Investment Banking- Valuation, Leveraged Buyouts, and Mergers & Acquisitions

Chapter 1: Comparable Companies Analysis

 Comparable companies analysis provides market benchmark to establish valuation for a private company or analyze value of
public company at given point in time
 Foundation is built on premise that similar companies provide relevant reference point for valuing given target due to
companies sharing key business and financial characteristics, performance drivers, and risks
 Valuation is established by determining relative position among peer companies
 Peer companies are benchmarked against another and the target based on various financial statistics and ratios
 Trading multiples are calculated for universe, which serve as basis for extrapolating valuation range for target
o Valuation range is calculated by applying selected multiples to target’s financial statistics
 Most widely used trading multiples- EV/EBITDA and price to earnings (P/E)
o Measure of value in numerator and financial statistics in denominator
 P/E is mostly used outside Wall Street, but multiples based on EV are widely used by bankers b/c they are independent of
capital structure and other factors unrelated to business operations
 Comparable companies analysis reflects “current” valuation based on market conditions and sentiment
o In many cases it is more relevant than intrinsic valuation analysis
o However, market trading levels may be subject to high or low conditions
o Furthermore, no two companies are the same, can’t completely capture company’s true value
o Trading comps is therefore used with other valuation methods
1. Select Universe of Comparable Companies
a. Identify companies with similar business and financial characteristics
b. Broader group of potential companies is refined to a subset of “closest comparables”
2. Locate Necessary Financial Information
a. Needed to calculate (spread) key financial statistics, ratios, and trading multiples
3. Spread Key Statistics, Ratios, and Trading Multiples
a. Calculate market valuation measures such as EV, equity value, income statement items
b. A variety of ratios and other metrics measuring profitability, growth, returns, and credit strength are also calculated at this point
c. Employ various financial concepts and techniques at this stage such as LTM statistics, calendarization of company financials, and
adjustments for non-recurring items
4. Benchmark the Comparable Companies
a. In-depth examination of comp companies in order to determine target’s relative ranking and closest comparables
b. To assist in benchmarking, banker lays out calculated financial statistics and ratios for the comparable companies alongside target
in spreadsheet
c. Trading multiples are also laid out for benchmarking purposes
5. Determine Valuation
a. Trading multiples serve as basis for deriving valuation range for target
b. Begin by using means/medians as basis for initial range
c. High and low multiples provide further guidance
d. Use the closest comparables in order to arrive at tightest, most appropriate range

In-depth portion of each step

Step 1.Select Universe of comparable companies
a. Study the target by using 10-K and 10-Q SEC filings, research estimates, equity and fixed income research reports, press releases, etc.
b. Identify key characteristics of target for comparison purposes
Business Profile Financial Profile
Sector – industry or markets in which a company operates. IT Size-measured in terms of market valuation as well as key
conveys a great deal about its key drivers, risks, and financial stats. Companies of similar size in a given sector
opportunities more likely to have similar multiples
Products and Services- companies that product similar Profitability-ability to convert sales into profit. High profit
products typically serve as good comparables margins = higher valuations
Customers and End Markets- purchasers of products and the Growth Profile-Investors reward high growth companies with
broad underlying markets into which it sells its products and higher trading multiples than slower growing peers. Organic
services. Company performance is generally tied to economic growth is preferable over acquisition-driven growth. For
and other factors that affect end markets and its consumer growth rates, historical and future growth rates for stats are
base examined. For mature companies, EPS growth rate is more
meaningful
Distribution Channels- avenues through which a company Return on investment- measure’s company’s ability to
sells its products and services to the end user. Companies that provide earnings. ROI metrics include return on invested
sell to wholesale vs direct to customer have different capital, return on equity, and return on assets
organizational and cost structures
Geography- companies based in different regions of the Credit Profile-refers to company’s creditworthiness as a
world differ substantially in terms of fundamental business borrower. Measured by metrics relating to company’s debt
drivers and characteristics. Focus on US based level (leverage) and its ability to make interest payments
(coverage). It reflects key company and sector-specific
benefits and risks
 c. When screening for comparables, start by an examination of target’s public competitors, which usually share the same key business
and financial characteristics. Companies discuss their competitors on their 10-Ks, proxy statements, and initiating coverage equity
reports.
d. M&A transaction in the sector (merger proxy) contains excerpts from a fairness opinion -> discusses the “fairness” of purchase price
and deal terms offered by acquirer
a. This is supported by a valuation of the target, including comparable companies
Step 2. Locate Necessary Financial Information
a. Valuation is driven on basis of both historical performance and expected future performance
b. Banker uses SEC filings to source historical financial information for comparable companies
c. Financial information is used to determine historical sales, gross profit, EBITDA, EBIT, and net income on annual and LTM basis
a. Also includes balance sheet data, capex, shares, stock options, non-recurring items
d. 10-K -> Annual report, provides comprehensive overview of company and its prior year performance
a. 10-Q-> quarterly report by public registrant that provides overview of most recent quarter and year-to-date period (YTD), less
comprehensive than 10-K
b. 8-K->current report, which is filed to report occurrence of material corporate events or changes that are of importance to
shareholders or security holders (i.e. earnings announcements, purchase/sale agreement, acquisitions, etc.)
c. Proxy Statement->document that public company sends prior to shareholder meeting containing information regarding matters on
which shareholders are expected to vote
e. Equity Research
a. Research reports-> provide individual analyst estimates of future company performance, used to calculate forward-looking
multiples. Include estimates of sales, EBITDA, EBIT, and EPS. Also provides commentary on non-recurring items and recent
M&A and capital markets transactions
b. Initiating coverage research reports are more comprehensive than normal interim reports
c. Consensus Estimates are widely used by bankers as basis for calculating forward-looking trading multiples -> Primary sources
for consensus estimates are First Call and IBES (via Bloomberg, Fact Set, Thomson Reuters)
f. Press Releases and News Runs -> company issues press release when it has something to report to public (dividends, earnings,
management changes, etc.)
Step 3. Spread Key Statistics, Ratios, and Trading Multiples
a. Once necessary financial information for each of comparables has been located, it is entered into an input page, used to assist
banker in calculating key financial statistics, ratios, and multiples for comparables universe
b. Size:
i. Equity Value is value represented by give company’s basic shares outstanding plus “in-the-money” stock options
(granted to employees that allow them to buy stocks at set price (strike price) during a given time period), warrants
(security that is sold with a debt instrument but works similarly to stock options, it is usually sold as a “sweetener” for
riskier securities), and convertible securities (total = “fully diluted shares outstanding”)
1. Equity Value = Share Price * Fully Diluted Shares Outstanding
2. Fully Diluted Shares outstanding = Basic Shares + “In the money” options and warrants + “in the money”
convertible securities
3. Equity value only provides measure of relative size, therefore banker looks at current share price as
percentage of 52-week high to gauge outlook for company and its sector
4. To calculate options and warrant, we use the treasury stock method
a. TSM assumes all tranches of options are exercised at their strike price and the option proceeds are
used to repurchase outstanding shares of stock at company’s current share price. Since the strike
price is below current market price, number of shares repurchased is less than additional shares
outstanding from exercise options
b. To calculate:
i. Multiply strike price by # of options (Proceeds)
ii. Divide by current share price (Shares repurchased from option proceeds)
iii. New Shares from Options = # of options – shares repurchased
iv. Add this value to Basic Shares Outstanding
c. To calculate convertible securities
i. Divide Amount Outstanding of convertible securities by Conversion price, add result to
total number of shares
ii. Enterprise Value is the sum of all ownership interests in a company and claims on its assets from both debt and equity
holders.
1. Equal to Equity Value + Total Debt + Preferred Stock + Noncontrolling Interest – Cash and Cash Equivalents
2. EV is considered independent of capital structure => changes in company’s capital structure do not affect its
enterprise value
a. I.e. If company raises debt as cash, the increase in cash is offset by increase in total debt
iii. Sales = first line item of an income statement, represents total dollar amount realized by company through sale of its
products and services during a given period
1. Sales levels and trends are key factor in determining company’s relative positioning among its peers
iv. Gross Profit = sales – COGS
1. Key indicator of operational efficiency and pricing power
 2. Usually expressed as a percentage of sales
v. EBITDA = earnings before interest, taxes, depreciation, and amortization
1. EBITDA is a non-GAAP financial measure and is calculated by taking EBIT and adding back depreciation
and amortization based off cash flow statement
2. EBITDA serves as fair means of comparison among companies b/c it is free from differences resulting from
capital structure (interest expense and tax expense)
vi. EBIT = earnings before interest and taxes/ operating income/ operating profit
1. EBIT is also independent of tax and interest
2. However, it is less indicative of operating cash flow b/c it includes D&A expense
vii. Net Income = residual profit after all company’s expenses have been netted out
1. Typically viewed on a per share basis (EPS)
c. Profitability
i. Gross Profit Margin = percentage of sales remaining after subtracting COGS
1. Gross Profit Margin = Gross Profit / Sales
2. EBITDA Margin = EBITDA/ Sales
3. EBIT Margin = EBIT / Sales
ii. Net income margin measures company’s overall profitability as opposed to its operating profitability (EBITDA/EBIT
Margin)
1. It is net of interest expense and tax expense and therefore affected by capital structure
2. Net Income Margin = Net Income / Sales
d. Growth Profile = banker typically looks at historical and estimated future growth rates as well as compound annual growth rates
(CAGRs) for selected financial stats
e. Return on Investment
i. Return on Invested capital (ROIC) measures return generated by all capital provided to a company
1. ROIC = EBIT / Average Net Debt + Equity
ii. Return on equity (ROE) measures return generated on equity provided to a company by its shareholders
1. ROE = Net Income / Average Shareholder’s Equity
iii. Return on Assets (ROA) measures return generated by a company’s asset base
1. ROA = Net Income / Average Total Assets
iv. Dividend Yield = measure of returns to shareholders. It measures annual dividends per share paid by a company to its
shareholders, expressed as a % of share price
1. Since it is paid on a quarterly basis, Implied Dividend Yield = Most Recent Quarterly Dividend Per Share *
4/ Current Share Price
f. Credit Profile
i. Leverage is the company’s debt level
1. Typically measured as a multiple of EBITDA (e.g. debt-to-EBITDA) or as a percentage of total capitalization
(debt-to-capitalization)
2. Company’s leverage reveals a great deal about financial policy, risk profile, and capacity for growth
3. The higher the leverage, the higher its risk of financial distress due to greater interest expense and principal
repayments
ii. Leverage = Debt/EBITDA (debt-to-EBITDA)
iii. Debt-to-Capitalization = Debt/ (Debt + Preferred Stock + Noncontrolling Interest + Equity)
iv. Coverage refers to company’s ability to meet its interest expense obligations.
1. The higher the coverage ratio, the better positioned the company is to meet debt obligations and the stronger
its credit profile
2. Interest Coverage Ratio = EBITDA, or EBIT / Interest Expense
g. Credit Ratings = assessment by independent rating agency of a company’s ability and willingness to make full and timely
payments of amount due on its debt obligations
i. Typically needed for companies seeking to raise debt financing in capital markets
ii. Three primary credit rating agencies are Moody’s, S&P, an Fitch
Calendarization of Financial Data:
a. Since some companies report on a different schedule other than the fiscal year ending December 31, these differences much be
addressed for benchmarking purposes
b. In order to account for this, we calendarize the data
c. I.e. for sales projection:
a. Next Calendar Year Sales = [Month # * FYA Sales] / 12 + [(12 – Month #)*(NFY Sales)]/12
i. FYA = fiscal year actual, NFY = next fiscal year
In order to measure financial performance for most recent annual or LTM period, company’s financial results for previous four quarters are summed
LTM = Prior Fiscal Year + Current Stub – Prior Stub
To assess a company’s performance on a “normalized” basis, we must adjust financial data for non-recurring items
a. This involves adding back or eliminating charges and gains
b. Typical charges include those for restructuring, losses on asset sales, changes in accounting principles, inventory write-offs, goodwill
impairment, and losses from litigation settlements, etc.
c. Typical benefits include gains from asset sales, favorable litigation settlements, and tax adjustments
 d. Non-recurring items are described in the MD&A section and financial foots notes
a. Usually depicted as “non-recurring”, “extraordinary”, “unusual” or “one-time”
e. It is up to banker to exercise judgment in deciding if a charge is non-recurring
f. When adjusting for non-recurring items, it is important to distinguish between pre-tax and after-tax amounts
a. For pre-tax restructuring charge, add back to adjusted EBIT and EBITDA
b. To calculate adjusted net income, pre-tax charge must be tax-effected
c. Vice-versa for post-tax charge -> add back to income, tax-effected for EBIT and EBITDA
Bankers must also make adjustments for recent events such as M&A transactions, financing activities, stock splits, etc.
Calculation of Key Trading Multiples:
-Most widely used multiples are EV/EBITDA and P/E (market valuation tool on top, and financial performance in denominator)
1. Price to Earnings Ratio: P/E ratio is the most widely recognized trading multiple
a. Assuming constant share count, P/E is equivalent to Equity Value to Net Income
b. Can also be viewed as measure of how much investors are willing to pay for a dollar of company’s current or future earnings
c. Typically based on forward-year EPS
d. Higher P/E means high earnings growth expectations
e. However, P/E is not effective for companies with little or no earnings, and two companies of the same size and operating
margins may have different P/E ratios due to differences in leverage
f. P/E = Share Price/ Diluted EPS
g. P/E = Equity Value/Net Income (if share count is constant)
2. EV/EBITDA is a valuation standard
a. Independent of capital structure and taxes and also any distortions that may arise from differences in D&A
3. EV/Sales is also used as a valuation metric, but is less relevant than other multiples
Step 4. Benchmark the comparable companies
 Benchmarking centers on analyzing and comparing each comparable company with one another and the target
 Objective to determine target’s relative ranking in order to frame valuation accordingly
 Banker hones in on a selected group of closest comparables as basis for valuation range
1. First Stage is a comparison of target and comparables universe on basis of key financial performance metrics
(the ones calculated in step three)
a. The results are displayed on spreadsheet output pages, which also display mean, median,
maximum, and minimum for the statistics
2. The second step is to benchmark the trading multiples and assess relative valuation for each of the
comparable companies
a. The banker uses multiples to further refine comparables universe
b. This may result in certain outliers to be excluded
Step 5. Determine Valuation
 Banker typically begins by using means and medians of most relevant multiple for the sector to extrapolate a defensible range of
multiples
 Multiples of best comparables are typically relied upon as guideposts for selecting the most appropriate range
o Therefore, only two or three selected comparables serve as ultimate basis for valuation
1. Valuation implied by EV/EBITDA
a. We multiply the multiple range of EV/EBITDA by EBITDA to obtain EV
b. We can subtract net debt in order to get equity value
c. Divide that value by fully diluted shares and we get share price
2. Valuation implied by P/E
a. The financial metric for this case is net income, and we obtain equity value by multiplying the multiple by net income (divide
equity value by shares to get share price)
b. We can add back debt to get enterprise value
Remember, it is a MULTIPLE RANGE => WE GET a RANGE OF EQUITY VALUES AND ENTERPRISE VALUES
We should compare valuation range with other methods as an insanity check.
Chapter 2: Precedent Transactions Analysis
 Precedent transactions analysis, like comparable companies analysis, employs a multiples-based approach to derive an implied valuation
range for company
 It is premised on multiples paid for comparable companies in prior M&A transactions
o Precedent transactions has broad range of applications, most notably to help determine potential sale price range for company
 Selection of appropriate universe of comparable acquisitions is foundation for performing precedent transactions
 Best comparable acquisitions typically involve companies similar to target on fundamental level
 Most relevant transactions (within past 2-3 years) took place under similar market conditions
 Under normal market conditions, transaction comps tend to have a higher multiple range than trading comps
o Buyers generally pay a “control premium” when purchasing another company
 This premium allows acquirer t control decisions regarding’s target’s business and its cash flow
o Buyers also have the opportunity to realize synergies, which supports ability to pay high purchase prices
 Synergies are expected cost savings, growth opportunities, and other financial benefits that occur as a combination of
two businesses
Summary of Steps of Precedent Transactions Analysis:
1. Select Universe of Comparable Acquisitions
a. This requires a strong understanding of the target and its sector
b. Search through M&A databases, examine M&A history of the target and its comparable companies
c. Equity and fixed income research reports, its comparable companies, and overall sector may also provide lists of comparable
acquisitions
2. Locate Necessary Deal-Related and Financial Information
a. Location information on comparable acquisitions is easier for transactions involving public companies due to SEC disclosures
3. Spread Key Statistics, Ratios, and Transaction Multiples
a. After relevant deal-related and financial information has been located, the banker spreads each selected transaction
b. The key multiples used for precedent transactions mirror those used for comparable companies (EV/EBITDA and P/E)
c. Notable difference is that multiples for precedent transactions often reflect a premium paid by acquirer for control and synergies
d. Multiples for precedent transactions are typically calculated on basis for actual LTM financial statistics
4. Benchmark Comparable Acquisitions
a. Identify most relevant comparable acquisitions to value the target and remove outliers
b. Examine key financial statistics and ratios for acquired companies
5. Determine Valuation
a. Multiples for selected acquisitions universe are used to derive implied valuation range for the target
b. Banker uses mean and median multiples as a guide for valuation range from two or three most similar transactions
c. This range is multiples by LTM financial statistics to product implied valuation range
d. This valuation is checked with other valuation methodologies as a sanity check
In-depth Steps:
1. Select Universe of Comparable Acquisitions
a. Investment banks generally have internal M&A transaction databases containing relevant multiples and other financial data which
are updated for new deals
b. Screen for Comparable Acquisitions
i. Goal is to locate as many potential transactions as possible for a relevant, recent time period and then further refine
universe
1. Search M&A transactions
2. Examine target’s M&A history and determine the multiples it has paid and received for purchase and sale of
its businesses
3. Examine M&A history of each comparable company
4. Search merger proxies for comparable acquisitions for fairness opinion that cite list of selected transactions
analyzed by financial advisors
5. Review equity and fixed income research reports for target and comparable companies
ii. Examine other considerations
1. Gain a better understanding of specific circumstances and context for each transaction
iii. Market Conditions
1. Market conditions refer to business and economic environment as well as prevailing state of capital markets
2. Must be viewed within context of specific sectors and cycles
a. These conditions effect availability and cost of acquisition financing and therefore price an acquirer
is willing/able to pay
iv. Deal Dynamics
1. Deal dynamics refer to specific circumstances surrounding a given transaction
 a. Strategic Buyer vs Financial Sponsors
i. Strategic buys pay high purchase prices than financial sponsors due to their ability to
realize synergies
b. Motivations
i. Buyer and seller motivations may also play an important role in interpreting purchase
price
c. Sale Process and Nature of the Deal
i. Sale process and nature of the deal should also be examined
ii. Auctions, for example, are designed to maximize competitive dynamics in order to
product best offer at highest possible price
iii. Hostile situations, where a target seeks alternatives to a proposed takeover may also
produce higher purchase prices
d. Purchase conditions
i. The use of stock for purchase consideration tend to result in a lower valuation than all-
cash transaction
ii. This is because when target shareholders receive stock, they retain equity interest in
combined entity (it Is better for stock to be received in order to acquirer to obtain equity
interest)
iii. Target shareholders may require less upfront compensation than for an all-cash
transaction b/c they would be able to participate in value creation opportunities that result
from combing the two companies
2. Locate Necessary Deal-Related and Financial Information
a. Locating data is easier for public companies due to SEC filings
b. Banker conducts searches for information on private transactions via news runs and various databases
c. For public targets:
i. Proxy statement:
1. Proxy statement provides a summary of the background and terms of the transaction, a description of
financial analysis underlying fairness opinion of financial advisor, copy of definitive purchase/sale agreement
and summary financial data
2. This is filed under codes PREM14A (preliminary) and DEFM14A (definitive)
ii. Schedule TO/Schedule 14D-9
1. In a tender offer, acquirer offers to buy shares directly from shareholders
2. As part of this process, acquirer males Offer to Purchase and files Schedule TO
3. In response to tender off, target files Schedule 14D-9 within ten business days of commencement
a. 14D-0 contains recommendation from target’s board of directors to targets shareholders on home to
response to tender offer, which includes fairness opinion
iii. Registration Statement/Prospectus
1. When public acquirer issues shares as part of purchase consideration for public target, acquirer files a
registration statement/prospectus in order for those shares to be freely tradable by target’s shareholders
a. Same also goes for public debt securities
b. The registration statement/prospectus contains terms of issuance, material terms of transaction and
purchase price detail
i. May also contain acquirer and target financial data
iv. Schedule 13E-3
1. A “going private” deal may require enhanced disclosure
a. This is when a company engages in certain transactions that delists shares from a public stock
exchange
b. This information is included in 13E-3, which may include materials such as presentations to target’s
board of directions in support of actual fairness opinion
v. 8-K
1. Company is required to file 8-K within 4 business days of transaction announcement
2. In event that a company sells a subsidiary or division that is significant in size, parent company files 8-K
upon announcement
3. Public acquirers also are required to file 8-K for material transactions
vi. 10-K and 10-Q
 1. Target’s 10K and 10Q are primary sources for calculating LTM financial statistics including adjustments for
non-recurring items and significant recent events
vii. Equity and Fixed Income Research
1. These often provide helpful deal insight including information about adjustments and expected synergies, as
well as deal dynamics and other circumstances
d. For private targets
i. Private target does not need to file documentation under M&A as long as it is not subject to SEC disclosure
requirements
ii. When a public acquirer buys private target, it may be required to file disclosure documents
iii. Also, regardless of type of financing, acquirer files 8-K upon announcement and completion of material transactions
iv. Banker must rely on press releases and news articles and relevant sector-specific trade journals
Step 3: Spread Key Statistics, Ratios, and Transaction Multiples
1. The process for spreading key financial statistics and ratios for precedent transactions is similar to that outlined in Chapter 1 for
comparable companies
a. There are certain nuances for calculating equity value and enterprise value in precedent transactions
2. Equity Value for public targets is calculated similarly to comparable companies
a. However, it is based on announced offer price per share as opposed to closing share price on a given day
b. To calculate equity value for public M&A target, the offer price per share is multiplied by target’s fully diluted shares outstanding
at given offer price
c. In the case where an acquirer purchases less than 100% of the target’s outstanding shares, equity value must be grossed up to
calculate implied equity value for the entire company
d. To calculate fully diluted shares, all outstanding options and warrants are converted at their strike prices regardless if they are
exercisable or not
i. For convertible and equity-linked securities, banker must determine whether they are in the money and perform
conversion in accordance with terms and change of control provisions as detailed in registration statement/prospectus
e. For M&A transactions where the company is private, equity value is EV less assumed/refinanced net debt
f. We must also include purchase considerations, which refers to mix of cash, stock, or other securities that the acquirer offers to
target’s shareholders
i. This can affect target shareholder’s perception of value in offer (i.e. Preference for stock or money purchase)
1. All-Cash Transaction-Acquirer makes offer to purchase all or a portion of target’s shares outstanding for cash
a. This makes equity value = cash offer price * # fully diluted shares outstanding
2. Stock-for-stock transaction-Calculation for equity value is based on fixed exchange ratio or floating exchange
ratio
a. This exchange ratio is calculated as offer price per share divided by acquirers share price
b. Fixed exchange ratio = fixed ratio of how many of acquirer’s stock are exchanged for each share of
target’s stock
c. Floating exchange ratio = number of acquirer shares exchanged for target shares fluctuates to
d. Using Fixed Exchange Ratio Structure

e. Fixed exchange ratios links both parties’ share prices, thereby enabling them to share the risk or
opportunity from stock movements post-announcement
f. Floating Exchange Ratio: represents set dollar amount per share that the acquirer has agreed to pay
for each share of target’s stock in form of shares of the acquirer’s stock
i. In this case, dollar offer price per share is set, and number of shares exchanged fluctuates
in accordance with movement of acquirer’s share price
ii. Acquirer assumes full risk of a decline in its share price
3. Cash and Stock Transaction
a. Acquirer offers combination of cash and stock as purchase consideration
 ii. Enterprise value (transaction value) is total value offered by acquirer for target’s equity interests as well as assumption
or refinancing of target’s net debt

iii. The key transaction multiples are the same for trading comps
1. Multiples are higher than those in trading comps due to premium paid for control/synergies
2. Multiples are also calculated on basis of actual LTM financial statistics at time of announcement, which
needs to be adjusted for non-recurring items and recent events
3. Offer Price per Share-to-LTM EPS/ Equity Value-to-LTM Net Income (P/E) –most commonly used

4. Enterprise Value-to-LTM EBITDA, EBIT, and sales

a. The most prevalent is EV/ LTM EBIDTA

5. The premium paid refers to incremental dollar amount per share that acquirer offers to target’s unaffected
share price, expressed as a percentage
a. Closing share price on day prior to official transaction announcement serves as good proxy for
unaffected share price (price that is unaffected by effect of purchase offer)
b. Banker has option of choosing different intervals in case “leakage” of information occurs
 6. Synergies-refers to expected cost savings, growth opportunities, and other financial benefits that occur as a
result of combination of two businesses
a. Represents tangible value to acquirer in the form of future cash flow and earnings above and
beyond what can be achieve by target alone
b. Higher synergies translate into higher potential price that acquirer can pay
c. Information about synergies are usually communicated via press releases and investor presentations
d. We can adjust multiples for synergies

Step 4: Benchmark the Comparable Acquisitions

a. The next step is an in-depth study of selected comparable acquisitions to determine those most relevant
b. Output sheets help facilitate this analysis
c. Each comparable acquisition is closely examined and the obvious outliers are eliminated
Step 5: Determine Valuation
 The multiples of selected comparable acquisitions universe are used to derive an implied valuation range for target
 Key multiples driving valuation tend to be EV/LTM EBITDA and P/E
 Banker use means and medians of these multiples to establish preliminary valuation range
o Use the best two or three of best transactions for establish valuation
 Banker compares the valuation to other valuation methods as a check
Chapter 3: Discounted Cash Flow
 DCF is premised on principle that value of company, division, business, or collection of assets can be derived from present value of its
projected free cash flow (FCF)
 FCF is derived from assumptions and judgments about expected performance (including sales growth rates, profit margins, net working
capital (NWC))
 DCF valuation is also known as intrinsic value as opposed to market value
o Serves as alternative to comp companies which is market based
o DCF is also valuable when there are limited peer companies
 In DCF, company’s FCF is projected for a period of 5 years
o Projection period may be longer depending on company’s sector, stage of development, etc.
o Terminal value is used to capture remaining value of target beyond projection period
 Projected FCF and terminal value are discounted to the present at the target’s weighted average cost of capital (WACC)
 o This is the discount rate
 Present Value of FCF and terminal value summed to determine EV
 WACC and terminal value assumptions have substantial impact on output
o DCF is therefore viewed as a valuation range
o Impact of assumptions is tested using sensitivity analysis
 Use of defensible assumptions regarding projections, WACC, and terminal value helps shield valuation from market distortions
o However, DCF is only as strong as its assumptions
Summary of DCF Steps
1. Study the target and determine key performance drivers
a. Learn as much as possible about target and its sector
b. Determine key drivers of financial performance to establish assumptions
2. Project Free Cash Flow
a. Project unlevered FCF (cash generated by company after paying all cash operating expenses and taxes, as well as funding of
capex and working capital, but prior interest expense)
b. Projected FCF is driven by assumptions
c. Project FCF to a point in the future where the target’s financial performance is deemed to have reached a steady state which can
serve as basis for terminal value calculation
3. Calculate WACC
a. WACC is the rate used to discount target’s projected FCF and terminal value to the present
b. Reflects target’s business and financial risk
c. WACC is weighted average of required return on invested Capital (aka discount rate or cost of capital)
d. WACC is dependent on capital structure
4. Determine Terminal Value
a. Terminal value is used to quantify remaining value of target after projection period
b. Accounts for a large portion of target’s value in a DCF
c. Two widely accepted methods used to calculate it
i. Exit multiple Method and Perpetuity growth method
5. Calculated Present Value and Determine Valuation
a. Discount the projected FCF and terminal value to present and sum to calculate enterprise value
b. Implied equity value can be derived from EC
c. To present value calculation is performed by multiplying FCF for each year and terminal value by respective discount factor
In-depth Steps
1. Study Target and Determine Key Performance Drivers
a. Carefully read recent SEC filings, earnings call transcripts, and investor presentations to get a solid introduction to business and
financial characteristics
b. Read MD&A to determine performance drivers
c. Analyze key drivers of company’s performance in order to craft FCF projections
i. These drivers can be internal (new facilities, new products) as well as external (acquisitions, market trends, consumer
patterns)
2. Project FCF
a. Reminder: FCF is cash generated by company after paying all cash operating expenses and associated taxes, as well as funding of
capex and working capital, but prior to interest expense
b. Historical performance provides valuable insight for developing defensibly assumptions
i. Past growth rates, profit margins, and other ratios are reliable indicators of future performance
ii. We usually lay out target’s historical data for prior 3-year period as well
c. We project target’s FCF for 5 years depending on its sector, stage of development, and predictability of its financial performance
i. Project FCF to a point where target’s financial performance reaches steady state or normalized level
ii. Five years is sufficient time for at least one business cycle and allows time for successful realization of planned
initiatives
iii. If the target is in the early stages of rapid growth, it is more appropriate to build a longer-term projection model
d. The management case is the five years of financial projections for target
i. Banker makes adjustments to management’s projections that incorporate assumptions deemed more probable (Base
Case), while also creating upside and downside cases
e. Without an initial set of projections, consensus research estimates typically form basis for developing projections
f. Sales Projections
i. Source first two or three years of projection period from consensus estimates
ii. Banker must derive growth rates in outer years from alternative sources
iii. In the absence of reliable guidance, banker typically steps down growth rates incrementally in outer years of projection
period
iv. For highly cyclical business, sales levels need to track movements of underlying commodity cycle
1. However, the terminal year financial performance represents a normalized level rather than a cyclical high or
low
v. Perform a sanity check vs target’s historical growth rates as well as peer estimates and sector/market outlook
g. COGS and SG&A Projections
 i. Banker relies on historical COGS and SG&A levels for initial years of projection period
ii. For outer years of projection period, hold gross margin and SG&A as a percentage of sales constant (slight
improvement or decline if justified by company trends)
h. EBITDA and EBIT Projections
i. EBITDA and EBIT projections for future two- or three-year period are typically sourced from consensus estimates
ii. Common approach for projecting EBITDA and EBIT for the outer years is to hold their margins constant at level
represented by last year provided by consensus estimates
i. Projection of Free Cash Flow
i. EBIT – Taxes =EBIAT
ii. EBIAT + D&A – Capex – Increase/Decrease in NEW = FCF
iii. Tax-effected EBIT = EBIAT
1. This is calculated by multiplying EBIT by (1-t) where t is target’s marginal tax rate
2. Marginal tax rate of 35-40% is generally assumed, but company’s effective tax rate in previous years can also
serve as a reference point
iv. Depreciation and Amortization Projections
1. Depreciation is non-cash expense that reduces PPE
2. Amortization is non-cash expense that reduces value of definite life intangible assets
3. D&A expense is added back to EBIAT in calculation of FCF
4. Depreciation expenses are scheduled over several years corresponding to useful life of an asset
a. Straight-line depreciation = uniform depreciation over useful life
b. Accelerated depreciation = asset loses most of its value in early years of life
c. For DCF, depreciation is a percentage of sales/capex based on historical levels
d. We assume that the percentage is equal in perpetuity to represent a steady state business
5. Amortization reduces intangibles rather than tangible assets
a. Includes copyrights, licenses, patents, etc.
b. These assets are amortized according to determined/useful life
c. Amortization can be projected as a percentage of sales
d. Combined D&A is projected as percentage of sales/capex as well
v. Capital Expenditure Projections
1. Capital expenditures are funds that a company uses to purchase, improve, expand, or replace physical assets
such as buildings, equipment, facilities, and other assets
a. Capex is an expenditure not an expense
b. It is capitalized on balance sheet once expenditure is made and expensed over useful live as
depreciation
c. Since it is an expenditure, it effects cash outflows and must be subtracted from EBIAT in
calculation of FCF
d. Historical capex is disclosed directly on company’s cash flow statement under investing and also in
MD&A
e. Historical levels generally serve as reliable proxy for projecting future capex
f. Capex projections may deviate from historical levels in accordance with company’s strategy/phase
of operations
vi. Change in Net Working Capital Projections
1. Net Working Capital is non-cash assets (current assets) – non-interest-bearing current liabilities (current
liabilities)
a. It is a measure of how much cash a company needs to fund its operations
b. Current Assets = A/R + Inv + Prepaid Expenses and Other Current Assets
c. Current Liabilities = A/P + Accrued Liabilities + Other Current Liabilities
d. Change in NWC represents annual source or use of cash for company
i. Increase in NWC = use of cash
ii. Decrease in NWC = source of cash
iii. Change in NWC = NWC (current) – NWC (prior year)
1. This is known as Year-over-year (YoY) change in NWC
e. Quick and dirty way to project YoY changes in NWC involves projecting NWC as percentage of
sales at designated historical level and calculating YoY changes accordingly
f. Or, you can project current assets and liabilities based on historical ratios
g. Banker typically assumes constant working capital ratios
vii. A/R = amounts owed to company for its products and services sold on credit
1. Projected as days sales outstanding (DSO) = A/R / Sales * 365
2. DSO gauges how well company is managing collection of A/R by measuring number of days it takes to
collect payment after sale of product
3. Lower DSO, faster it collects cash
viii. Inventory = value of company’s raw materials, work in progress, and finished goods
1. Days Inventory Held (DIH) = Inv / COGS * 365
2. DIH = number days It takes a company to sell its inventory
 3. Inventory Turns = COGS/ Inv = number of times a company turns over its inventory in a given year
ix. Prepaid expenses and other current assets = payments made by company before product has been delivered or service
has been performed
1. Increase in prepaid expenses and other current assets represents a use of cash
x. Accounts Payable = amounts owed by company for products and services already purchased
1. Days Payable Outstanding = A/P / COGS * 265
2. DPO measures number of days it takes for a company to make a payment of its outstanding purchases of
goods and services
3. Increase in A/P represents a source of cash
xi. Accrued Liabilities and Other Current Liabilities = expenses such as salaries, rent, interest, and taxes incurred by
company but not yet paid
1. Similar to Prepaid expenses and other current assets, it is projected as percentage of sales in line with
historical sales
2. Increase in Accrued Liabilities = source of cash
xii. After above items are projected, annual FCF for projection period can be calculated using FCF equation. This is only a
portion of target’s value. Remainder is captured in terminal value.
3. Calculate Weighted Average Cost of Capital
a. WACC is broadly accepted standard for use as discount rate to calculate present value of company’s projected FCF and terminal
value
b. Represents weighted average of required return on invested capital in a given company
c. WACC is dependent on a company’s target capital structure
d. WACC can also be thought of as an opportunity cost of capital or what an investor would expect to earn in an alternative
investment with similar risk profile
e. WACC = [rd * (1-t)]* [D/D+E] + re*[E/E+D ]
i. Rd = cost of debt
ii. Re = cost of equity
iii. T = marginal tax rate
iv. D = market value of debt
v. E = market value of equity
f. 3(A) Determine Target Capital Structure:
i. WACC is predicated on choosing a target capital structure for company that is consistent with long-term strategy
ii. This is represented by D/D+E and E/D+E
iii. Public comparable companies provide a meaningful benchmark for target capital structure as it is assumed that their
management teams are seeking to maximize shareholder value
g. 3(B) Estimate Cost of Debt
i. Cost of debt reflects a company’s credit profile at target capital structure
ii. Assuming company is currently at its target capital structure, cost of debt is derived from blended yield on its
outstanding debt instruments
1. If it is not at its target capital structure, we obtain it from peer companies
iii. For publicly traded bonds, cost of debt is determined on current yield on all outstanding issues
h. 3(C) Estimate Cost of Equity
i. Cost of Equity is required annual rate of return a company’s equity investors expect to receive
ii. To calculate expected return on company’s equity, banker uses capital asset pricing model (CAPM)
1. CAPM is based on premise that equity investors need to be compensated for assumption of risk in form of
risk premium, or amount of market return in excess of a stated risk-free rate
2. A company’s level of systematic risk is measured by its beta
3. In general, the smaller the company and the more specified its product offering, the higher its unsystematic
risk
4. Cost of Equity = Risk-free Rate + Levered Beta * Market Risk Premium
a. Market Risk Premium = Expected return on market – risk-free rate
iii. Risk-free rate is expected rate of return by investing in a “riskless” security
1. U.S. government securities are accepted by market as “risk-free” b/c they are backed by government
2. Yields for government securities can be located on Bloomberg or US. Treasury Website
3. Investment Banks may vary by which yield to use (10-year or 20-year securities)
a. Goal is to match expected life of company to debt instrument
iv. Market Risk Premium is spread of expected market return over risk-free rate
1. There are differences on which historical time period is most relevant for observing market risk premium
2. Depending on which time period is selected, risk free rate may vary
3. From 1927-2007 period, market risk premium is about 7.1%
4. Firms usually have firm-wide policy for market risk premiums
v. Beta is measure of covariance between rate of return on company’s stock and overall market return (Systematic risk)
1. Stock with beta 1.0 should have expected return equal to that of market
a. Stock with lower than 1.0 should have lower systematic risk than market
b. Stock with greater than 1.0 should have greater systematic risk
 2. Company’s historical beta can be sourced, but is not a reliable indicator of future returns
a. Banks typically use predicted beta
b. Calculating WACC involves deriving beta from a group of publicly traded peer companies that may
or may not have similar capital structures to one another or the target
c. To neutralize effects of different capital structures, banker must unlever beta for each company to
achieve asset beta (unlevered beta)

d. After calculating unlevered beta for each company, banker determines average unlevered beta for
peer group. This beta is then relevered using company’s target capital structure and marginal tax
rate. Formula for relevering is:

e. The resulting beta serves as beta for calculating company’s cost of equity using CAPM
f. For public company not at target capital structure, asset beta must be calculated and then relevered
at target D/E
g. Smaller sized companies are riskier and should have a higher cost of equity (size premium). Banker
may choose to add size premium to CAPM formula for higher perceived risk

i. 3(D) Calculate WACC

i. After the steps are completed, we can calculated WACC

4. Determine Terminal Value

a. Banker uses terminal value to capture value of company beyond projection period
b. Terminal value accounts for substantial portion of company’s value in DCF
c. There are two ways to calculate company’s terminal value, both ways need to be sensitized
i. Exit Multiple Method
1. Calculates remaining value of company’s FCF produced based on multiple of terminal year EBITDA
2. Multiple is typically based on current LTM trading multiples for comparable companies
3. It is important to use a normalized trading multiple and EBITDA
4. Common approach is to derive a multiple range (i.e. 6.5 – 7.5x, we would do a range from 6.0x – 8.0x
increments of 0.5)
5. Terminal Value = EBITDA *Exit Multiple (EBITDA is for terminal year of projection period)
ii. Perpetuity Growth Method
1. PGM calculates terminal value by treating company’s terminal year FCF as perpetuity growing at an assumed
rate
2. This is based on company’s expected long-term industry rate (2% - 4%)
 3. PGM is used with EMM as a sanity check (both should be around the same)

5. Calculate Present Value and Determine Valuation

a. Calculating present value centers on notion that a dollar today is worth more than a dollar tomorrow
b. In a DCF, projected FCF and terminal value are discounted to present at company’s WACC due to time value of money
c. Present Value calculation is done by multiplying FCF for each year in projection period and terminal value by respective discount
factor
d. N = year in projection period
e. Discount factor is applied to given future financial statistics to determine present value

f. To account for fact that annual FCF is received throughout the year rather than year end, it is typically discounted in accordance
with mid-year convention. This assumes a company’s FCF is received evenly throughout the year

g. Terminal Year Considerations:

i. When employing mid-year convention for projection period, mid-year discounting us applied for terminal value under
PGM
ii. For EMM, we use year-end discounting
h. Determine Valuation
i. Company’s projected FCF and terminal value are each discounted to present and summed to provide an enterprise
value

ii. We derive equity value through: EV – (Net Debt + Preferred Stock + Noncontrolling Interest)
iii. Implied share price = Implied Equity Value/ Fully diluted shares outstanding
i. Since DCF incorporates assumptions which have sizable impacts on valuation, DCF is usually viewed as a range based on key
input assumptions
i. Exercise of deriving valuation range by varying key inputs is called sensitivity analysis
ii. It is important to compare values from DCF from other valuation methods for a sanity check