Last month we discussed the importance of re-grounding ourselves in strategic fundamentals prior to calculating our deal valuation, and we also discussed the EBITDA multiple approach to those calculations. This month we’ll discuss the cash flow approach, as well as a few other considerations for calculating estimated deal value.
Stream of unlevered cash flows
A common valuation approach is to calculate the target company’s projected future cash flows- often over a period of the next 5 to 10 years. The cash flows are usually first “unlevered’, meaning that interest expense is added back for the purpose of valuation. Now it’s time for a trip back to our college finance classes. Don’t worry, we’ll make it quick.
Recall that our basic formula for the present value of something is:
Future value=present value *[ (1+rate)^number of periods]
Present values are calculated using the company’s cost of capital, or the required hurdle rate (as set by leadership/board of directors) if higher. An example assuming a 10 year horizon and 18% hurdle rate:
Note that there are a few wrinkles with this approach. First, we are assuming that our ability to forecast out 10 years is solid. Second, we need a relatively near-term positive cash flow stream to make the calculations useful. Third, we are essentially valuing anything beyond our horizon at zero.
It is in part to address this problem that investment bankers will often convert the net present value to an internal rate of return (IRR). The IRR is a fancy way of saying what hurdle rate would we need to use in the NPV formula to give us a net present value of $0? Once calculated, this IRR rate is then applied to future projected cash flows in the assumption that reinvestment would be available at that rate.
Real-World Example: Bad Sport
I was recently asked to assist a CFO in the preparation of a valuation model for an acquisition. The projected unlevered cash flows, along with forecasted financial statements, had been provided by the investment banking team. The small target company had a single product, which they sold only domestically via their website, at a fixed price of $25. For purposes of this discussion let’s just say that the product was a sporting goods item. Thus, you would only need one of these if you participated in that sport, and even so the useful life should be between 5-10 years once purchased.
In looking at the sales figures, I noticed something didn’t look right. I quickly ran a US population analysis, and did some quick total addressable market calculations. To sum up the results, every man, woman, and child in the United States would have needed to purchase 1.32 of these items every 5 years in order to reach sales numbers in the financial projections.
Obviously, this didn’t seem realistic to me, so I checked in with the bankers. Were prices expected to rise? Were new products on the horizon? Markets being expanded? Distribution increasing? Nope, nope, nope, and nope. They had simply applied the growth rate of the last 2 years to the next 5 years, without taking into account the actual constraints of the market itself!
Bottom line, always check the financial models. Make sure all assumptions are stated, and run market analysis on any projections. Be prepared to explain what market share capture is assumed, and why that is realistic.
This solves one problem but creates a few more. First, there can mathematically be more than one IRR- i.e. more than 1 hurdle rate that causes the net present value of future cash flows to be zero- particularly if cash flows fluctuate between positive and negative values. Second, IRR valuations tend to be on the high side, because they treat investment in the target the same as they would treat putting money in a bank account at that rate of compound interest. Since we know that all companies experience a lifecycle of growth, stabilization, and decline, that is a fairly optimistic viewpoint- particularly in highly competitive industries or those subject to higher than average risks.
Note that all of the methods we have discussed thus far are highly dependent on the company’s results of operations. Normally this is appropriate; however, a lot of time can be saved by taking a closer look at what assets the company may have.
I was recently asked by a small, privately-held company to evaluate a potential acquisition. We had some really good comps to use, which yielded an enterprise value of $7 million for the target. NPV analysis suggested a value of about $6.2 million; however, the company had just achieved profitability, after accumulating over $100 million in losses during prior years. Assuming a 30% tax rate, that means that there could be upwards of $30 million of tax reduction value to the company that acquires this target! This suggests a valuation far beyond what my client could afford, and one that would bear no resemblance to the comps or NPV of cash flows. Luckily, we caught this prior to the CEO calling in the Board to review the acquisition, and he was able to save face!
Most acquirers will study the income and cash flow statements carefully, but remember to also look at the balance sheet, and to consider the actual market value of any tax benefits, real estate, or other assets, getting the appropriate experts in to value these as needed.
This is a good time to mention tax considerations. In general, it is highly critical to have skilled tax personnel involved in the evaluation and calculation of the value of any proposed deal. The example above is just one of many I could name. For instance, I once worked on an acquisition with a value in excess of $15 billion, much of which was actually paid for via careful tax planning regarding the legal entity structure of the deal. On the flip side, I also worked on a deal where tax had been left out of the discussion to date, and we discovered a potential loss of several million in value resulting from ignoring tax considerations in the deal structure. As we discussed in our due diligence chapters, make sure tax is at the table, and that they have sufficient time and funding to avoid any unnecessary value seepage!
There is no “perfect” valuation method. Comparisons rely heavily on the judgement of others, and are often apples to oranges. NPV overlooks the value generated beyond the consideration horizon. IRR tends to over-value the company’s long-term contribution to the bottom line. Both NPV and IRR rely heavily on the ability to accurately estimate the future cash flows, which is no easy task in itself. In mature industries I personally prefer to use the median of at least 7 good comps paired with a 10-year NPV to provide a valuation range, with an understanding that am likely to be looking at lower valuations than my competitors that are using IRR. Overall, remember that more than half of acquisitions have historically failed to deliver on their projected value, so our skepticism bias is certainly warranted.
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