limit” before the others. These drivers all have pre-defined limits; however, these limits are
ultimately market driven (as the debt typically needs to be sold down or syndicated to market participants)
and can vary dramatically between transactions:
 EBITDA Debt Leverage (debt cover)
Total net debt

EBITDA
The multiple of total net debt to EBITDA is often used as the key determinant of debt capacity, indeed this
ratio is often put forward as a benchmark indicator. However, as stated above, it should not be used to the
exclusion of the other drivers. The total debt to EBITDA ratio uses EBITDA as a proxy for cash flow and shows
the number of years of such cash flow that would be required to repay all debt. Total net debt would
normally exclude trapped cash which is either required for operations or “trapped” in a foreign jurisdiction.
 Free Cash Flow
Total net debt

FCF (post interest)
The ability of a company to repay debt out of free cash flow (after interest) is critical. Most LBO transactions
are structured with an element of amortising senior debt which is repaid over a given number of years from
cash flow. Limited free cash flow results in limited senior debt capacity.
 Interest coverage
EBITDA
Cash interest
A basic measure of a firm’s ability to meet its cash interest obligations.

 Fixed Charge Coverage (also called DSCR, Debt Service Coverage Ratio)
Cash flow available for debt service

Cash interest plus scheduled repayment
A more comprehensive measure of a firm’s ability to meet its fixed-charge obligations. Although banks
normally only consider cash interest, they might also look at the coverage including PIK interest.
 Equity Gearing
Equity
Debt + Equity
The amount of equity required in a transaction is governed both by debt capacity but also by the extent to
which the industry and development story of the company is determined to be “equity risk”.

5.6.5 Financing restrictions on LBOs

Acquirers are normally restricted in what they can and cannot do with their LBO company primarily in order
to ensure that sufficient cash is available to service the debt. It is normal to agree a repayment schedule for
senior debt which is usually straight line amortisation over the period of the loan. Other typical restrictions
might include:
 Dividends restricted or prohibited until interest cover reaches an acceptable level, typically
2.5 times covered
 Material acquisitions and disposals can only be made with the permission of the lenders
 Limitation on capital expenditure
 No new borrowings
 Mandatory cash flow sleep, i.e. 75% of FCF has to be used to pre-pay debt
5.7 LBO Modelling
5.7.1 Modelling a LBO

Determining the LBO value and structure requires balancing a number of variables in order to meet several
different targets for providers of different forms of finance. As a consequence, without developing an
mathematical model, the process of satisfying all these requirements and deriving a value is extremely
difficult. The principal targets of minimum returns, fixed charge cover and debt repayment are set out above.

5.7.2 Suggested starting points

In order to simplify the iterative process to an extent, some suggestions for a starting point are set out below:
1 Model the cash flows of the business for a forecast period of 10 years. The key components for
cash flows are Revenue, EBITDA, Depreciation, Capex and Change in Net working capital. A guide
to building up projections is set out in Section 4. In addition, we should consider whether there are
any ways of generating further cash such as reducing working capital requirements or capital
expenditure (although take account of any impact this may have on growth) and model these into
the business
You should also consider disposals of surplus assets. However, little reliance should be put on
disposals in order to make the financing ”work“ as there is often significant execution risk around
disposals. The projections should generally be for the business on a stand alone basis and this may
necessitate adjustment of the numbers available to reflect the costs of provision of certain
central functions
2 When modelling a LBO, the base interest rate for senior debt tranches should be taken as the
blended rate between the three-year swap rate and the three-months LIBOR rate in the currency of
borrowing to reflect the cost of interest rate hedging (normally LBOs are required to fix at least
50% of their variable borrowing cost to reduce risk). If the debt is to be multi-currency, then a
weighted average rate should be estimated given the relative proportions of the regional revenues
or assumed currencies through which the borrowing take place
In addition to the base rate, the interest rate margins applicable to senior debt vary according to
tenor, amortisation schedule, market conditions and deal structure. In general, a shorter term
amortising tranche (Term Loan A) will have lower margins than a longer bullet repayment tranche
(Term Loan B and C). The price of senior debt, as with other debt tranches, is ultimately market
driven as LBO debt is usually syndicated. As such, the GSF team should always be consulted in
determining appropriate margins and the overall level of debt
Purely for illustrative purposes, a seven year amortising tranche may price at a margin of
approximately 325 basis points above the base rate while an eight year bullet repayment tranche
may price at around 400 basis points above base rate
3 In practice, capital structures vary significantly according to the nature of the business and market
conditions. Normal European structures would have Term Loan A, B and C as well as a Mezzanine
tranche. Previously, there have been second lien and high yield tranches in some deals as well. In
2007-2008, many deals were executed without a Term Loan C
For example, a buy-out in March 2008 of a European based telecoms company with an EV of
€2,000m and EBITDA of €200m could have had approximately 5.0x total debt as of the transaction.
The capital structure might have looked as follows:
Amount EBITDA Margin Tenor

Facility type (€m) (%) (x) 1 (bps) 2 (yr)
Term Loan A 250 12.5 1.3 325 7
Term Loan B 275 13.8 1.4 400 8
Term Loan C 275 13.8 1.4 425 9
Total senior debt 800 40.0 4.0
Mezzanine 200 10.0 1.0 1050 3 10
Total debt 1,000 50.0 5.0
Total equity 1,000 50.0 5.0
Total 2,000 100.0 10.0
Notes:
1 Based on Pro forma LTM EBITDA of €200m
2 Margin over base rate of X%. Base rate assumed to be a blend of 3 year Euribor and 3 year Euro swap rate as of [date]
3 Mezzanine price includes an element of cash margin at 500bps and PIK at 550bps
4 EV assumed to be 10x LTM EBITDA. EV assumed debt free and cash free at the date of acquisition

4 Based on a typical scenario, assume an exit in year 3 at an EBITDA multiple equivalent to the multiple
at which the business is assumed to be purchased. However, as referenced earlier, more
sophisticated assumptions are normally required
5 The iterative process now begins. The first step would be to check if fixed charge cover, leverage
(i.e. the gross and net debt/EBITDA ratio), debt repayment and investor returns are adequate. If they
are, then a higher total valuation may be possible. If not then an iterative process begins of flexing
the proportions of debt, equity and total value so as to reach a position when all investors'
requirements are satisfied. If they cannot be, then the total value may need to be reduced
6 The outcome of a LBO will be sensitive to a number of assumptions, in particular the rate of growth
of the business, the exit multiple and the year of exit. The modeller should sensitize the assumptions.
Basic sensitivity tables have been incorporated into the standard LBO model
5.7.3 Flexing effects

A matrix setting out the impact of INCREASING certain variables whilst keeping all others constant is set out
below to aid the flexing process:
Fixed Return for Returns Debt repayment
Variable being increased charge cover debt holders for equity period
Interest rate Down Up Down Up
Proportion of equity Up No effect Down Down
Growth rate of EBITDA Up No effect 1 Up Down
Entry multiple No effect ² No effect Down No effect ²
Exit multiple No effect No effect Up No effect
Notes:
1 A material improvement of the credit could positively impact the secondary trading value of the debt
2 If because of a lower entry EV the debt/equity ratio decreases, the fixed charge cover will be up and debt repayment period down
Given these multiple effects, it is normal to show a range of sensitivities when presenting LBO valuation
outputs, typical tables may be as follows

A yr 3 IRR
Purchase EV (£m)
120.0 125.0 130.0 135.0
Entry LTM EBITDA (x)
9.3 9.7 10.1 10.5
Offer premium (%)
20.0 25.7 31.4 37.1
Offer price (£)
1.20 1.26 1.31 1.37
7.5 26.7 21.3 17.1 13.6
Exit LTM EBITDA (x)
8.0 29.6 24.1 19.8 16.3

8.5 32.3 26.7 22.3 18.7
9.0 34.7 29.0 24.5 20.9
9.5 37.0 31.2 26.6 22.9
10.0 39.1 33.2 28.6 24.8
10.5 41.1 35.1 30.4 26.6
B Entry EV to achieve target IRR after 3 years

Target IRR (%)
15.0 20.0 25.0 30.0
7.5 137.8 131.3 126.3 122.4
Exit LTM EBITDA (x)
8.0 142.0 134.6 129.0 124.6

8.5 146.1 137.9 131.6 126.8
9.0 150.2 141.2 134.3 128.9
9.5 154.3 144.5 137.0 131.1
10.0 158.5 147.8 139.6 133.3
10.5 162.6 151.1 142.3 135.4

As with DCF valuations, LBO valuations rely upon future projections of the business and therefore if reliable
sources of information are not available, these projections can become highly subjective and therefore raise
the potential for inaccurate results.
LBO valuations represent the value to a financial investor, and as such, and in common with other valuation
methodologies, they do not represent what an investor would actually pay for a business. In particular, whilst
target investment returns are generally accepted to be around 20–30% per annum, this will vary between
investors, particularly if they feel that there is more or less risk in a particular investment.
A LBO valuation depends upon the performance of the business until exit. Therefore, if an investor is a
specialist in a particular sector, they may take a different view on the future projections of a business, which
an independent standalone LBO will not capture. Similarly, financial investors often use their relationships
with financing institutions to secure preferential terms or larger quantums of debt. This can lead to
asymmetry in the market, and therefore the valuation may not be representative of the terms which are
practically available to all potential investors.
As described above, not all companies are ideal LBO candidates. This valuation methodology is only relevant
where a LBO could actually be realised, and therefore for businesses with unpredictable cash flows or other
unattractive attributes to a financial investor, a LBO valuation becomes irrelevant.
As can be seen from the example output tables above, LBO valuations are very sensitive to the exit multiple. It
is essential that a considered view is taken on the most likely exit multiple to ensure that the valuation
remains accurate.

5.9 Data sources
5.9.1 LIBOR and swap rates

The best sources for up to date, accurate LIBOR and swap rates are the live information sources: Bloomberg
(codes: BTMM/BBAM and IRSM/WS) or Reuters (code: LIBOR). Alternatively, DataStream can be used (codes:
LDNIBON for LIBOR, EUEONIA for EURIBOR).
5.9.2 Debt margins and acceptable leverage levels

It is best to contact the GSF team for margins on leveraged debt. These are constantly evolving with market
conditions, and can differ significantly from issuer to issuer. A detailed view is therefore required, even for
basic valuations.
Similarly, the appropriate level of acceptable debt metrics varies with market conditions. The GSF team will be
able to provide an up-to-date view.

A thorough check of the entire model is even more important for LBOs than other valuation methods due to
the fact that any LBO model will inherently be circular, and therefore it can be substantially harder to identify
any errors. There are however some quick checks which you can do to ensure that the outputs are sensible to
start with:
 Balance sheet—does it balance?
 Financial profile—are the long term projections realistic?
 Entry and exit multiples—are they reasonable? What level would you expect the exit multiple to be
compared to entry?
 IRR—is it reasonable given entry and exit assumptions? An IRR for a regular company over 100% is always
wrong. Period
 Debt levels—is the entry debt/EBITDA in line with precedent transactions? Are the debt tranches paid off
by their maturity? Are the debt metrics throughout the projection period within market limits?
 Equity—the amount of equity in the structure should be high enough to meet minimum requirements by
debt providers, but not too high in value to be out of reach of target investors
 Use of cash—is cash in excess of that required being used to pay down the debt tranches in order of
seniority? If not, where is the cash going?
5.11 Common errors

 Inaccurate financial projections
 Using wrong LIBOR or swap rates for the currency debt is issued in, or sourcing incorrectly
 Not checking latest market views for leverage and margins with the GSF team, or getting updated views
when required (particularly in volatile markets)
 Inaccurate exit multiple assumptions and inappropriate sensitivities
 Modelling errors—particularly given circularity in models
 Incorrectly reflecting mid-year acquisitions—not accurately calculating an appropriate rump year (only
cash from acquisition date to year end should be included, as this is the only cash available to the acquirer
to pay down debt). Also ensuring the XIRR function is used to take count of acquisition date where the
time period between entry and exit in years is not a whole number
 Incorrect cash sweep—ensuring cash only pays down debt when it is available after the repayment of
interest and more senior debt tranches (always stress-test the model to ensure this works, particularly if
adding new tranches to a standard model)
 Management equity—is it properly reflected in the sponsor returns (i.e. impact of dilution)


 Sense-check the output—don’t assume you have finished once you have completed the inputs
 Challenge the financials—the result is only as good as the inputs, so make sure you believe the raw data is
accurate and appropriate for the business
 Challenge the appropriateness of leverage multiples—ensure you provide the GSF team with detailed
views of the relative merits of the target compared to peers to enable them to come to the best view in
the current market
 Present appropriate sensitivities—include additional sensitivities to standard exit multiple and IRR tables
tailored to uncertain areas (e.g. different financial cases, earnings growth sensitivities, etc)
 Source every assumption clearly and check multiple sources
5.13 Example of UBS model

Below are a number of outputs from a standard UBS LBO model used for valuation. Please note that this
model is currently being redesigned and the new will be available soon. As such, be sure to check within your
team for the latest version.
The LBO model for valuations is separate from the standard GSF model, which is used for NBCC and GSFCC
purposes, where UBS is required to provide a firm view of available debt financing, or commit its own capital.
This model is far more detailed, and provides outputs tailored to the approvals process.
 The below overview page highlights some of the key assumptions required for a LBO valuation – the
assumed purchase price, sources and uses of funds, margins on debt products together with the
benchmark rate and, importantly, the exit multiple.
Corleone LBO Analysis: Summary (Capital Structure I)

OFFER AT 25% PREMIUM IRR ANALYSIS SPONSOR IRR MANAGEMENT IRR
LTM ¹ 2009E 2010E 2011E Exit LTM EBITDA (x) 2011E 2012E 2013E 2011E 2012E 2013E
Current share price (GBP) 6.00 Sales 1.4x 1.4x 1.4x 1.3x 5.0x 8% 11% 12% 12% 16% 17%
Offer price (GBP) 7.50 EBITDA 5.4x 5.4x 5.1x 4.9x 5.5x 15% 15% 15% 25% 24% 22%
No of shares (m) 300 EBITA 6.7x 6.7x 6.3x 6.0x 6.0x 20% 18% 17% 37% 31% 27%
Equity value (GBPm) 2,250 EBIT 7.2x 7.3x 6.9x 6.5x 6.5x 26% 22% 19% 47% 37% 31%
LTM Interest Debt Capital

EBITDA Margin rate split split Split
SOURCES OF FUNDS (GBPm) (x) (%) (%) (%) (%) USES OF FUNDS (GBPm) (%)
Term loan A 234 0.5x 5.00% 7.26% 25% 9% Consideration for Corleone's equity 2,250 87%
Term loan B 234 0.5x 5.50% 7.76% 25% 9% Purchase of stock options 35 1%
Term loan C 234 0.5x 6.00% 8.26% 25% 9% Refinancing of existing net debt 250 10%
Second lien 0 0.0x 5.00% 7.26% 0% 0% Pension deficit 0 0%
Total senior debt 702 1.5x 75% 27% Minority interest 0 0%
Mezzanine 234 0.5x 3.74% 6.00% 25% 9% Transaction fees (including financing fees) 51 2%
High yield 0 0.0x 7.74% 10.00% 0% 0%
PIK 0 0.0x 10.74% 13.00% 0% 0%
Total subordinated debt 234 0.5x 25% 9%
TOTAL DEBT 936 2.0x 5.06% 7.32% 100% 36%
Loan note 825 32%
Ordinary equity 825 32%
TOTAL EQUITY 1,649 64%
TOTAL SOURCES 2,586 100% TOTAL USES 2,586 100%
RCF available (undrawn) 200 0.4x 5.00% 7.26% OK
SUMMARY FINANCIALS CREDIT RATIOS

(GBPm) LTM ¹ 2009E 2010E 2011E 2012E 2013E (x) LTM ¹ 2009E 2010E 2011E 2012E 2013E
Sales 1,766 1,781 1,870 1,959 2,047 2,129 Senior debt / EBITDA 1.5x 1.5x 1.2x 0.8x 0.4x 0.1x
% growth na 5.5 5.0 4.8 4.5 4.0 Senior debt / (EBITDA-Capex) 3.3x 2.7x 1.9x 1.2x 0.6x 0.1x
EBITDA 468 466 493 519 544 566 Cash pay debt / EBITDA 2.0x 2.0x 1.7x 1.4x 1.0x 0.6x
% growth na (2.8) 5.7 5.3 4.8 4.0 Cash pay debt / (EBITDA-Capex) 4.4x 3.7x 2.7x 2.0x 1.3x 0.8x
% margin 26.5 26.2 26.4 26.5 26.6 26.6 Total debt / EBITDA 2.0x 2.0x 1.7x 1.4x 1.0x 0.6x
EBIT 350 347 369 391 412 429 Net debt / EBITDA 2.0x 2.0x 1.6x 1.2x 0.7x 0.3x
% margin 19.8 19.5 19.7 20.0 20.1 20.2 EBITDA / Cash interest 6.8x 6.7x 7.6x 9.2x 12.2x 19.1x
(EBITDA - Capex) / Cash interest 3.1x 3.6x 4.8x 6.3x 8.9x 14.1x
Total debt nm 836 704 534 339 332 EBITA / Cash interest 5.1x 5.4x 6.1x 7.4x 9.9x 15.5x
Cash nm (40) (83) (133) (187) (440) EBIT / Cash interest 5.1x 5.0x 5.7x 6.9x 9.2x 14.5x
Net debt nm 796.5 621.1 401.5 152.9 (108.3) Fixed charge cover na 1.2x 1.2x 1.2x 1.2x 1.2x
Note: (1) LTM based on 12 months to 31 Jan 09
 12

 A LBO critically relies on the ability of a company to generate cash to service its debt. In the example
below, cash flows in excess of servicing fixed charges are relatively modest in the stub year. Thereafter,
significant cash becomes available to pay down some of the outstanding debt
LBO—Income statement & cash flow statement (Capital Structure I)

INCOME STATEMENT
(March y/e GBPm) LTM ¹ 2009E Stub 09 2010E 2011E 2012E 2013E 2014E 2015E 2016E 2017E 2018E
Sales 1,766 1,781 288 1,870 1,959 2,047 2,129 2,203 2,269 2,337 2,408 2,480
growth (%) na 5.5 na 5.0 4.8 4.5 4.0 3.5 3.0 3.0 3.0 3.0
EBITDA 468 466 75 493 519 544 566 584 597 611 625 639
growth (%) na (2.8) na 5.7 5.3 4.8 4.0 3.2 2.3 2.3 2.3 2.3
margin (%) 26.5 26.2 26.2 26.4 26.5 26.6 26.6 26.5 26.3 26.1 25.9 25.8
Depreciation (88) (89) (14) (93) (98) (102) (106) (110) (113) (117) (120) (124)
Intangibles amortisation (30) (30) (5) (30) (30) (30) (30) (30) (30) (30) (30) (30)
Amortisation of acquisition goodwill 0 0 0 0 0 0 0 0 0 0 0 0
EBIT 350 347 56 369 391 412 429 443 453 464 474 485
margin (%) 19.8 19.5 19.5 19.7 20.0 20.1 20.2 20.1 20.0 19.8 19.7 19.5
Pre-tax net EBIT synergies 0 0 0 0 0 0 0 0 0 0
Adjustments (net) 0 0 0 0 0 0 0 0 0 0
Net interest (27) (165) (165) (162) (157) (156) (161) (169) (177) (187)
PBT 29 205 226 250 273 288 292 295 297 298
Tax (13) (86) (96) (105) (115) (123) (128) (133) (138) (143)
PAT 16 118 131 144 157 164 164 162 159 155
CASH FLOW STATEMENT

(March y/e GBPm) LTM ¹ 2009E Stub 09 2010E 2011E 2012E 2013E 2014E 2015E 2016E 2017E 2018E
EBITDA 468 466 75 493 519 544 566 584 597 611 625 639
Pre-tax net EBIT synergies 0 0 0 0 0 0 0 0 0 0
Δ Net working capital -9 -8 (1) (7) (7) (7) (7) (6) (5) (5) (6) (6)
Δ other operating LT assets/(liabilities) -9 (10) (2) (8) (6) (4) (2) (2) (2) (2) (2) (2)
Capital expenditure (257) (214) (35) (182) (162) (148) (148) (158) (156) (160) (158) (162)
Free cash flow 194 234 38 296 343 385 409 417 433 444 459 469
cash conversion (%) 41.4 50.2 50.2 60.1 66.2 70.9 72.3 71.5 72.6 72.7 73.4 73.5
Tax charge (13) (86) (96) (105) (115) (123) (128) (133) (138) (143)
Other cash flows 0 0 0 0 0 0 0 0 0 0
Cash flow before debt service 25 210 248 280 294 294 305 311 320 326
Target fixed charge cover (4) (35) (41) (47) (49) (49) (51) (52) (53) (54)
Cash interest expense (11) (65) (57) (45) (30) (21) (21) (22) (24) (25)
Cash flow available for debt repayment 10 110 150 189 215 224 233 236 243 246
Note: (1) LTM based on 12 months to 31 Jan 09
 13
 It is essential that the use of excess cash is properly modelled. Below is an extract from the debt
schedule, from which the sequential order in which the debt tranches are paid down is evident
Outstanding debt balances (Capital Structure I)
(March y/e GBPm) Stub 09 2010E 2011E 2012E 2013E 2014E 2015E 2016E 2017E 2018E
RCF
RCF available 200 200 200 200 200 200 200 200 200 200
RCF, BoP 0 0 0 0 0 0 0 0 0 0
Drawdown/(repayment) 0 0 0 0 0 0 0 0 0 0
RCF, EoP 0 0 0 0 0 0 0 0 0 0 0
Average drawn RCF 0 0 0 0 0 0 0 0 0 0
Average undrawn RCF 0.5% 200 200 200 200 200 200 200 200 200 200
Interest on RCF 7.3% (0) (1) (1) (1) (1) (1) (1) (1) (1) (1)
Cash flow available post repayment of RCF 10 110 150 189 215 224 233 236 243 246
Term Loan A
Term loan A, BoP 234 224 115 0 0 0 0 0 0 0
Recap 0 0 0 0 0 0 0 0 0 0
Repayment (10) (110) (115) 0 0 0 0 0 0 0
Term loan A, EoP 234 224 115 0 0 0 0 0 0 0 0
Interest on Term loan A 7.3% (3) (12) (4) 0 0 0 0 0 0 0
Cash flow available post repayment of Term loan A 0 0 35 189 215 224 233 236 243 246
Term Loan B
Term loan B, BoP 234 234 234 199 10 0 0 0 0 0
Recap 0 0 0 0 0 0 0 0 0 0
Repayment 0 0 (35) (189) (10) 0 0 0 0 0
Term loan B, EoP 234 234 234 199 10 0 0 0 0 0 0
Interest on Term loan B 7.8% (3) (18) (17) (8) (0) 0 0 0 0 0
Cash flow available post repayment of Term loan B 0 0 0 0 205 224 233 236 243 246
Term Loan C
Term loan C, BoP 234 234 234 234 234 29 0 0 0 0
Recap 0 0 0 0 0 0 0 0 0 0
Repayment 0 0 0 0 (205) (29) 0 0 0 0
Term loan C, EoP 234 234 234 234 234 29 0 0 0 0 0
Interest on Term loan C 8.3% (3) (19) (19) (19) (11) (1) 0 0 0 0
Cash flow available post repayment of Term loan C 0 0 0 0 0 195 233 236 243 246
Second Lien
Second Lien, BoP 0 0 0 0 0 0 0 0 0 0
Recap 0 0 0 0 0 0 0 0 0 0
Repayment 0 0 0 0 0 0 0 0 0 0
Second Lien, EoP 0 0 0 0 0 0 0 0 0 0 0
Interest on Second Lien 7.3% 0 0 0 0 0 0 0 0 0 0
Cash flow available post repayment of Second Lien 0 0 0 0 0 195 233 236 243 246

 Below is the key valuation output for the LBO. IRRs on the equity investment are calculated based upon
set exit years and exit multiples. This table should also be accompanied in any presentation by the
sensitivity tables outlined above (see section 5.7.3)
EQUITY SPLIT AT EXIT EXIT COSTS

(%) (GBPm)
Financial sponsor 90% Cost of pensions 0
Management 10% Other 0
Mezzanine provider 0% Total 0
FINANCIAL SPONSOR RETURNS
LTM Exit Net Loan Equity Money Inv. Cost Year 1 Year 2 Year 3 Year 4 Year 5
EBITDA multiple EV debt note value IRR multiple (GBPm) 2009E 2010E 2011E 2012E 2013E
(GBPm) (x) (GBPm) (GBPm) (GBPm) (GBPm) (%) (x) Jan 09 Mar 09 Mar 10 Mar 11 Mar 12 Mar 13
2010E 493 5.0x 2,464 796 922 745 1% 1.0x (1,574) -- 1,593
493 5.5x 2,710 796 922 992 13% 1.2x (1,574) -- 1,814
493 6.0x 2,956 796 922 1,238 25% 1.3x (1,574) -- 2,036
493 6.5x 3,203 796 922 1,485 36% 1.4x (1,574) -- 2,258
493 7.0x 3,449 796 922 1,731 48% 1.6x (1,574) -- 2,480
2011E 519 5.0x 2,594 621 1,014 959 8% 1.2x (1,574) -- -- 1,877
519 5.5x 2,853 621 1,014 1,218 15% 1.3x (1,574) -- -- 2,110
519 6.0x 3,113 621 1,014 1,478 20% 1.5x (1,574) -- -- 2,344
519 6.5x 3,372 621 1,014 1,737 26% 1.6x (1,574) -- -- 2,577
519 7.0x 3,631 621 1,014 1,996 31% 1.8x (1,574) -- -- 2,811
2012E 544 5.0x 2,720 401 1,115 1,203 11% 1.4x (1,574) -- -- -- 2,198
544 5.5x 2,992 401 1,115 1,475 15% 1.6x (1,574) -- -- -- 2,443
544 6.0x 3,264 401 1,115 1,747 18% 1.7x (1,574) -- -- -- 2,687
544 6.5x 3,535 401 1,115 2,019 22% 1.9x (1,574) -- -- -- 2,932
544 7.0x 3,807 401 1,115 2,291 25% 2.0x (1,574) -- -- -- 3,177
2013E 566 5.0x 2,828 153 1,227 1,449 12% 1.6x (1,574) -- -- -- -- 2,531
566 5.5x 3,111 153 1,227 1,731 15% 1.8x (1,574) -- -- -- -- 2,785
566 6.0x 3,394 153 1,227 2,014 17% 1.9x (1,574) -- -- -- -- 3,040
566 6.5x 3,677 153 1,227 2,297 19% 2.1x (1,574) -- -- -- -- 3,294
566 7.0x 3,960 153 1,227 2,580 22% 2.3x (1,574) -- -- -- -- 3,549
Note: 1. Assumes offer price of GBP7.50, EV purchase price of GBP2,586m, and an entry leverage of 2.0x LTM EBITDA

SECTION 6
Alternative valuation methods

6
Alternative valuation methods

6.1 Sum of the parts analysis (SOTP)
6.1.1 Definition
The sum-of-the-part (“SoTP”) methodology values a company by applying different valuation techniques to
its separate units. The sum of these values makes up the total enterprise value (“EV”) of the company.
6.1.2 Application
 This methodology is used to value holding companies or conglomerates where the constituent businesses
require different valuation techniques. It is well-suited to valuations involving restructuring and where a
client is considering a strategic review or sale of one of its businesses. It is quite common for UBS or other
equity research to include a SOTP valuation in their reports
 The individual businesses can be valued on a (1) trading, (2) break-up or (3) fundamental basis
– (1 & 3) a group conducting a full de-merger of its businesses in two separately quoted entities
– (2 & 3) a group selling one of its subsidiaries to a trade buyer
– (1, 2 & 3) an acquirer disposing unwanted parts of its recently acquired target via a combination of
flotation and a trade sale
 Helps to understand whether the company is more valuable as a whole or in parts
 Helps to identify value-driving business units
 Care needs to be taken to account for synergies and dissynergies
6.1.3 Trading sum-of-the-parts

The trading sum-of-the-parts is the total value of the company as if each part of the business was
separately listed. It is typically undertaken by comparing the financial metrics of the different divisions with
the appropriate set of comparable companies and thereby implying a valuation for each part of the business.
When undertaking a trading SOTP valuation, certain additional factors need to be considered as follows:
6.1.3.1 Conglomerate discount

A conglomerate is a group of different businesses whose operations are not integrated with each other
A holding company is a company whose single raison d’être is to hold shares in other companies (usually
the company does not produce goods or services itself)
The conglomerate/holding company discount is the discount to underlying net asset value (“NAV”) at
which conglomerates are valued
 Discount tends to increase in weaker market conditions and reduce in a stronger environment
 Discounts are volatile over time and vary significantly between companies
Conglomerates and conglomeracy come into and out of fashion at different times and in different countries.
6.1.3.1.1 Understanding the conglomerate discount

Investors can spread their risk by investing in a conglomerate (the ultimate passive conglomerate is the stock
market index). A holding company with significant stakes in unlisted companies can represent the only way
to invest in these assets (“scarcity value”). The market typically applies a conglomerate discount to companies
which hold assets which are not necessarily synergistic. As a result, a SOTP valuation (done on a trading value
basis) often produces a higher value than that attributable by the stock market to the group as a whole
 Individual parts will be valued higher as there usually is an investor who would value it highest per se
 One or two badly run business segments can be enough to create negative investor sentiment for the
entire company
 Financial and intangible resources (e.g. ability of central management) can add value to the parts
SECTION 6: Alternative valuation methods 89

Key factors to influence level of holding/conglomerate discount:

 Active management of the underlying portfolio should produce higher returns, thus lower discount
 A higher level of ownership of subsidiaries should lower the discount (as the parent company can exert a
greater degree of control) as there will be less dividend/cash flow leakage
 Level of overhead costs at the parent company level
 Latent tax liability (if subsidiaries are sold)
 Multi-layered holding companies are generally penalised as the discount is multiplied through the
control chain
6.1.3.2 Corporate costs

Some companies allocate head office costs by division but others do not. In the former case, these costs are
captured in your valuation of the different parts of the business but in the latter case, these need to be
valued separately. This can be done in a variety of ways but typically they are either capitalised at the multiple
implied by the group SOTP or on a perpetual growth basis, using the group WACC and a nominal growth
rate which is typically 2.0–3.0%.
6.1.3.3 Excess cash and debt

Excess cash or debt should be valued at 1x
6.1.4 Break-up and fundamental valuation

The break-up or fundamental value is the total value of the company if operations are sold separately. As
such this is a transaction valuation. It tends to be more complex than a trading SOTP analysis as the latter is
typically a question of finding the appropriate peer set for each division while the former needs to take into
account the practicalities of a break-up.
6.1.4.1 Break-up costs

 Are there any overheads that will be eliminated (e.g. head office costs)?
– will the pieces need to repurchase some of these services (e.g. IT)?
 Is there a loss of financial economies of scale?
– losing lower borrowing or higher deposit rates
– losing group tax relief/tax management
 Have break-up costs been calculated and deducted in present value terms?
– related tax costs (capital gains tax for selling a subsidiary), redundancy costs and other associated costs
 The costs of separating the individual businesses in practice can be prohibitive if there is a high degree of
integration between them.
Typically it will be difficult to quantify many of these elements, particularly from an “outside-in” perspective
so when presenting this type of analysis it is important to highlight assumptions made and where further
work is required to understand the true value that can be created via a break-up.
6.1.4.2 Post break-up adjustments

 Following the break-up, management charges and other services provided by the corporate centre will no
longer be borne by the subsidiaries (assuming some of this had been financed by them before)
 The purchase price of inputs and sales price of output need to reflect the lack of transfer pricing
going forward

6.1.4.3 Legal considerations

 Are there change-of-control clauses or other arrangements that may be triggered through a break-up
(e.g. pre-emption rights of a partner in a partly owned subsidiary once it leaves the group's control)?
 Are there debt covenants (e.g. on low-coupon debt of the parent) that might be triggered on a change of
control, resulting in a loss of value?
– the nature of lenders' covenants will reflect the borrower's general standing and creditworthiness and
this may be affected by splitting up the group into smaller components
6.1.4.4 Listing of shares

If the break-up valuation assumes that the company will list the shares of one of its subsidiaries, the new
issue price will have to be discounted (relative to the theoretical trading value) in order to attract investors to
participate in the offer. This is commonly referred to as the “IPO discount”. Therefore a simple reference to
multiples of comparable companies may not tell the full story.

6.1.5 Worked example

Remember to include the corporate function and eliminations.
This example is a depicting a trading, not a break-up valuation. In the latter case, we need to
account for break-up costs and tax considerations.
6.1.5.1 Calculations
Multiple (x) Value
(€m) Methodology Low-high Reference Share held (%) Low-high
Listed portfolio
Subsidiary 1 Market cap na 2,526 68.3 1,725
Subsidiary 2 Market cap na 1,236 43.4 536
Non-listed portfolio
Subsidiary 3 P/E 8–10 10 88.0 70–88
Subsidiary 4 P/TBV 1.0–1.5 600 95.3 572–858
Subsidiary 5 EV/EBITDA less 5–7 254 63.7 809–1,133
net debt¹
Operating units 3,713–4,340
Corporate function P/E 8 (8) (64)
Net debt P/BV 1 (150) (150)
Total 3,499–4,126
Note:
1 Assumed net debt at the subsidiary is zero
Sum-of-the-parts valuation
4,500 4,340
1,133 4,126
4,000
809 3,713
3,500 3,499
858 ( 64 )
( 150 )
3,123
3,000 572
(€m)
2,500 536 88
70
2,000
1,725
1,500
1,000
500
Sub 1 Sub 2 Sub 3 Sub 4 Sub 5 Operating Corporate Debt Total Market
units cap
Source: UBS Investment Bank

6.1.6 OpCo-PropCo valuation

This is a specific type of SOTP valuation which looks at the value of splitting a business with real estate assets
into two separate companies – an Operating Company (OpCo) and Property Company (PropCo). The
theoretical advantage of this is that the PropCo can sustain more leverage than the OpCo (due to the stable,
long-term rental income), and thus for a financial investor it may be possible to increase overall returns. The
PropCo is typically valued on the basis of a market real estate yield, which will in turn depend on the sector
which the asset is related to and the strength of the underlying OpCo. This yield is then applied to the rents
the OpCo pays to the PropCo to derive an implied value of the PropCo. The OpCo is then separately valued
using standard methodologies.
6.1.7 Drawbacks of methodology

There are a number of complexities which can undermine a SOTP valuation:
 Obtaining financial details and forecasts for each business unit can be difficult
 Cash flow projections can be complex and interdependent on different units
 Allocation of corporate function and elimination of double-counting between units are usually estimates
at best
 Valuations can vary over a wide range
 Particularly in the case of a break-up SOTP, it is a theoretical valuation unless there is a real prospect of
selling the company on a piecemeal basis
6.1.8 How to check efficiently

Error Comments
Check against  The SOTP approach uses any of the techniques described earlier to value
respective methods the separate businesses of the company. Therefore the same
used to value the cross-checks are to be done on the individual pieces as the respective
parts technique allows for
Consistency  Ensure the values for all parts are either EVs or equity values
Trading vs.  No break-up costs are to be assumed in a trading valuation

break-up valuation – double-check the post break-up adjustments otherwise
Excess cash/debt  Do no forget to add the value if applicable as a separate item

– valued at 1x
6.2 Economic Value Added (EVA)
6.2.1 Definition and applicability

Economic Value Added (“EVA”) was developed by Stern Stewart in 1991. EVA is a measure of the surplus
value created by an investment or a portfolio of investments/assets. EVA has become a popular measure of
corporate performance, valuing businesses and equity investments.
The EVA concept is very simple whereby to create value for shareholders, returns on capital should exceed
the relevant cost of capital. To illustrate, take a company, Castle plc which has capital of €100 million
(shareholders’ equity and debt) and whose post-tax cost of capital is 15% (equity underwriting costs and
interest on debt). Castle plc will only add value once it has generated a post-tax return on capital (typically
measured as taxed EBIT) exceeding €15 million a year. If the company generates €25 million, the EVA will be
€10 million for that year.

6.2.2 Alternative uses of EVA concept

Uses Comments
1. As part of an  Powerful internal management tool for divisional performance
internal evaluation and management remuneration
management  Focuses management on the factors which add value e.g. (profitability,
reporting system efficient use and re-allocation of capital)
2. As a measure of  EVA sets a minimum acceptable performance level to the rate of

performance return/cash generated in the long run
 If a division or investment cannot achieve the hurdle rate—then,
according to EVA theory, a company would be better off closing or
selling this operation. All positive EVA projects should be undertaken,
subject to having enough capital to undertake these. In the event capital
is constrained, those with the highest proportional EVA to capital should
be undertaken first
 Focus on:
– positive versus negative EVA
– annual change in EVA
– EVA impact of strategic decisions
3. As a valuation  Economic value = Capital employed + present value of forecast EVA

technique  Mathematically equivalent to a DCF valuation
– should give the same answer if calculated in a consistent manner
6.2.3 EVA as a valuation technique

EVA is usually calculated from an enterprise perspective (i.e. based on all capital rather than just equity) and
therefore based upon normal operating profit less adjusted taxes (“NOPLAT”). EVA is defined as a measure
of profit (NOPLAT) less a charge which represents the economic cost of the capital employed in generating
that profit.
EVA = NOPLAT – Opening Capital employed x WACC

OR
EVA = Capital employed x (ROCE – WACC)
 NOPLAT = Normal operating profit less adjusted taxes. Essentially EBIT adjusted to exclude income from
non-core assets and remove any implied interest cost in respect of unfunded pensions less tax related to
this core EBIT
 Capital employed = the total capital utilised in the generation of operating profit (essentially shareholders
funds plus net debt and the value of other sources of finance). This should capture shareholders' funds
plus minority interests, net debt, unfunded pension provisions and any other source of finance less the
value of non-core assets
 WACC = Weighted average cost of capital. This should capture the average post tax cost of all sources of
finance weighted according to market values
 ROCE = A post tax rate of return on invested capital = NOPLAT / Capital employed (either average or
opening capital is used)


EVA valuation
Assumptions
WACC 10.0%
Terminal growth (g) 6.0%
Return on new investments (ROCE) 20.0%
Tax rate 25%
% D&A of Sales 6.0%
% Capex of D&A 120.0%
% of change in WC 7.5%
1 2 3 4 5 TV
Capital employed
Opening balance 1,000 1,020 1,040 1,063 1,088 1,109
D&A (60) (66) (73) (80) (83)
Capex 72 79 87 96 100
Change in WC 8 8 8 9 4
Closing balance 1020 1040 1063 1088 1109
1 2 3 4 5 TV
EBIT 250 275 303 333 346 367
Tax (63) (69) (76) (83) (87) (92)
NOPLAT (A) 188 206 227 250 260 275
Opening capital * WACC (B) (100) (102) (104) (106) (109) (111)
EVA (A-B) 88 104 123 143 151 164
NPV of EVA 80 86 92 98 94
Sum of NPV of EVA (C) 449
Value of Economic Profit (1st year of Perpetuity) (D) 1,643

EVA TV / WACC = 164 / 10%
Incremental value beyond 1st year of Perpetuity created (destroyed) by additional growth (E) 2,063
NOPLAT TV x (g / ROCE ) x (ROCE – WACC) / (WACC x (WACC – g))
= 275 x (6% / 20%) x (20% – 10%) / (10% x (10% – 6%))
Terminal Value (D + E) 3,706
NPV of Terminal value (F) 2,301
Terminal value / (1+WACC)^(1 / terminal year)
= 3706 / (1+ 10%)^(1/5)
Invested capital at beginning of forecast 1,000

PV during explicit forecast period (C) 449
PV of Terminal value (F) 2,301
Total EV 3,751

6.2.5 Drawbacks of Methodology

 EVA is often unreliable as a performance measure
– the difficulty of identifying a realistic measure of capital employed
– differences in accounting policies
6.2.6 How to check efficiently

Error Comments
Change opening  In a correct EVA valuation changing opening capital employed should
capital employed… not affect the valuation
– if the valuation changes then the model is wrong!
 All the accounting adjustments made in calculating EVA are irrelevant
and do not affect value
– higher capital employed is offset by lower annual EVA
– capital employed does not feature in a DCF valuation and EVA is
mathematically equivalent to DCF
– capital employed is a ‘sunk cost’ and therefore irrelevant—only the
incremental return on new investment matters
Check against a  “Mathematically” an EVA valuation is equivalent to a DCF valuation

DCF valuation… (although this may not be the case if you use a value driver approach
from TV rather than a multiple or perpetuity growth rate)
– if the values differ it is probably a problem with the EVA model!
 Ensure the change of capital employed each year equals NOPLAT–FCF
 Work on the basis of year end cash flows and use opening capital not
average capital in calculating EVA
 Ensure that if a terminal value is used for EVA that a true steady state
has been reached
Terminal values in  A constant terminal growth of cash flows does not imply the same
EVA… constant terminal growth of the EVA!
 The growth rate you use to estimate after-tax operating income in future
periods should be estimated from fundamentals when doing discounted
cash flow valuation.
– Set growth rate = Reinvestment rate x Return on capital
– if the above relationship does not hold, different values will obtained
from the DCF and EVA valuations
6.2.7 Adjusted Present Value

Adjusted Present Value (“APV”) is a business valuation method which calculates the value of the company as
if it was unlevered (i.e. financed 100% with equity) and then adds the value of the tax shield generated by
the debt in the capital structure
APV = PV of all-equity financed project + PV of financing effect
The APV valuation method is considered effective in situations which have a changing capital structure of the
company over time (as opposed to DCF valuation which assumes a long-term, constant capital structure).
A key advantage of the APV approach is the flexibility it gives. Essentially it allows the separation of the
effects of debt into different components and allows the use of different discount rates for each component.
APV and the standard DCF approaches should give the identical result if the capital structure remains stable.
APV analyses financing effects separately and then adds their value to that of the business. APV allows the
manager to more easily identify the sources of value in a project, providing a better understanding of
the project.

6.2.8 APV as a valuation technique

The difference with a standard DCF model is that the APV model separates the value of operations into
two components:
1. The value of operations as if the company was entirely equity financed:
– calculate the non-levered annual FCF and Terminal value as usually done for DCF models
– calculate the non-levered cost of equity (Ku)
Ku = risk-free rate + (non-levered beta x equity risk-premium)
Non-levered beta = βu = [βe x E + βd x D x (1-t)] / [E + D x (1-t)]
– where βu = non-levered beta; βe = Levered beta; βd = beta of debt; E = Market Value of Equity; D =
Market Value of Debt; t= tax Rate
– discount the non-levered annual FCF and terminal values using Ku
– this results in the NPV assuming the business were financed entirely by equity
2. The value of the tax benefits associated with debt financing:
– calculate the interest tax shield by multiplying the annual interest expenses with the marginal tax rate
on a year-by-year basis
Interest tax shield = interest expenses x marginal tax rate
– calculate Terminal value of interest tax shields (based on long term capital structure assumptions)
Terminal value = interest tax shieldN+1 / (cost of debt – perpetual growth rate)
– discount the tax savings at the estimated cost of debt. The cost of debt should be pre-tax
Assumptions
Tax rate 35.0%
Cost of debt 6.0%
Cost of equity 12.4%
Debt ratio (D/V) 40%
Long-term growth forecast 3.0%

1. Calculation of Base case PV

1 2 3 4 5 6 TV
EBIT 20.9 22.4 23.9 25.1 25.9 26.7 27.5
Tax (7.3) (7.8) (8.4) (8.8) (9.1) (9.3) (9.6)
D&A 6.6 7.1 7.6 7.9 8.2 8.4 8.7
Capex (8.8) (9.4) (10.1) (10.6) (10.9) (11.2) (11.6)
Change in NWC (1.0) (0.8) (0.8) (0.6) (0.4) (0.4) (0.4)
FCF 10.4 11.4 12.2 13.1 13.7 14.1 14.5
NPV of FCF 9.5 9.5 9.2 9.0 8.6 8.0
Terminal Value 242.2
NPV of TV 144.4
Base case PV 191.6
Calculation of TV
FCFTV / (WACC – long term growth forecast) 242.2
= 14.5 / (9% -3%)
NPV of Terminal value 144.4
Terminal value / (1+WACC)^(1 / terminal year)
= 242.2 / (1+ 9.84%)^(1/6)
2. Calculate PV interest tax shields

1 2 3 4 5 6
Debt 50.0 49.0 48.0 47.0 46.0 45.0
Interest 3.06 3.00 2.94 2.88 2.82 2.76
Interest tax shield 1.07 1.05 1.03 1.01 0.99 0.97
PV Interest tax shields 5.0
3. Total APV
Base Case PV 191.6

PV Interest tax shields 5.0
Total APV 196.7
6.2.10 Drawbacks of Methodology

 More complicated than WACC approach and easily misapplied
– information for analysis is not always readily available
 WACC adjusts the discount rate to account for financial enhancements
– thus, the value created by financing side effects remains obscure
 Difficulty of estimating probabilities of default and the cost of bankruptcy, which is usually ignored.
This means that enterprise value from APV method is usually overstated, particularly at high
leveraged companies
 Need to estimate long term debt structure (when you assume zero debt once existing debt is repaid)

6.3 Dividend discount model (DDM)

In certain sectors the conventional valuation methodologies cannot be applied due to the nature of the
company’s business model. Banks and insurance companies for example need to meet capital requirements
that are set by particular regulatory bodies.
Only when a certain portion of the net income is put to increase the capital or a minimum capital position is
reached, can dividends be paid out. This cash flow is discounted as a normal DCF to arrive at the equity value
of the company. Use only the cost of equity for your calculations.
Subtracting debt would not make sense in this case, as debt is more like working capital for a bank, not so
much a pure financing instrument as for companies in other sectors. Banks make money on the margin
between the interest payments they pay (to entities the bank owes money to) and interest they receive (from
those who owe money to the bank).
6.4 Appraisal Value (AV)

Calculating Appraisal Value is the key methodology to value life insurance companies. It is ultimately a DCF,
made easier with the use of Embedded Value (EV) and Value of New Business (VNB).
Appraisal Value = EV + Goodwill
The aim of an EV is to recognise the profit as it is earned over the life of the insurance policy (i.e.: when it is
earned, not when it is released to shareholders). EV is the value of the product sold, estimated at time of sale
and booked in P&L. The future profits are discounted at a risk discount rate, typically calculated as risk free
rate plus a risk premium and often different for different products.
The goodwill can be calculated as a multiple of the VNB, usually in the order of 4–8 times. Do not mistake
this goodwill with the accounting term—this is the terminology used for the franchise value in life insurance.
For an in-depth calculation of AV, please refer to the UBS Valuation Guide Book, Life and Pensions Insurers,
prepared by FIG.
6.5 Special cases
6.5.1 Loss-making companies

In this case valuation based on multiples and precedents is not valid. Consider valuing by reference to
underlying net assets.
Consider also assuming a "normalised" operating margin based on the industry/sector, work out a
theoretical profitability level, based on turnover/assets, and value the business. Then deduct amounts for risk,
uncertainty, in achieving those theoretical profitability levels (very subjective) and costs incurred in getting to
that stage including losses in the intervening period. (Turnover multiples can be used as a shortcut in
following this approach, particularly in sectors where there are other loss-making quoted companies).
Most companies that make a positive EBIT should be capable of being recapitalised with more equity and less
debt, even if they are presently making a pre-tax loss. We would value the EBIT (using multiples or DCF) and
then produce enterprise value. This may show that the debt is actually bigger than the enterprise value.
6.5.2 Liquidation value

This represents the value remaining once all the assets have been sold and the liabilities settled.
We have to bear in mind the incidence of redundancies, stock clearance and other transaction costs and
taxes on disposals within the Company during the liquidation process.
When, as in liquidation, there is a forced sale element, it is always possible that assets will not be sold for
valuation hoped for, or even book values. In particular, there may be losses on stocks and certain types of
fixed assets (e.g. plant).

APPENDIX A
Comps & Precedents adjustments

7.
Comps & Precedents adjustments
A.1. Adjustments
It is difficult to make a list of all possible EV adjustments. In practice, adjustments will be decided within each
team. Focus should be on adjustments that are likely to have a material impact on the enterprise value
calculation. The key is being consistent with all adjustments.
A.1.1. Information sources

Sources of information
Category Information needed? Where to find it?
Market data Latest closing share price Datastream, Bloomberg

Latest number of shares Bloomberg, Datastream, Company reports
Market value of debt Bloomberg
P&L — historical Full financial section of latest Company website,
annual report http://www.sec.gov/edgar.shtml (for US companies)
Balance sheet Full financial section of latest Company website,
report (annual/interim) http://www.sec.gov/edgar.shtml (for US companies)
P&L forecasts UBS Research forecasts Researchweb, analyst models (for European
companies only!)
Other broker notes The Markets or Thomson Research
Other Any significant news or Company website, Factiva, Bloomberg and Reuters
corporate events?
A.1.2. Classes of shares

Comments
Principle  Include all classes of shares
– there should be a price for each class
Impact on NOSH  Equity value = (“A” shares x “A” price) + (“B” shares x “B” price)
A.1.2.1. Options
Comments
Principle  Only include “in the money” options in number of shares outstanding
– typically all options vest on “change of control” event
 Treasury method is the most common
– proceeds from conversion of options are used to buy back shares at
offer price
 In theory, “out of the money” options will also have value and should be
included in equity value – in practice this value is not available from
public documents and requires specialist option valuation
Impact on NOSH  Use “outstanding” options and average strike price

– calculate by each class if available
 Net new shares = options − (options × strike price ÷ offer price)
APPENDIX A: Comps & Precedents adjustments 101

A.1.2.2. Convertibles
Comments
Principle  “In the money” when the conversion price < offer price
– increases diluted NOSH
– adjust Net income for the interest expense (post tax)
– convertible bond should be EXCLUDED from the net debt
 “Out of the money” when the conversion price > offer price
– convertible bond should be INCLUDED in the net debt
– use aggregate amount of the debt and option components
Impact on NOSH  New shares issued = face value of convertibles ÷ conversion price
Impact on  The convertible interest charge (post tax) is added back to get the
income earnings figure as if the convertible did not exist
Impact on  Either: “out of money” in which case treat convertible as part of net
debt debt
 Or: “in the money” in which case include as part of net debt as market
value (and do not make the other adjustments above)
A.1.2.3. Pensions
Comments
Principle  Pension liabilities are effectively long-term debt used to fund employee
compensation and as a result have an impact on EV
 Pension deficit (post tax) needs to be added to the EV
– = (value of plan assets) – (value of plan liabilities)
 Other pension employment benefits (OPEBs) is not usually funded
– OPEBs deficit treated as debt equivalent in EV on a post tax basis
 Normally pension expense treated as operating item and included in EBIT
– in reality, only service is truly the operating item
Impact on EV  Adjusted EV = EV + pension deficit + OPEBs

– include pension deficit and OPEBs on a post tax basis
Impact on  Adjusted EBIT(DA) = EBIT(DA) + pension expense – service cost

EBIT(DA) – in some companies, this adjustment has already been made in the
accounts therefore no need to “clean out”
A.1.2.4. Operating leases

Comments
Principle  Add back the equivalent liability of a capital lease
 8x lease expense used a rule of thumb
– however depends on industry
– NPV method sometimes used as a better cross-check
Impact on EV  Adjusted EV = EV + equivalent liability of a capital lease
Impact on EBITDA  EBITDAR = EBITDA + lease expense

A.1.2.5. Investments and associates

Comments
Principle  In order to calculate the value of the “core business”,
investments/associates should be stripped out and valued separately
 The value of an investment/associate is reflected in the market cap of the
company and therefore needs to be subtracted from the EV
Impact on EV  There are several methodologies to value investments/associates

– market value if listed
– estimated market value (apply a multiple to earnings)
– book value (last resort)
 Most of the time, under IFRS, associates in the P&L are shown as a share
of net income
– Therefore an appropriate P/E multiple can be applied e.g. relevant
peer group multiple
Impact on  EBIT(DA) should also reflect the core business

EBIT(DA) – i.e. exclude any earnings from associates/investments
A.1.2.6. Exceptionals
Comments
Principle  All line items should be adjusted for exceptionals and exclude
discontinued operations where relevant
 Common exceptionals include:
– restructuring charges
– impairment of fixed and intangible assets
– large loss/gain on disposals
 Goodwill amortisation has disappeared (US GAAP + IFRS)
– but replaced by impairment—to be treated as an exceptional
Impact on  EBIT(DA) should be adjusted to reflect the operating nature of

EBIT(DA) the business
Impact on  Net income should be adjusted for exceptionals post tax

net income – look for actual tax charge on exceptionals
– otherwise apply the marginal tax rate

APPENDIX B
Glossary
8.
APPENDIX B: Glossary 104

Glossary
Term Meaning
Adjusted present value A variant of the DCF used to calculate the net present value of a company or
(“APV”) project assuming it were financed entirely by equity plus the net present value
of the tax shield created by using debt in the capital structure
Appraisal value (“AV”) Appraisal Value is the key methodology for the valuation of life insurance and
pensions companies. It is an intrinsic valuation methodology similar to a DCF
or DDM but made simpler by the use of Embedded Value (“EV”) and Value of
New Business (“VNB”)
Beta A measure of the sensitivity of the stock to movements in the market
Covariance (historical stock return, historical market return)/
Variance (historical market return)
Break-up value Break-up value is the total value of the company if its operations are sold
separately, as such this is a transaction valuation
Call Option Right, but not the obligation, to buy a security at a specified price
Capex Capital expenditures
Capital Asset Pricing Model Theoretical model used to estimate expected cost of equity based on
(“CAPM”) correlation with the overall market
Capital lease See Finance Lease
Compound annual Equivalent annual growth for a given period CAGR
growth rate (“CAGR”) (Year “n” value ÷ Year 1 value) ^ (1 / (n-1)) – 1
Conglomerate Conglomerate is a group of different businesses whose operations are not
integrated with each other
Conglomerate/holding Conglomerate/holding company discount is the discount to underlying net
company discount asset value (“NAV”) at which conglomerates are valued
Contingent liability A liability for which its value depends on certain other values or events
(e.g. Lawsuits)
Control premium Incremental price required to obtain control
Conversion price Price at which a convertible security converts
Convertible security Security that is convertible into another security at a prestated price
Creditor days Creditors/Cost of Goods Sold x 365
Debt risk premium The premium over the yield on long-term government bonds demanded by
the market on the company’s debt
Debtor days Debtors/Sales x 365
Deferred tax Deferred tax is an accounting item that effectively smoothes the difference
between the tax charge expected in the accounts and what is actually payable
Defined benefit pension A plan where the retirement benefits are defined by a company,
who are obligated to meet payments at a set level, regardless of
investment performance
Defined A plan providing an individual account for each participant, who will reveive
contribution pension benefits based solely on the amount contributed to the plan and the returns
on assets in which the plan invests
Discounted cash flow Present value of cashflow. Cashflow/(1+Discount rate)t
(“DCF”)
Dividend discount model Valuation method to derive equity value by discounting future dividends
(“DDM”)

Term Meaning
EBITA Earnings before interest, tax and amortisation
EBITDA Earnings before interest, tax, depreciation and amortisation
EBITDA Debt Leverage Total net debt
EBITDA
EBITDAR Earnings before interest, tax, depreciation, amortisations and rents/leases
Economic value added Valuation methodology comparing the returns a company generates with cost
(“EVA”) of capital
NOPLAT – opening capital employed x WACC OR
Capital employed x (ROCE – WACC)
Effective tax rate Income tax expense/taxable income
Enterprise value (“EV”) Represents the total value of a business/enterprise to all providers of capital
(debt, minorities, preference, equity)
Equity value + net debt + minority interests + pension deficit + off-balance
sheet items + other debt-like items
Equity Gearing Equity
Debt + Equity
Equity risk premium The premium demanded by equity investors on shares which have an
“average” degree of market related risk and an “average” level of gearing
Equity value Represents the value to the providers of equity, after net debt, minorities and
preference shares have been deducted from enterprise value
EURIBOR European Interbank Offer Rate
Exercise price Price at which an option holder may buy or sell a security
Finance lease A finance or capital lease generally lasts for the life of the asset, with the
present value of lease payments almost equivalent to the price of the asset
Fixed Charge Coverage Cash flow available for debt service
Interest plus scheduled repayment
Free cash flow (“FCF”) Cash flow available to service capital (cash flow from operations less capex)
Fundamental valuation Reflects the net present value of the cash flows of the business
Holding company Holding company is a company whose single raison d’être is to hold shares
in other companies (usually the company does not produce goods or
services itself)
Internal rate of return Equivalent annual return CAGR on an investment
(“IRR”) Corresponds to discount rate at which NPV=0
Lease A lease is a contract between two parties: one party (lessee) has right to use
an asset which is owned by another (lessor) for a fixed or indefinite period of
time, whereby the lessee obtains exclusive possession of the property in return
for paying the lessor a fixed or determinable payment. The lessor retains the
legal ownership of the asset
Leveraged buy-out (“LBO”) Purchase of a company through use of a high proportion of debt financing
LIBOR London Interbank Offer Rate
Marginal tax rate Statutory tax rate in specified jurisdiction
Minority interest Third party ownership in a parent company’s subsidiary
Money multiple Cash exit value as a multiple of cash entry value of a given investment
Net debt Short-term + long-term interest-bearing liabilities—cash and cash equivalents
(marketable securities)
Net present value (“NPV”) See discounted cash flow

Term Meaning
NOPLAT Net operating profit less adjusted taxes (practically speaking, taxed EBIT
adjusting for non-deductible items)
Off-balance sheet liability Liability of a company which does not appear on its balance sheet
Operating lease An operating lease is usually signed for a period considerably shorter than the
useful life of the asset and the present value of lease payments are generally
much lower than the actual price of the asset
Option Right to buy or sell a security. See Call Option and Put Option
Perpetual growth Method for calculating terminal value based on a single future growth rate
FCFt 1
WACC  g
Preference shares Shares paying a fixed return. May be supplied with warrants attached
Put Option Right, but not the obligation, to sell a security at a specified price
Return on Return a business generates on its total capital
capital employed (“ROCE”) ROCE = EBIT / (average shareholders funds + net debt)
Return on equity (“ROE”) Return a business generates on its equity
ROE = Net income / average shareholders funds
Return on invested capital See return on capital employed
(“ROIC”)
Stock days Stock / Cost of Goods Sold x 365
Sum of the parts (“SOTP”) Valuation method involving the separate valuation of different parts of a
business to determine aggregate value
Synergies The financial benefits that a company expects to realise from the integration
of two businesses
Terminal value An estimate of the value of business at the end of the projection period
Trading valuation Reflects the theoretical value of one share as part of a listed entity
Transaction valuation Reflects the value an acquirer can derive from controlling a company
Unaffected market value Market capitalisation of a listed company implied by the closing price on the
day prior to rumour or speculation of impending corporate transactions (e.g.
takeover speculation)
Volume weighted Average share price over a period where each day’s closing price is weighted
average price (“VWAP”) by volume traded that day
Warrant Entitlement to buy an amount of a security (usually common stock) at a
specified price
Weighted average cost Weighted cost of debt + weighted cost of equity =
of capital (“WACC”)
D E
 (Cost of debt"Kd" ) (1  T)   (Cost of equity"Ke")
D E D E

APPENDIX C
Further reading
9.
APPENDIX C: Further reading 108

Further reading
Valuation & Accounting
 Damodaran on Valuation: Security Analysis for Investment and Corporate Finance
 Equity Valuation: Models from Leading Investment Banks by Jan Viebig, Thorsten Poddig and
Armin Varmaz
 Applied Mergers And Acquisitions by Joseph R. Perella, Robert F. Bruner
 Accounting For M & A, Equity, And Credit Analysts by James E. Morris
 Valuation: Measuring And Managing The Value Of Companies by Tim Koller, Marc Goedhart &
David Wessels
 Security Analysis: Principles And Techniques by Benjamin Graham and David Dodd
 Corporate Finance: Theory And Practice by Pierre Vernimmen and Pascal Quiry
 Business Analysis And Valuation: Using Financial Statements by Krishna G. Palepu and Paul M. Healy
 The Quest for Value by G. Bennett Stewart
 Beyond Greed and Fear: Understanding Behavioral Finance and the Psychology of Investing by
Hersh Shefrin
Business & Finance

 The Smartest Guys in the Room—by Bethany McLean and Peter Elkind
 When Genius Failed: The Rise and Fall of Long-Term Capital Management by Roger Lowenstein
 Den of Thieves by James B. Stewart
 Barbarians at the Gate: The Fall of RJR Nabisco by Bryan Burrough and John Helyar
 All That Glitters: The Fall of Barings by John Gapper & Nicholas Denton
 Disney War by James B. Stewart
 The Warburgs: The Twentieth-Century Odyssey of a Remarkable Jewish Family by Ron Chernow
 Stealing Time, Steve Case, Jerry Levin and the Collapse of AOL Time Warner by Alex Klein
 Taken for a Ride: How Daimler Benz drove off with Chrysler by Bill Vlasic and Bradley A. Sterz.
 Goldman Sachs: The Culture of Success by Lisa J. Endlich
 Blue Blood and Mutiny: The Fight for the Soul of Morgan Stanley by Patricia Beard
 The House of Morgan: An American Banking Dynasty and the Rise of Modern Finance by Ron Chernow
APPENDIX C: Further reading 109

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SECTION 2 Comparable company analysis ____________________________________________ 13

SECTION 3 Precedent transaction analysis ____________________________________________ 41

SECTION 4 Discounted cash flow ____________________________________________________ 47

4.5 How to discount _________________________________________________ 63

SECTION 5 Leveraged buy-out (LBO) _________________________________________________ 72

SECTION 6 Alternative valuation methods ____________________________________________ 88

APPENDIX A Comps & Precedents adjustments ________________________________________ 100

Current price 2 57.3

12-month VWAP 50.9

52-week trading range 45.2 57.7

Analyst price targets 50.1 63.2

Comparable companies 3 55.6 62.6

Trading sum-of-the-parts (SoTP) 4 55.8 62.8

6-month VWAP plus 30–40% premium 63.4 66.4

Precedent transactions 5 68.4 74.5

Take-out SOTP 4 66.0 72.5

Leveraged buyout (LBO) 6 60.8 63.4

Discounted cash flow (DCF) 7 67.4 69.2

1.2 Principal valuation methodologies

1.2.1 Comparable company analysis (trading valuation)—Chapter 2

1.2.2 Precedent transaction analysis (transaction valuation)—Chapter 3

1.2.3 Discounted cash flow analysis (fundamental valuation)—Chapter 4

1.2.4 LBO (transaction valuation)—Chapter 5

1.2.5 Other valuation methods—Chapter 6

1.3 Pros and cons of valuation methodologies

Method Pros Cons

expectations of future performance broker coverage may not fully reflect

Discounted  Reflects “fundamental” value of a  Valuation is highly sensitive to

identifies business and financial “manipulation” of assumptions and

Leveraged  Provides a valuation that is independent  Standalone LBO will underestimate

1.4 General principles to consider

1.4.1 Price vs. value

1.4.2 Trading value vs. transaction value

1.4.3 Control premium

1.4.4 Ensuring a consistent approach (numerator vs. denominator)

1.5 Capital structure adjustments

1.5.2 Existence of convertible securities, warrants and options

1.5.3 Preference shares

1.5.4 Other debt-like liabilities

1.5.6 Minority interests

1.6 ROCE vs. ROE

EBIT ÷ (average shareholders funds + net debt) = ROCE pre tax

Net income ÷ average shareholders’ funds = ROE

ROE = (Net profit ÷ sales) * (sales ÷ assets) * (assets ÷ equity)

1.7 Enterprise value (“EV”) vs. equity value

1.8 Effect of gearing on valuation

EV/EBITDA 5.0x 5.0x

1.9 Valuation process

1.9.1 Quantitative factors

1.9.2 Qualitative factors

1.9.3 Exercise of judgement in triangulating for the “right” answer

1.10 Tips for success

Comparable company analysis

SECTION 2: Comparable company analysis 13

Comparable company analysis

EV 1/(EBITDA- Revenue EBITDA

SECTION 2: Comparable company analysis 14

2.1.2 Value drivers

(Year “n” value ÷ Year 1 value) ^ (1 / n) – 1

2.1.2.4 Sector specific value drivers

Consumer products and retail

SECTION 2: Comparable company analysis 15