Tag Archives: DCF

Watchdog or Lapdog?

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Take a guess how many corporate accounting fraud cases the SEC has prosecuted through the first half of this year.

Give up? The answer is 79. And that’s the lowest level in over a decade, according to the Wall Street Journal.

A couple months ago, Craig M. Lewis, who heads the SEC’s risk division, unveiled the SEC’s “new”, pro-active approach – an accounting quality model that helps “assess the degree to which registrants’ financial statements appear anomalous.” The analysis will also look at the wording in financial reports concerning companies’ results and future prospects, particularly those under “management discussion and analysis.”

Sounds like a good idea, but…this is “new”?  I’m a bit surprised no one has thought of this before, but apparently that is the case. The SEC acknowledges that its previous means of uncovering fraud have been primarily passive and market-based (i.e., trading irregularities). Really? Isn’t that akin to always closing the stable door after the horse has bolted? Even my $30 tax software has an algorithm that alerts me to audit risk, based on the numbers in my return, before I file my taxes.

I don’t mean to cast stones. I appreciate that accounting fraud is actually very difficult to find, prove, and successfully prosecute. Gathering evidence requires detailed, often forensic accounting work to see whether a company has failed to report its results according to the then prevailing “accounting rules” (my emphasis). And proving there actually was a violation – most often relative to generally accepted accounting principles (GAAP) – includes an additional layer of difficulty because GAAP itself is often vague and malleable.

Case in point…in a recent accounting fraud prosecution in California involving a high-tech company, the United States Court of Appeals for the Ninth Circuit overturned the conviction of the company’s chief financial officer because the government could not prove that his aggressive accounting in recognizing revenue violated GAAP. On the contrary, the appeals court actually opined that the government’s evidence showed he was “doing his job diligently” by skating right up to the line.

Mary Jo White, the SEC’s new chairwoman, has said that she wants to turn the agency’s attention back to what was once seen as its core mission: policing corporate disclosure to ensure everyone is protected. I wish her luck. It’s a crazy world out there, and there’s not much active oversight. Caveat emptor, my buyside brethren. Good thing I’ve got my trusty copy of Financial Shenanigans handy…

Posted by: Mory Watkins

The Interpretation

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Last time, I went over how to choose comparable companies and transactions to make a relative valuation of a target company. Today, I want to make a couple points about interpreting and drawing reliable conclusions from that comparable data.

Here goes…

Suppose your comparable data indicates that the market values similar companies at an average Enterprise Value/EBITDA multiple of 5x, but your target company, a small public company, has a higher Enterprise Value/EBITDA multiple, of say 10x.  Is your target over valued? Is the target a “better” company than its apparent peers?

Well, the difference in multiple may be for a reason as simple as the target is less profitable than the comps. If the target has lower profitability, for example an EBITDA/Revenue of 5% compared to an EBITDA/Revenue of 10% for the comps data set, the enterprise value multiple will be higher, all other things being equal. I raise this issue because people usually think, “Higher EBITDA multiple = better”, but that is not always true – it might only mean that the target company’s EBITDA margin is lower. And if you are noticing significantly different growth rates and margins between your target and your data set, they might not be that comparable in the first place.  Lesson: Verify business models are similar and look closely at margins when picking comparables.

Suppose that in order to pick good comparables you must select companies that have vastly greater (or smaller) enterprise value than your target. Is this a problem?

The short answer is…not necessarily. While size is an important metric in comparability, relative valuation and the process of examining multiples handle this issue rather nicely. Absolute equity or enterprise values, in themselves, really don’t say anything about the valuation of the company. Size is just size. You must examine multiples because, really, what you are seeking is the market’s assessment of value relative to revenue, cash flow, profit, or whatever other metrics you choose. Lesson: Don’t be overly concerned with size. It’s much more important to look at multiples in relation to financial performance.

Suppose you’ve selected good comparable companies, and the financial performance and margins are largely the same between your target and the comparable companies data set, but your target, a small public company, is valued markedly higher than it “should be” by the market.  What could explain the higher market value and what are the implications?

I’ll address this one by first revisiting what I consider to be one of the most important tenets of corporate M&A — always analyze and buy trailing performance.  As I say here in Part Two of my Successful Corporate M&A best practices posting, it is critical to maintain focus on pricing deals as a multiple of trailing cash flows and not be distracted by notions of paying for projected performance. In my opinion, the purchase price should always be set (or at least considered) as a multiple of trailing cash flow.

Returning to the problem, if trailing financial performance shows that the target and the comparables are about the same, the only logical reason for a large deviation in value must lie in future growth prospects. If the answer isn’t in the past, it must be in the future. Here, I’d advise i) exercising a healthy dose of caution, and ii) becoming a lot more familiar with and comparing/contrasting the growth prospects of the comps and the target.  A quick and easy way to do this is simply by pulling some equity research reports.  Lesson: Use extra caution when deviating from the tried and true corporate M&A practice of purchasing trailing performance.

Next time — a high level overview of M&A transaction modeling.

Posted by: Mory Watkins

Comparability

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Last time, I finished a couple thoughts about relative valuation but left out the most important part: how to actually find comparable companies and transactions. Today I’ll address that.

The first steps in finding comparables are to obtain raw data and then to decide which are the most important screening criteria.  Data for analysis is readily available for purchase online. I like to use Capital IQ, Thomson Reuters, Bloomberg, and FactSet Research.  And here are the four (most important) selection criteria I would suggest, roughly in order of importance:

  1. Industry
  2. Size
  3. Geography
  4. Date

Industry: Industry should be as narrowly defined as possible. For example, North American Laminated Paper Manufacturers or European Electric Bulb Distributers. Using SIC codes will obviously help.

Size: Size may be defined in terms of market capitalization (for public companies), revenues, or any derivation of cash flow (EBIT, EBITDA, FCF, etc.).  I use cash flow most often.

Geography: Geography is necessary primarily to distinguish US from foreign companies.

Date: For transactions, the addition of date criteria establishes recency and relevance.

For comparable companies, you’d typically want to try to generate a list of about 10 close matches in your data set. It would be odd to deviate far from this range; 2 is too few, and 50 is too many.

For comparable transactions, you would apply the screening criteria to the selling party at the time of the announcement (for public companies) and try to generate between 5 and 10 comparable deals.  It’s advisable to use the announced purchase price per share and TTM (trailing twelve month) financial numbers rather than fiscal year numbers in the valuation. Note that it can be difficult to get complete information when using comparable transactions, particularly for private companies. Consequently, comparable transaction analyses usually have far less data than comparable company analyses.

Once you have a solid list of similar companies/transactions you can analyze the multiples (as described last time) and rather easily infer your target’s valuation.

Make sense?

Posted by: Mory Watkins

Relativity in Valuation (Part Two)

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Last time, I discussed the difference between Relative and Intrinsic Valuation. I made the point that in every day corporate M&A, strategic buyers rarely use Intrinsic Valuation as a primary means of deciding how much to pay for a target acquisition.

Today, I want to dig a little bit further into the preferred method — Relative Valuation.

So, practically speaking, how do you do a relative valuation?

  • First, you need to choose comparable assets and obtain market values for these assets (more on that in my next post).
  • Then, you have to convert the market values into standardized values, such as multiple of cash flow.
  • Last, you’ve got to compare the standardized values to the target, controlling for any differences that might affect the analysis, and determine whether the asset is under or over-valued.

Actually, quite a bit of “art” goes into the conversion/standardization step of the valuation. As already discussed, the most common metric used in corporate M&A valuations is some derivation of cash flow, but all sorts of other financial yard sticks, including revenues, earnings, and balance sheet items like book value are fair game and very useful. In particular, combinations that include industry specific KPIs and financial metrics, like sales per square foot for retail or cost per passenger mile for airlines, are excellent for establishing comparability and then extrapolating value.

Speaking of comparability, what’s the best way to establish that a company or a transaction is, in fact, comparable?  Garbage in, garbage out, as the saying goes.  Even the best valuation methodology won’t work if the sample set chosen isn’t a close match with the target…

Next time, I’ll propose step-by-step advice for selecting truly comparable companies and transactions that you can then use in relative valuation.

Posted by: Mory Watkins

Relativity in Valuation (Part One)

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I’d like to continue with some thoughts about valuation and briefly explore the differences between “relative” and “intrinsic” valuation methods.

Working definitions for today’s discussion:

  • Relative valuation methods use comparable companies and transactions to establish valuation.
  •  Intrinsic valuation methods use metrics related only to the company itself to establish valuation.

First, let me say that in real world corporate M&A, most companies are valued on a “relative” basis. In relative valuation, you establish value by looking at how the market has previously priced similar situations, companies, and/or transactions. Value is first gauged according to a selected group of comparable assets and then extrapolated to the target using a common variable such as cash flow multiple.  A good, simple analogy (once again) is home buying. When trying to determine what to pay for a house, it’s common practice to use the value of similar houses in the neighborhood as a benchmark. The two most common relative valuation methods use Public Company comparables and Precedent Transaction comparables.

With intrinsic valuation, on the other hand, the value of the company is based upon its own cash flows, growth potential, and perceived risk relative to the whole market. The classic example of intrinsic company valuation is DCF, or discounted cash flow valuation. In DCF, the value of a company is determined by the present value of its expected cash flows. Expected cash flows are projected and then discounted back to present at a risk-adjusted discount rate, which, in turn, is an estimate of the riskiness of those future cash flows that is calculated by adding a risk premium to the risk-free discount rate. The risk-free discount rate, in turn,…blah, blah, blah. I digress. Listen, if you want more information on DCF, you can Google it. I think your eyes would roll back in your head if I went too far into this right now.  I know mine would.

Anyway, my point, as you may have already sensed, is that intrinsic valuation really tends to be the more academic exercise of the two, and it is rarely used in every day corporate M&A as the principal means of valuation. There are simply too many real and strategic considerations to analyze before going off the theoretical deep end.  Aside from how difficult it is to accurately project cash flows and decide what the proper discount rate should be, intrinsic value, by definition, just isn’t a real world, observable, or market-based valuation.  The truth is that they can sometimes vary wildly from the market’s emotion and perception.

I hasten to add though that all intrinsic valuation isn’t ivory tower and theoretical in nature. There are a couple very useful (and practical) intrinsic valuation methodologies to consider when valuing targets – Book Value, Liquidation Value, Sum of Parts Value, Replacement Value, and LBO/Recap Value come to mind – but DCF just isn’t the go-to method for valuation in M&A from the corporate development perspective.

Next time, more about Relative Valuation.

Posted by: Mory Watkins