Monday, August 18, 2014

Valuation: Tales from the Real World

The most important skill in successful M&A is valuation. Buyers cannot determine whether the target is worth the price without a valuation anchor. Many buyers are simply price takers subject to market distortions - noise. The problem with price is that it is not value. The biggest risk in M&A is paying too much relative to value received. There is a huge gap between valuation in practice and valuation in theory which complicates the situation.

Price reflects investor opinions of value - the target’s ability to deliver expected cash flows. Opinions are influenced by market behavioral finance including technical factors like mood, momentum, liquidity, and herding. Consequently, price can differ from fundamentally based value for long periods of time. As Keynes famously noted, markets can remain irrational longer than investors can remain solvent. Prices and value eventually converge, but the convergence process can be quite painful. The risk is using prices, usually expressed in market multiples for comparable transactions, to make over priced M&A purchase decisions.

Paraphrasing President Reagan, we should trust, but verify market prices. This is achieved through valuation - primarily based on discounted cash flow (DCF) models. Valuation provides the discipline necessary to control overpaying. Unfortunately, no one likes discipline. As St. Augustine put it so well - God, make me chaste, but just not yet. Keep in mind, however, everything in moderation. Do not over rely on DCF models - they are just a tool to understanding price. This is no one true fixed eternal intrinsic value - it depends on the target’s strategy and execution of that strategy.

Acting on good valuation analysis is hard in the real world. Finding that market prices exceed value estimates means telling your boss that the market is wrong. This is usually a career limiting choice for young analysts - especially when your boss wants to do the deal because all of his peers are acquiring. You cannot create acquisition opportunities when there are none, but boy it can be difficult to sit on your hands and wait.  The Rizzi motto in such a case is please 'stand and don’t do anything' - if only Hewlett Packard, TPG and others had followed that advice! Human nature seems to be buy high. For example, 2010 LBOs were priced in the 8X EBITDA range, while they are now above 10X. Are they really worth 25% more? Obviously, it depends, but the likelihood of high returns at 10X is most likely lower than at 8X.

Remember how LBOs are priced. You determine the market multiple of funded debt to EBITDA-now around 6. The current required equity percentage contribution is 35%. Then assuming a $1000 EBITDA, the affordable purchase price is 6000 in debt plus equity of around 3000 for a total of 9000.This represents a purchase price multiple of 9. If this is below the market multiple of 10, then the PE firm’s options are:

1)     Walk away
2)     Contribute more equity
3)     Increase the debt multiple
4)     Assume higher pro forma (AKA earnings without the bad stuff) EBITDA
5)     Synergies

Notice that none of this has anything to do with textbook DCF - no forecast period projections, terminal values or WACC calculations. You may see some fancy models in the offering memoranda, but they are multiple based and disguised as DCF.  This is like my Uncle Tony who used a 4 year payback rule when making capital investment decisions. When told he should switch to something more modern like a risk based discount model he said OK - I chose 25%!

Practitioners survey responses state they use DCF, but in name only. Look at the terminal value calculation in most DCF models. It compromises the majority of the value-usually > 65%. That calculation is usually based on an EBITDA multiple - usually the entry price multiple. Using price in valuation models is like a financial chain letter. The acquisition is usually taking place when markets are heating up and is inflated. How sure are you that this same multiple can be used for exit purposes?

As Yogi Berra noted- in theory there is no difference between theory and practice, but in practice there is. There is a great divide between what academics teach, practitioners say and what takes place in M&A valuation. That is what makes it so difficult to do M&A correctly.


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