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M&A Fundamentals – The DCF Present Value Method of Business Valuation

A DCF present value business valuation model treats an M&A target as a financial asset that generates cash available for distribution to the owners.  It puts a value on owning those cash flows into the future.  It is generally acknowledged to be the most “rigorous” approach to M&A target valuation.  Properly executed the model of future cash flows forces the M&A team to examine the cost and revenue drivers behind each element of the M&A target’s operation.

The rigour of the DCF approach is an essential cross check to the simpler multiples methods of valuation that often drives seller and buyer price expectations.  We looked at some of the weaknesses of multiples-based valuations in another article from this series (M&A Fundamentals – The Multiples Method of Business Valuation).  At a minimum the DCF valuation model must check that the M&A buyer can make a return on capital at the prevailing market price for the M&A target.

The other great strength of the DCF Present Value approach for the M&A professional is the ability to look at the value of the M&A target from two different perspectives – the standalone value as operated by its existing owners, and the strategic value when fully synergised with the M&A buyer’s own organisation.  This is an important distinction, and it is crucial that the M&A professional keeps this separation between the standalone value and the strategic value in the modelling process.  Hybrid models that fail to make this separation, and incorporate buyer synergies into the standalone valuation, can easily lead to overpaying for an M&A target.

These separate perspectives on value, and the preparation of the forecasts that are inputs into the DCF present value model, are examined in more detail in our Advanced Business Valuation course.

 

 

The Principles of DCF Present Value

 

The concept behind discounted cash flow is that the value of an asset, in this case a business, lies in the future economic benefits (cash flows) the M&A buyer receives from owning it.   An amount of cash received now is worth more than the same amount received in 3 years’ time. This is because the money invested in the M&A target could be reinvested elsewhere, and make a return.  Economists call this concept “opportunity cost”.  In DCF present value models cash flows received in the future are DISCOUNTED to take account of the time you are waiting to get your money.

The formula for the discount rate to be applied to a year is set out below:

 

Diagram 1:  Formula to Calculate PV of Cash Flows in Future Year

 

 

PV = Present Value

CF = Free cash flow to enterprise

N = Year to which discount applies

R = Cost of capital (Discount Rate)

 

In plain English the present value of the cash flows today (year 0) is the actual cash flow arising in a year (year n) multiplied by the discount factor for that year.

 

The more mathematically inclined will realise this formula is a close relative to the formula for compound interest:

 

Diagram 2:  Formula to Calculate Compound Vale of Investment in Future Year

 

 

CF = Cash invested

n   = Investment period (years)

r    = Rate of interest

 

 

Elements of the DCF Present Value Business Valuation Model

 

For this explanation, we are going to start with a straightforward M&A scenario.  The M&A function has been tasked with acquiring a company aligned with our strategic focus, and in the growth phase of its development.  International Group Incorporated has been identified as the ideal M&A target, and the M&A team have been asked to calculate the standalone or “intrinsic” value of the company.

Diagram 1 shows the layout of the valuation model.  Your first impression might be that this is a more complex way to value a business than the more straightforward multiples method. (The multiples method is explained in our article M&A Fundamentals – The Multiples Method of Business Valuation).  Your first impression is correct. The DCF present value model forces the M&A professional to analyse the fundamental drivers of the business and how they will evolve into the future.

Below we look at each element of the model in turn.

 

Diagram 3: Layout of DCF Present Value Calculation for M&A Business Valuation

 

 

 CASH FLOW FROM OPERATIONS

Cash flow from operations derives from the income statement (profit and loss account) of the M&A target.  To the operating income line from the income statement, we add back depreciation and amortisation of intangible assets to arrive at cash flow from operations.  We examine the use of income statement information in M&A business valuation in another article:  M&A Fundamentals – Understanding the Income Statement From an M&A Perspective.

Depreciation and amortisation are non-cash accounting entries that reflect the consumption over their useful life of assets that were purchased (the cash-flow event) in past years.

You will notice that the cash flow from operations figures start in year 0.  This is the cash flow from the year before the expected M&A transaction.  Note that the cash flow from this year is not added into the Enterprise Value total.  We are measuring the present value of the cash flows under the M&A buyer’s potential ownership, not the previous owners.

To arrive at cash flow from operations for future years the income statement must be projected forward several years.  If the M&A target has established a predictable level of growth this is a straightforward exercise – little more than a mathematical progression of historic figures.  If the company is growing quickly, developing new product lines, and entering new markets, it may be necessary to develop a more sophisticated income statement model that analyses each driver of growth in detail.

For this model, the M&A professional has assumed a stable level of above market growth and estimated a future compound average growth rate (CAGR) of 5.9%.  This has been applied to the cash flow from operations line.

REINVESTMENT RATE

As companies grow, they typically reinvest capital into their operations to sustain and support the growth.  This capital may be invested in the form of fixed assets, or working capital, or both.  To calculate the reinvestment rates the M&A professional will review historic income statements and balance sheets to establish the historic relationship between profit growth, and investment in fixed assets and working capital.  This number is typically expresses as a % of cash flow from operations.

In this example the M&A professional is projecting the reinvestment rate at 26%.  In our model for year 1, applying a 26% rate to cash flow from operations of $110m we arrive at reinvestment of $29m for the year.

CORPORATE INCOME TAXES

Corporate income taxes are another deduction that reduces the cash available for distribution to the shareholders of an M&A target.  In the first cut of a DCF present value model for an M&A target, the M&A professional would typically use the marginal rate of corporate income tax that applies to a company operating in its home country.  In this example, the rate is 20%.  Applied to cash flow from operations in year 1 of $110m we arrive at corporate income tax expense of $22m.

In practice, calculating the marginal rate of corporate income tax can be a more complicated exercise.  The M&A target may have legacy tax losses that can be offset against taxable income to reduce the actual marginal rate of corporate income tax paid, or the M&A target’s jurisdiction might offer accelerated right down of capital investment against corporate income tax.  The detailed data needed to understand the likely real marginal rate of corporate income tax may not be made available to the M&A professional until the due diligence phase of the M&A transaction.

FREE CASH FLOW FROM OPERATIONS

The discounted cash flow present value models that M&A professionals use to value M&A target companies are based on potential future free cash flows.  Free cash flows in M&A valuation are cash flows that are available for distribution to providers of debt or equity.

It is important to remember that when an M&A professional uses a DCF present value model to calculate the intrinsic value of an M&A target they are almost always calculating the enterprise value of the company.  The concept of Enterprise Value is explained in our article:  M&A Fundamentals – Enterprise Value.

PRIMARY PERIOD

The primary period is the number of years into the future the M&A buyer can expect the M&A target company to maintain its existing level of growth in revenues and profitability.   In our example the M&A professional has been tasked with buying an M&A target in the growth phase of its development.  How long will International Group Incorporated be able to maintain levels of growth in advance of other companies in its market, or the level of growth in the overall economy?  In this case the M&A professional, undoubtedly in conjunction with the strategy and commercial functions of the M&A buyer, have decided growth at existing levels can be sustained for seven years.

The M&A professional will prepare detailed forecasts of revenues, costs, income, and cash flow for the entire primary period.

TERMINAL PERIOD

The life of a large corporation, such as the M&A buyer in this example, is not limited to the working life of the shareholders.  Such a company can continue indefinitely into the future.  The terminal period recognises that after the end of the high growth primary period the M&A target can sustain lower levels of growth and profitability into the future.  The terminal value is the M&A professional’s attempt to put a value on owning these long-term cash flows.

TERMINAL VALUE

The terminal value is an important part of the valuation of an M&A target.  It is not unusual for the value of these long-term cash flows to make up more than 50% of the value of an M&A target.  Especially when the primary period is relatively short.

M&A professionals use a perpetuity with growth calculation to arrive at the terminal value.  The formula for this is set out below:

 

Diagram 4:  Formula to Calculate Terminal Value (Perpetuity with Growth)

 

 

TV = Terminal Value

CFt = Free cash flow to enterprise in first terminal year

r     = Cost of capital (Discount Rate)

g     = Expected growth rate in terminal period (Perpetual Growth Rate).

 

In plain English the terminal value is the free cash flow in the first year of the terminal period, divided by the cost of capital minus the expected long-term rate of growth (Perpetual Growth Rate).

This formula is very sensitive to the value used for the long-term expected rate of growth.  If a high level of growth is used, the value of r-g becomes very small.   Mathematically this leads to a high Terminal Value.  M&A professionals are generally reluctant to use growth rates higher than the expected long run rates of economic growth for the countries in which the M&A targets operates.  At the most they might be use long-term growth projections for the overall market sector.

Some M&A professionals have been known to use an estimated exit valuation by multiple for the target in the first terminal years in place of the perpetuity.  Mathematically this is not considered to be a good practice unless the business is actually expected to be sold at this time.

We will explore this complex area of primary periods, terminal periods, and terminal value assumptions in a later article in this M&A fundamentals series.

DISCOUNT FACTOR

The discount factor is the level of discount applied to the free cash flows arising in a year to reflect the opportunity cost of waiting for the cash to be available for distribution.  This is described in more detail in the section ‘The Principles of DCF Present Value’ earlier in this article.

An example from Diagram 3.  In year 4 free cash flow from operations is $71m and the discount factor at a 12% discount rate (cost of capital) is 63.6%.  This gives a present value of the free cash flows arising in year 4 of $46m ($71m x 63.6%).

It is worth noting that the discount factor applied to the Terminal Value is the factor for the first year of the M&A target’s terminal period.  In diagram 3 this is year 8.

DISCOUNT RATE

Is the cost of capital for the target.  We will explore the calculation of the cost of capital for a target in a later article.  If an M&A professional is trying to put a value on an M&A target that operates in the same market space as their employer, they might well use their own company’s cost of capital as the discount rate.  If the M&A target operates in a riskier market space or country, the M&A professional might well use a higher cost of capital to reflect the higher risk.

PERPETUAL GROWTH RATE

Is the long-run growth assumption that will be used in the Terminal Value calculation.

PERPETUAL REINVESTMENT RATE

In the high growth phase of its development an M&A target will typically require high levels of reinvestment.   In the terminal period the company will likely be operating from a relatively fixed stock of capital assets.  Reinvestment in this period will be for essential replacement of aging assets and working capital.  To reflect this a lower reinvestment rate can be used for the terminal period of the M&A targets cash flow.

ENTERPRISE VALUE

The Enterprise Value is the output of the valuation model.  The figure in the mustard colour box ($798m) in diagram 3 is the sum of the present values for the cash flows in years one though seven, plus the present value of the terminal value in the year eight column.

This is a valuation of the M&A target, but it is important to understand what this value represents.  It is the present value (today’s value) of the free cash flows the M&A target is expected to generate in future years AT THE COST OF CAPITAL.  A useful way to think of this is as the price for the business at which the M&A buyer would exactly cover its cost of capital.  That is, there would be no surplus value on the transaction.  Absent any synergies available to the M&A buyer it is the most that should be paid for the M&A target.

 

What if the Valuation by Multiples for an M&A Target is HIGHER than The Intrinsic Value by DCF?

 

This question gets to the heart of why it is essential to prepare a DCF present value for the M&A target in addition to the multiples valuation.  If the valuation by multiples is higher than the DCF enterprise value this means one of two things.  Either, other M&A buyers are overpaying for this type of M&A target, or other M&A buyers have synergies and are prepared to pay more than its intrinsic to secure the M&A target.  As an M&A buyer it is important to understand that if in the absence of synergies you pay more for an M&A target than the intrinsic enterprise value by DCF, you are in danger of destroying shareholder’s capital.

 

DCF Present Values and Strategic Value for an M&A Target

 

We will look at the strategic value of an M&A target in more detail in an upcoming article in this M&A fundamentals series.  The bedrock of strategic value in The Merger Training Institute’s approach is that the strategic value of an M&A target is something that can be calculated, and added as a positive cash flow to a DCF present value model.

The process itself is straightforward to understand.  We add an extra line below cash flow from operations in the DCF present value model set out in Diagram 3.  We can call this line Net Synergy Cash Flows.  Into this line we enter the net cash flows arising from the synergies (cost reduction and revenue growth), transition costs, additional capital expenditures, and any balance sheet reductions (whether from disposal of surplus assets or working capital changes).

 

Diagram 5 – Additional Cash Flows to Calculate Strategic Value

 

The additional net cash flows are forecast on a year-by-year basis, subject to corporate income tax, and then added into free cash flow from operations.  Enterprise value in this version of the model will be the fully synergised strategic value of the M&A target.  Some M&A professionals call this Strategic Deal Value.

It is crucial that the strategic value model is kept separate from the intrinsic value model.  A common mistake by inexperienced M&A professionals is to include M&A buyer’s synergies in the intrinsic valuation model.

One final though on this issue of M&A strategic deal value.  It is important to understand that with all potential synergies added into the model, strategic deal value is the absolute maximum an M&A buyer can pay for an M&A target.  The M&A professional that pays more than strategic value will definitively destroy shareholder’s capital.

 

 

 

About The Merger Training Institute

We provide practical, in-career mergers and acquisitions training for boards, executives and professionals in global corporations.

Our short, intense M&A courses are designed for executives needing to understand best M&A practice or adding new M&A responsibilities to their existing roles.

The courses are taught by tutors with hands-on M&A experience gained as part of corporate management teams. As well as being academically rigorous they are rich with case studies and real-world examples based on our tutor’s practical mergers and acquisitions experience.

Our course participants come from a wide range of industries and roles including general management, business development, strategy, marketing, finance, human resources, operations and legal.

 

Our Mergers and Acquisitions Training Courses

Core Mergers and Acquisitions Skills Training Course

The Core Mergers and Acquisitions Skills programme (M&A training course) is a three- day programme that teaches all the commercial and technical skills you will need to confidently lead or support a successful M&A transaction.

Our expert tutors guide you through the M&A process from strategy and deal origination to valuation, due diligence, deal structuring, contract negotiation and post-merger integration.

M&A Due Diligence Training Course

The M&A Due Diligence Training Course is a two-day programme that offering a solid grounding in the techniques used by some of the world’s most successful companies to assess risks, evaluate synergies and confirm the strategic fit of an M&A target. The course is designed specifically for executives involved in corporate M&A.

Successful Post-Merger Integration Training Course

The Successful Post-Merger Integration Training Course is a two-day programme that provides a solid grounding in the post-merger integration techniques used by some of the world’s most successful companies to deliver value from their M&A transactions.

Across the two days of the course you move from the key decisions made in the pre-deal phase, through the critical first 100 days and on to full synergy delivery. The course covers the post-merger integration issues most likely to arise in each business function and the most important business processes.

Advanced Business Valuation Training Course

The Advanced Business Valuation training course is a two-day expert level business valuation training course that teaches participants how to prepare robust business valuations in the context of a corporate M&A transaction.

Our expert tutors move you past the stage of plugging numbers into a standard spreadsheet and help you explore how risk, synergies and the quality of the target company might impact its value.


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