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101 Concepts for the Level II Exam

Level II Concept 41: Target company valuation


Discounted cash flow analysis: In this method, we discount the company’s expected future free cash flows to the present in order to estimate the value of the company.

A two-stage model is used. The first stage includes only those years where an analyst can provide reasonably accurate estimates of the company’s free cash flows. These are discounted to their present value, using an appropriate discount rate. The second stage incorporates value derived from years beyond the first stage. This is called the terminal value of the company. The terminal value is then discounted back to the present. The sum of the values derived from the two stages is the estimated value of the company.

Advantages:

  • It is easy to model expected changes in the target company’s cash flows that may occur after the merger.
  • It is based on forecast of fundamentals rather than current data.
  • It is easy to customize.

Disadvantages:

  • Difficult to apply when free cash flows are negative
  • Estimating future cash flows and terminal values is difficult and prone to error.
  • Discount rate can change over time, this will have a huge impact on the valuation
  • Majority of the estimated value is based on the terminal value which is highly sensitive to growth and discount rate estimates. Thus, estimation error is a major concern.

Comparable company analysis:

Steps of this approach are:

  1. Define a set of comparable firms. Include companies in similar industries that have similar size and capital structure.
  2. Calculate various relative value measures based on the current market price of the comparable companies. For example, EV/EBITDA, P/S, P/E, P/CF etc.
  3. Review descriptive statistics like mean, median, and range for the metrics chosen and apply judgment and experience to estimate company value.
  4. Estimate a takeover premium.
  5. Calculate estimated takeover price by adding the estimated company value and the takeover premium.

Advantages:

  • This method provides a reasonable approximation of the target company, since it is based on the assumption that similar assets have similar market values.
  • Most of the required data is readily available.
  • Estimates of value are derived directly from the market unlike DCF method which is based on many assumptions and estimates.

Disadvantages:

  • The method is sensitive to market mispricing. If comparable companies are overvalued, it will result in a target company value that is too high.
  • It provides an estimate of fair stock price, not the fair takeover price. A fair takeover premium must be estimated separately.
  • It is difficult to incorporate any synergies of the merger in the analysis.
  • Data for past premiums may not be timely or accurate for the target company under consideration.

Comparable transaction analysis:

Steps of this approach are:

  1. Collect a sample of recent and relevant takeover transactions.
  2. Calculate various relative measures like P/E, P/CF, P/B based on prices actually paid in the deals (not current market prices)
  3. Review descriptive statistics like mean, median, and range for the metrics chosen and apply judgment and experience to estimate company value.

Advantages:

  • There is no need to estimate a separate takeover premium. It is derived directly from the comparable transactions.
  • Estimates of value are derived directly from values recently established in the market unlike DCF method which is based on many assumptions and estimates.
  • It reduces the litigation risk for both companies’ board of directors and managers regarding mispricing the deal.

Disadvantage:

  • If past transaction were mispriced, then the mispricings will be carried over.
  • Enough comparable transactions may not be available. If data from related industries is used, it may not be accurate for the company under study.
  • It is difficult to incorporate any synergies of the merger in the analysis.