Introduction to valuation techniques Section 1

1.1. Introduction to valuation

In theory, the fair value of an asset is determined by the meeting of a willing, but not anxious, buyer
and a willing, but not anxious, seller. Irrespective of what any theoretical valuation indicates, in
practice a business or an asset is only worth what a purchaser will pay for it. Different categories of
buyers, strategic/corporate buyers versus financial buyers for example, may be prepared to pay
different prices.

The value will also be dictated by the level of ownership required:

„ Investment <20%
„ Minority interest >20%, <50%
„ Joint venture 50%
„ Control >50%

A valuation is not a scientific exercise and is dependent on the quality of information available. It is
a set of arguments supporting a view on value and we therefore usually express it as a range (see
page 11 for example valuation slide).

1.2. Purpose of valuation

The valuation exercises that we undertake are generally from the view of what a business might cost
to acquire or what price it might attract upon a disposal. It is extremely important therefore to keep
in mind the purpose for which the valuation is intended. Valuations can also be important for the
purposes of establishing fee levels in engagement letters.

Different purposes include:

„ Purchase or sale of a private company
„ Recommended bid for a public company
„ Hostile bid for a public company
„ Break-up valuation
„ Leveraged buy-out
„ Contribution to joint venture or merger
„ Flotation
„ Fairness opinion
„ Asset transfers with a group (tax or restructuring)
„ Providing of credit facilities

Principally, however, there is a distinction between the valuation of a whole business for the purpose
of transactions (transaction valuation) and the fair value of a single share.

1.3. Valuation techniques

This manual discusses three principal techniques for valuing a business:

„ Comparable companies analysis (compcos): shows where a company should be trading if it were
fairly valued by the market
„ Comparable transactions analysis (comptrans): shows us the amount that a purchaser should be
prepared to pay by reference to precedent transactions

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„ Discounted cash flow analysis (DCF): shows us the expected value of the business by reference
to future cash flows
Other industry-specific techniques (eg takeover premium, leveraged buy-out models, break-ups,
sum-of-the-parts (SOTP) valuations, liquidation values and real options techniques) are also applied.
The suitability of each technique is dependent on the purpose of the valuation and the information
available.

1.3.1. Comparable companies analysis (compcos)

Comparable companies analysis, commonly referred to as ‘trading comps’ or compcos analysis,

gives an indication of the likely value of a company if it were traded on the open market. The value
is stated in terms of market multiples and ratios (eg P/E ratio and EV/EBITDA multiple).

Market multiples and ratios are measures based on current market conditions. These multiples are a
‘shorthand’ method for valuing a company’s future cash flows.
„ If the company under analysis is not publicly traded, market multiples are used to imply a trading
valuation. These implied values do not incorporate the ‘control’ premiums reflected in
comparable transactions analysis
„ If the company is publicly, market multiples are helpful in understanding how the market views
the company relative to its peers (eg why the company trades at a discount or a premium to its
peers – the market is not always efficient)

Under this type of analysis, a universe of (publicly traded) companies is identified – those companies
that are deemed to be comparable with the company being valued (ie with similar operating and
financial statistics). A set of multiples are then calculated based upon the financials of each
comparable company and these multiples are then analysed to determine the multiple values that are
most applicable to the company being valued. Selected multiples are normally stated as ranges
rather than absolute figures. The multiple range is then applied to the financials for the company
being valued to arrive at a valuation. However, it must be borne in mind that there lies an inherent
difficulty with comps as companies are seldom identical and so multiples vary.

Multiples also offer a quick way to compare key company ratios and stats with comparable
companies. Compcos analysis also provides useful information on operating statistics for a group of
companies within the company’s industry (eg growth rates, margin trends, capital spending
requirements) which can be helpful in developing assumptions for a DCF analysis.

Compcos analysis may require subdividing the company into different areas of activity to enable
more applicable comparisons with quoted companies. When valuing a company with the
comparable company analysis for the purpose of estimating the acquisition value of the company, a
control premium must be added to the comp (or trading) value.

Please see Section 3 for full details on compcos.

1.3.2. Comparable transactions analysis (comptrans)

Comparable transactions give an indication of the pricing for past comparable deals, in other words,
the amount acquirors were willing to pay for comparable companies. The underlying assumption is
that comparable companies (typically in the same industry) show common characteristics that should
carry through to their acquisition value.

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This analysis is similar to compco analysis, in that multiples are calculated based upon the price paid
for the business and the financials of the business being acquired. It is most important to note that
the price paid for the company was based upon the information available to the acquirer at the time
of the bid, thus the financials analysed should only include the public information that would have
been available to the acquirer’s analysts prior to the transaction.

As in the review of comparable companies there lies an inherent difficulty with comps as companies
are seldom identical and so multiples vary. Therefore, there may be specific reasons behind the
pricing of any given transaction, thus each transaction should be viewed independently in terms of
its applicability to the new valuation. For instance, a comparable transaction may have taken place
in an environment that was fundamentally different from that prevailing at the time of the current
valuation (eg cyclical industries).

Comptrans analysis may require subdividing the company into different areas of activity to enable a
more direct comparison with past transactions.

1.3.3. Discounted cash flow analysis (DCF)

Discounted cash flow analysis involves estimating the present value of the future cash flows that the
business being valued is expected to generate.

DCF analysis requires high quality historic and projected financial information on the business. The
quality of the financial information is crucial to DCF valuation – “garbage in… garbage out”.

The particular information required will depend on the nature of the company being valued but at the
most basic level, detailed assumptions over the projected period are required for:
„ Turnover
„ Operating margins
„ Interest charges
„ Taxation charges
„ Depreciation charges
„ Capital expenditure
„ Working capital movements

There is a danger of over-generalising in preparing cash flow forecasts – ie assuming a constant

growth rate after the first couple of years. It is important to question the forecasts and consider all
cyclical, industry specific and other general or macroeconomic influences.

Rather than discounting cash flows indefinitely into the future, a terminal value, based on the
company’s long-term growth rate (perpetual growth rate methodology) or a multiple of the final
year’s earnings or cash flow (exit multiple methodology), is usually assumed after a period of, say,
five to ten years.

The terminal value can represent a very high proportion of the overall valuation of the business
(particularly in a company pursuing long-term growth and investing heavily during the forecast
period).

A DCF valuation is only as accurate as the assumptions/key sensitivities underlying it and the
easiest way to establish a margin of error is to vary the principal assumptions.

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In theory, the choice of discount rate or assessment of the internal rate of return will depend
critically on the cost of debt and the market risk premium in the country of the target, the share price
volatility of the target and the level of debt of an optimal target structure. However, a purchaser
would have to consider other issues, such as its funding costs and the value of the business to it.

1.3.4. Other valuation considerations

Rule-of-thumb measures (usually borne out of comps analysis) will vary for different industries.
These may include:
„ Property: discount to NAV
„ Oil and gas: US$ paid per net equivalent barrel of reserves or NPV of production
„ Cable TV: value per subscriber base
„ Asset management: % of assets under management

Many companies have threshold measures to assess whether a particular opportunity falls within
their investment criteria:
„ A threshold period within which any investment must be paid back out of the free cash flow
(pay back period); or
„ Set the maximum valuation on any acquisition by reference to a targeted return on investment,
usually in the 15% – 20 % range within a couple of years of the acquisition (Return of Capital
threshold)

1.3.5. Valuing private/unlisted companies

The valuation of a 100% interest in an unlisted company (including private companies or a division
of a publicly listed company) should be undertaken on the same basis as you would estimate the
value of a controlling interest in a listed company. That is to say, theoretically there should be little
difference between acquiring 100% ownership of an unlisted company or a 100% stake in a listed
company.

In practice, there is some evidence that the sale of private companies occur at a discount to listed
transactions. There are a number of reasons for this, including:
„ Size effect – private companies tend to be smaller than public companies and therefore are subject
to a size discount
„ The transparency of information – acquirers can obtain a high degree of comfort regarding
financial statements of a listed target. On the other hand, the more relaxed reporting requirements
for unlisted companies may cause an acquirer to be more cautious about its financial results. This
caution can lead to conservatism in estimating the earnings potential of the target
„ The superiority of general systems and controls in listed companies – given the nature of listing
rules and the additional scrutiny that public shareholders place on management, public companies
tend to have better systems and controls in place for managing risks and the business in general
„ HD costs tend to be higher and can be reduced (ie greater cost synergies)
„ Process for acquiring public companies tends to be more transparent and aimed at maximising
price (typically negotiating with two groups – directors and shareholders)

A portfolio interest or minority stake in an unlisted company can also be expected to sell at a
relatively significant discount to the portfolio value of a comparable listed investment. This is due to
the lack of liquidity of portfolio interests in unlisted investments which reduces the attractiveness of
the asset by increasing exit risk.

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1.4. Keys to good valuation

1.4.1. Initial company review

It is important to undertake a thorough examination of the company or business in order to assess

how best the valuation measures should be applied to the underlying financial data on the company
or business.
„ The capital structure of the business can have a significant impact on its value. For example, the
debt at year end may be significantly less than the average level throughout the financial year
„ There may be joint venture arrangements that have change of control provisions. The presence of
in-the-money options or favourable conversion rights attached to debt instruments can have a
significant effect on the cost of acquiring a business
„ Taxation is frequently a major issue in a valuation. The continued availability of tax losses and
net operating losses (NOLs) carried forward is not necessarily guaranteed upon a change of
control. There may also be adverse tax consequences for the acquiring company in making
distributions from the acquired business (consultation with tax specialists is advised)
„ Accounting policies can significantly impact the valuation, or a company’s perception of
valuation, either because the policies of the acquiror and the target are different (eg deferred tax
calculation for UK companies) or because of the method of accounting for the acquisition
(eg amortisation of goodwill)

1.4.2. Leverage past efforts

Every attempt should be made to avoid re-inventing the wheel:

„ Most industry groups have various schedules of comparable companies and comparable
transactions
„ Several software/applications can provide useful lists of comparable M&A transactions (eg SDC,
M&A Global) (though caution and checks of such information is advised)
„ Industry groups and/or the Financial Sponsors team can assist in assessment of likely purchasers
„ Transaction teams may have undertaken a similar valuation (but beware of the use of confidential
information)
„ Numerous models already exist that could act as aids, references or even the basis of the valuation
being conducted

When utilising precedent material ensure that it is complete for your purposes. Selective use of
library and secretarial staff can free up executive time for some of the more subjective aspects.

Deutsche Bank contacts, who have worked on projects for the same client in the past, may also be
helpful in providing a high-level overview of the company. All work must be checked by another
and often more senior team member.

1.4.3. Financial review

A general review of the company begins with an analysis of a company’s earnings and cash flow
profile. After getting a feel for the numbers, a thorough financial analysis of the company or
business to be valued should be undertaken.

Particular items that should be considered include:

„ Margin analysis/benchmarking

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„ Fixed assets, depreciation policy, valuation policy and other accounting policies
„ Investments or property assets
„ Required capital expenditure
„ Intangible assets (eg value of patents)
„ Working capital, in particular the values of stock and debtors
„ Taxation
„ Contingent liabilities (eg potential environmental claims)
„ Unrecorded liabilities
„ Foreign exchange exposures
„ Business acquisitions/disposals
„ Other exposures: geographic, market sectors, particular products

1.5. Highlight inputs and assumptions

A valuation is only as good as the assumptions, forecasts, and information on which it is based. It is
essential and regarded as good (modelling) practice to clearly state all inputs, assumptions, forecasts,
and information so that anyone who reviews the valuation understands how the valuation was
derived.

Retain all source documentation with key inputs highlighted to assist in the review process.

1.5.1. Forecast assumptions

Forecasts of future trading and financial performance tend to be critical in any valuation exercise.
We therefore need to consider carefully the validity of forecasts utilised:
„ Management projections may be prepared on unrealistic assumptions
„ Brokers’ forecasts may be out of date and accordingly may not have been adjusted for new
information

1.5.2. Non-financial assumptions

It is important to gain a good knowledge about the business and the market in which it operates to
make an initial assessment of the worth of the business.

Examples of non-financial factors that can have a very material effect on the value of a business
include:
„ Strategic position (eg market share or supply contracts)
„ Competitive pressures (from customers and/or suppliers)
„ Quality of management
„ Industry cycle (eg growth or mature industry)
„ Patents, licences and special regulations (environmental)

Industry knowledge can be obtained from:

„ Industry group teams
„ Equities research analysts
„ Structured finance teams

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„ Advisory teams with clients in the sector

„ Management consultants (eg McKinsey)
„ Published research materials (eg trade journals, brokers’ notes)

1.6. Understanding differences in valuation

1.6.1. Control premiums

The observed control premium for any specific transaction will be influenced by a number of factors
that are unique to the acquirer’s particular set of circumstances. The observed control premium will
incorporate two elements:
„ Pure control premium (stand alone)
„ The extent of any synergies (specific to the acquirer) that are included in the purchase price

Control premiums observed in listed transactions are generally in the order of 30% – 50% of the
portfolio (or trading) value. However, it should be noted that in a non-competitive bidding process
such a premium is not guaranteed. A sale process may lack competitive tension for a number of
reasons including, a lack of interested trade buyers, strict regulatory guidelines on cross ownership
of assets and an unattractive asset.

In the event that a sale process does not generate sufficient competitive tension then it is likely that
the portfolio value of the company will exceed the price that a trade buyer is willing to pay. There
have been a number of examples where a dual sale process, involving a competitive tender process
being run simultaneously with an initial public offering, has resulted in the highest sale proceeds
being realised by flotation.

1.6.1.1. Pure control premium

Different thresholds of ownership reflect different degrees of control or influence, depending upon
local regulations. For example, a 25% stake may also allow the holder to block special resolutions, a
50% stake may confer control of management and a 75% may allow the forcing of special
resolutions but this will vary from country to country. It should also be noted that given certain
circumstances (eg a diffuse share register) a shareholding of much less than 50% may still confer
effective control of management.

The difference between the portfolio value (trading value) and the value of a controlling interest
(takeover value) in a company is commonly referred to as the control premium.

Control premiums are paid in return for achieving the benefits that flow to those who can
significantly influence a business.

In the UK control is deemed to pass when a shareholder acquires 30% of a company’s voting right.

100% ownership of a company confers:

„ Control over the composition of the board and management
„ Control over all decision making
„ Power to pass special resolutions
„ Access to all the cash flows and dividends of the business (ie no leakage)

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„ Potential ability to realise synergistic benefits by merging the acquired business with their existing
business
„ Potential ability to utilise tax losses by tax grouping at a consolidated level

For these reasons, the value of 100% interest is greater than the total portfolio value.

1.6.1.2. Synergistic control premium

Synergies may arise through:

„ Cost savings through rationalisation
„ Revenue/EBITDA synergies
„ Consolidated/restructuring tax savings
„ Lower overall interest rate

Although there may be potential synergies, these may take some time to come through. However, a
purchaser will only be prepared to pay a portion (if any) of the identified synergies; nevertheless it is
inevitable that, in a competitive bidding environment, the price paid will include some component of
expected synergies. If there are potential synergies there are usually upfront rationalisation costs
which must be incurred.

1.6.1.3. The impact of control premiums on undertaking a valuation

When undertaking a valuation of a company for the purposes of a takeover offer, it is important to
make the distinction between a trading valuation (or portfolio value) and an acquisition valuation (or
control value). This can present different problems depending on the valuation method being
applied.
„ Capitalisation of earnings: When utilising the capitalisation of earnings methodology, the
distinction can easily be made between portfolio value and control value. By applying a multiple
range derived from comparable takeover transactions a control value will be derived. Conversely,
applying multiples based on the trading multiples of comparable listed companies will derive a
portfolio value
„ DCF valuations: The issue of whether a DCF valuation is inclusive of a premium for control is
not clear cut. On the one hand it can be interpreted as valuing a controlling interest because the
cash flows are forecast for the entire company. On the other hand it can be argued that the
forecast represents the cash flows current management is expected to produce. These represent
current operations and expectations. New management might be able to produce greater cash
flows by generating cost savings and extracting operating synergies. In this latter case it can be
argued that it is proper to add a control premium to the DCF value. The basic point is that the
underlying assumptions behind the cash flows must be considered carefully as part of assessing
whether the cash flows incorporate any control premium and if so to what extent

In practice, valuations for acquisitions are typically calculated based on required hurdle rates (ie a
required equity IRR or EPS calculations) and will usually be based on cash flows for the entire
company that include some synergies. This type of valuation will help derive a control/acquisition
value.

1.6.2. Costs arising on acquisitions

Transaction costs arising from the deal (eg legal fees, bankers’ fees and accountants’ fees) may be
considerable and should be taken into account.

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Other costs may also arise and should be addressed. Examples include:
„ The replacement of senior management in the firm to be acquired, which can be an expensive
exercise if they have long-term employment contracts
„ The cost of migrating information systems
„ Costs of implementing synergies (eg costs of closing plants, offices)

1.6.3. Competitive bid valuations

Whether acting on behalf of a potential acquiror or seller of a business, it is important to assess the
full range of likely purchasers. This will aid in determining whether the bidding process, and thus
the necessary offer price to win, will escalate.

In considering likely purchasers one should include an assessment of:

„ Their commercial interest in the business
„ Whether they would regard it as a strategically important acquisition
„ Their financial ability to undertake the acquisition
„ Their willingness to pay the likely asking price
„ The effect the acquisition would have on earnings at a range of prices
„ The regulatory impact that the acquisition might have

Where applicable, the relevant industry group (or the Financial Sponsors group in the case of
potential financial buyers) should be consulted in undertaking this exercise.

1.6.4. IPO discounts

It is generally accepted that the proceeds from the sale of a portfolio interest will be less then the pro
rata acquisition value of the whole entity. This concept obviously limits the proceeds that can be
expected from an initial public offering (when compared with a trade sale). However, in addition to
this, it is also normally the case that an initial public offering will be issued at a further discount
(IPO discount) to the expected secondary share market value (portfolio value) of the company.

There are a number of reasons why initial public offerings are issued at a discount to the estimated
portfolio value of the company. These include:
„ To provide an inducement to investors to subscribe in the offering
„ If the issue is underwritten, the underwriter to the equity raising needs to be satisfied that they will
be able to find subscribers to the new equity and not be left holding a large parcel of the company
themselves
„ To provide compensation to investors for bearing risk (eg the risk that there will be a market
downturn during the offer period)
„ To enhance the likelihood of a successful after-market performance. This is especially relevant in
privatisations where governments are keen to ensure a satisfied investor (voter) base and positive
investment community sentiment

1.6.5. Summary and conclusion

Although it is important to produce evidence in support of your views a valuation should not be
regarded as a mechanical exercise and a degree of flexibility may be required.

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„ It is important before commencing the exercise to gain an understanding of the purpose for which
it is to be used
„ A valuation is only as good as the information on which it is based
„ Every attempt should be made to gain a good understanding of the business to be valued and the
markets in which it operates
„ The quality of projections and assumptions is especially important in DCF valuations
„ The applicability of each precedent transaction and comparable company analysed must be
considered for every valuation
„ An assessment of other likely purchasers can often significantly impact the views on the valuation

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Example valuation summary – floating bar chart

27% bid premia to current

Current TEV = EUR4,315m market cap = EUR5,054m‡

12 month trading range* (enterprise value) EUR3,780 EUR4,666

DCF EUR3,810 EUR4,780

Sum of the parts valuation** EUR3,710 EUR5,245

Comptrans† EUR4,375 EUR5,500

Compcos EUR4,000 EUR5,000

3,000 3,500 4,000 4,500 5,000 5,500 6,000

Enterprise value

* Based on 12 month trading range high and low share price of EUR114.95 and E82.00 plus estimated 2003 net debt of EUR1,577m
** Based on Deutsche Bank Corporate Finance and Merrill Lynch Equity Research sum of the parts valuation (13 March 2003) of EUR5,245m and EUR3,710m respectively
† Represents 12 month high and low share price of EUR114.95 and E82.00 plus average Austrian bid premia of 27% and estimated 2003 net debt of EUR1,577m
‡ 27% bid premium applied to market capitalisation of EUR2,738m plus net debt EUR1,577m

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