Key Value Drivers of a DCF Analysis

Key Value Drivers of a DCF Analysis

Among many investment bankers, M&A consultants, university professors and other financial professionals, the Discounted Cash Flow analysis is considered as the gold standard of business valuation. A DCF analysis is a very flexible and accurate way to evaluate a project, division or entire companies.

Any DCF analysis, however, is only as accurate as the assumptions and forecasts it relies on. Errors in estimating key value drivers can lead to a very distorted picture of a company´s fair price. Depending on the determination of the key value drivers, the enterprise value for the same company can differ greatly. Therefore, every DCF analysis has to focus on a careful determination and justification of those important parameters. This article is intended to give an overview of the key value drivers and discuss their influence on the enterprise value.

Free Cashflow projections

Since the cashflows usually have the strongest influence on the enterprise value, the projection of the free cashflows is the decisive aspect of every DCF analysis. The development of the cashflows depend on various value drivers such as sales growth, profit margin, investments in fixed assets (CAPEX) and investments in working capital. These value drivers will be discussed below.

1. Sales

Logically, if all other value drivers remain the same, higher sales lead to higher cash flows and thus to a higher enterprise value. However, the assumption that other factors will remain unchanged with higher sales is unrealistic and untenable. For example, an increase in sales usually also entails additional investments in working capital. If the company encounters its production capacities at certain sales levels, investments in fixed assets must also be taken into account. The effects of the change in sales can therefore not always be clearly determined at first glance.

When planning sales, it is advisable to take into account the development of the entire economy, the industry and of course, the company´s position in the market. This results in a much more valid forecast of the turnover figures than a simple linear continuation of the turnover growth rates of the past.

2. Profit Margin

In contrast to an increase in turnover, a reduction in costs always has a value-increasing effect. If the company succeeds in reducing costs (ceteris paribus assumption), the EBIT margin and thus also the free cashflows and the enterprise value will increase.

3. Working Capital and CAPEX

Even if sales remain unchanged, there may be changes in working capital. Thus, for example the payment modalities of the customers or also the own payment modalities can change. Higher payment terms of the customers lead to an increase in trade receivables and thus to an increase

in the working capital requirements. The opposite effect is caused by greater utilization of the company’s own payment terms.

Investments in fixed assets (CAPEX) can largely be derived from the schedule of fixed assets. If replacement investments in fixed assets were not made in the past, they must be made sooner or later. In this case the future investments in fixed assets increase in comparison with those in the closer past, even if the conversion remains constant. A further reason for increased investments can be technical innovations of the own machinery. All these factors must be taken into account when forecasting capital expenditures.

Cost of Capital – Discount factor

The effect of the costs of capital on the enterprise value is immediately apparent. If the return requirements for debt and equity, and thus the discount factor increase, the cashflows will be discounted with a higher factor which results in a lower enterprise value. Mathematically, this relationship is clear because the present value of the cash flows is directly dependent on the level of the discount factor and thus on the cost of capital.

The discount factor is influenced by the following parameters (if WACC approach is used):

1. Cost of debt: The cost of debt is usually determined by the following three factors:

· The risk-free interest rate: If the risk-free interest rate rises, the cost of borrowing also rises.

· The default risk or risk premium: If the default risk of the company being valued increases, the cost of borrowing also increases.

· tax effect: as the cost of debt capital (interest payments) is tax deductible (tax shield), the cost of debt capital is reduced.

2. Cost of equity: If the return requirements of equity investors increase, the enterprise value decreases. In a DCF analysis, the cost of equity is usually calculated using the Capital Asset Pricing Model (CAPM). The amount of the cost of equity depends on the factors of the risk-free interest rate, the market risk premium and the beta factor.

3. The capital structure: The cost of capital of the company and also depends on the capital structure. As a rule, financing with equity capital is more expensive from the company’s point of view than with borrowed capital. Debt capital providers receive fixed payments that are independent of the profit generated. Equity investors, however, demand a risk premium due to the uncertainty of the payments to which they are entitled.

Growth rate of the Terminal Value

The growth rate of the cashflow in the Terminal Value reflects the growth of the cashflow at the end of the detailed forecasting period. This growth rate is intended to reflect corporate growth to infinity. It therefore makes sense to use a variable such as general economic growth as the growth rate for the company. In practice, growth rates between 0 and 3% are used, whereby 3% is the upper limit and is only used for companies in extremely dynamic industries. An increase in the growth rate from 1% to 3%, for example, results in an enormous increase in the Terminal Value and thus also in the enterprise value.

Length of the Forecast period

Contrary to the widespread opinion that the length of the detailed forecasting period does not affect the present value and thus the enterprise value, a change in the enterprise value can very well be observed when extending or shortening the detailed forecasting period in the DCF analysis. The direction and the extent of the change of the enterprise value depends on the individual case.

Usually, the growth rate applied in the years of the detailed forecasting period is significantly higher than the growth rate in the Terminal Value. Many companies are also planning a continuous increase of the EBIT margin during the planning horizon. If the forecast period is extended, the Terminal Value is calculated based on a higher cashflow (cashflow of the last detailed planning period). This results in a higher Terminal Value and thus also in a higher enterprise value.

Conclusion

The analysis of the value drivers not only serves to sensitize the user to the most important parameters of a DCF analysis but is also helpful in decision-making. Whether an acquisition or sale is the right decision depends on the price of the company. In the DCF analysis, however, this fair price is determined on the basis of forecasted figures that are subject to uncertainty. Therefore, when determining an enterprise value, different scenarios should always be considered that reflect this uncertainty. It is therefore advisable to analyze the enterprise value with multiple variants of the key value drivers. Three scenarios should be considered and analyzed: a base case, which represents the most probable development, a best case, which represents a very positive development, and a worst case, which represents a negative development. For each of the resulting scenarios, the company value is determined so that a value range is obtained.

 

Author:
Simon Fabsits, MSc
Dealbridge M&A Advisors Austria & Liechtenstein

How do M&A advisors create value?

How do M&A advisors create value?

When business owners decide it is time to sell their company, they have to answer the questions „Do I really need to hire an M&A advisors or does it make more sense to do it myself“? Although there are many benefits to hirings an advisor, some business owners still choose to bypass the intermediary, thinking the value is overstated. The point of this article is to discuss the overall value to a business owner of hiring someone to assist them in selling their company.

Do M&A advisors create value?

An independent study entitled „Does Hiring M&A Advisers Matter for Private Sellers?“ conducted by researchers from the University of Alabama examined the decision and the consequences of hiring sell-side M&A advisors. The study authors gathered and analyzed data from 3.8281 acquisitions of private firms and found out that 53% of private sellers do not use an M&A advisors. The results of the study definitely speak in favor of hiring an intermediary: sellers who retain an advisor receive an increased acquisition premium of 6 – 25% % more over a seller that attempts to sell the company on their own.

Going back to the initial question, it appears that M&A advisors create real value for a private seller. But how and where do they create value?

How do M&A advisors create value?

1. Expertise & Experience

When owners pursuing the sale of their business for the first time, a common challenge is that they do not know what they do not know. There are many steps in the process – from the business valuation to the preparation of the confidential business report (CBR) to the sourcing of buyers to negotiations and due diligence. An experienced M&A advisor has gone through those steps and processes over and over again and can therefore help owners to avoid common deal breakers, ask the right questions, ensuring a structured and well-planned process and finally execute a successful deal.

One very important document in the sales process of a business is the confidential business report (CBR). This document is shared with potential buyers and should educate the buyers about the company, excite them about the investment opportunity and move the transaction forward by providing buyers important information about the business. Professional advisors are experts on how to write the CBR and put the business for sale in a favorable light.

Another very crucial step in the sale of a business is an accurate valuation. Advisors provide the business valuation analysis which is needed by the seller to evaluate the reasonableness of a buyer´s potential offer. For instance, a seller may believe that the business is worth around €10 million, but based on an objective valuation, its M&A advisor may value it around €15 million, even before considering the value of synergies. Experienced advisors are specialists in the valuation of companies in accordance with international valuation methods which usually requires a lot of expertise and experience.

2. Bargaining Power

Private mid-market companies are less visible and receive less attention than publicly traded companies. This leads to fewer bids from investors. M&A advisors typically have the right business relationships, databases and the networks that they can utilize to identify financial and strategic buyers. A larger pool of potential buyers will result in a higher number of competing bids which creates a healthy competitive tension among buyers. Like supply and demand, a seller has more bargaining power when prospective buyers are competing with other bidders. An M&A advisor helps generating competition which will ultimately result in a higher acquisition premium for the business.

3. Credibility

A professional advisor also adds credibility to the sale of the business. Buyers know that the information provided to them are accurate, thorough and well-structured when an M&A advisor is involved. Professional investors often receive an enormous amount of investment opportunities, which they have to filter. Very often they will not even pursue an acquisition unless the business owner hires professional intermediaries. Professional buyers know from experience, that the whole sales process takes a significant amount of work and expertise. Dealing with M&A advisors gives them a strong feeling of confidence about the presented information, an efficient process of reviewing the opportunity and a higher chance of a successful closing.

4. Protection of the owners interest

Especially in the world of mid-market companies, the business is very often the „owners baby“. Selling can therefore be an emotional process. A professional advisor understands how to approach the business owners’ fears, answers questions and act as a middleman during negotiations with potential buyers. This is often crucial as direct negotiations between the parties can lead to a breakdown of the deal. Both sides will be under pressure at times and benefit from having a buffer that keeps the communication and the deal process on track. Experienced M&A advisors know how to handle investors during negotiations and know how to deal with tough and demanding buyers during due diligence.

Another important aspect is the protection of confidentiality. It is extremely difficult for a seller without a third-party advisor to go out to the entire market and keep their company sale confidential. M&A advisor know how to approach potential buyers without disclosing the identity of the seller. Every buyer should sign a non-disclosure agreement (NDA) before knowing anything about the company and its owner.

5. Reduction of workload

Most SMEs do not have a corporate development team. This means that those who are in charge of the sale of the company like the CEO, CFO or other executives, are also busy within their day jobs. However, the sale of a business requires an enormous amount of time and attention. If done without a third party advisor it would be inevitable that the responsible executives need to split their time between their daily tasks and the sales process. An M&A advisors can therefore augment a company’s internal resources.

Conclusion

The sale of the own company is likely to be the most important financial decision of a business owner. The primary reason sellers do not seek help from professional advisors is because of the perceived cost. However, when you look at the value provided by an M&A advisor during the sale process, that perception is proven inaccurate.

The study „Does Hiring M&A Advisers Matter for Private Sellers?“ provides empirical evidence that financial intermediaries improve M&A outcomes for private sellers, which are likely to lack deal-making experience and negotiating skills. Overall advisor-assisted private sellers receive an acquisition premium of 6–25% relative to their unassisted peers. Given the fact that mid-market advisors typically charge fees of 1-6% depending on the deal size, it is reasonable to conclude that experienced M&A advisors do add tangible value to a sales process.

Author:

Simon Fabsits, MSc

Dealbridge M&A Advisors Austria & Liechtenstein

Key Value Drivers of a DCF Analysis

What is business goodwill?

What is goodwill?

According to businessdictionary.com the word synergy is defined as „a state in which two or more things work together in a particularly fruitful way that produces an effect greater than the sum of their individual effects “. Synergies occur in many different settings. Biological organisms living in a collaborative state is called symbiosis, a championship winning sports team is said to have chemistry and a profitable company is said to have goodwill.

M&A experts agree that goodwill exists, but only a few agree on what it really is. Unlike machinery, real estate, cash or inventory, goodwill is something that cannot be touched or seen. Goodwill is an intangible asset and reflects the synergies among all assets that produce income. When buying or selling a business enterprise, the sale price is generally higher than the sum of its parts. Goodwill represents the value of the business that is above the value of the separately identifiable, tangible assets.

How to determine goodwill?

The value of the goodwill can be estimated using the methods of regular business valuation:

· Asset Approach
· Market Approach
· Income Approach

The outcome of this calculation should be the fair market value of the business. M&A professionals or accountants typically handle business goodwill by subtracting the fair market value of the company´s tangible assets from the total business value.

A company should list the value of goodwill on its balance sheet in case of an acquisition of another company for a price higher than the recorded value of assets. Generally accepted accounting principles suggest that business goodwill should never be amortized. Management is responsible for valuing business goodwill every year and determining if an adjustment is necessary.

Why is it important?

Even tough goodwill is intangible, it is important to assess its value to ensure that a business acquirer does not overpay, or a business seller does not receive less for his company than it is actually worth. According to a study conducted by KPMG back in 2010 with the title „Intangible Assets and Goodwill “, more than half of the purchasing price of a company is typically attributed to goodwill. Goodwill has a major value for the new business owner in case of a sale or acquisition because it reduces the risk that a business profitability will decrease after it changes the owner.

What creates goodwill?

The following factors are the key drivers of a company´s goodwill and should therefore be examined and improved by every business owner:

· Brand or trade name recognition
· Employee skills and experience
· Solid customer base
· Good relationsship to reliable suppliers
· Reputation
· Company website and domain name
· Licences, patents, copyrights, trademarks
· Contracts
· Customized databases and software tools
· Trade secrets
· Developed processes
· Managerial skills and talent
· etc…

Those factors are good examples of intangible assets that make up goodwill and constitute great value drivers of a company. Buyers are usually hesitant to pay too much for goodwill because those assets cannot be seen or felt directly. Every business owner should therefore put effort into articulating and promoting the goodwill of his/her business. This will likely result in a much higher company valuation.

Author:

Simon Fabsits, MSc

Dealbridge M&A Advisors Austria & Liechtenstein

How do M&A advisors create value?

Creating a simple business valuation with multiples

Introduction – Why should I use multiples?

Price is the paramount issue in any M&A transaction. Beyond anything else, it determines the amount of value that is transferred from the buyer in exchange for ownership of the company. While there are several established methods to estimate the price range of a company, M&A professionals gravitate toward discounted-cash-flow (DCF) analysis as the most accurate and flexible method for valuing companies. A DCF analysis, however, is only as accurate as the forecasts it relies on. Errors in estimating key factors such as a company’s growth rate or its weighted average cost of capital can lead to a distorted picture of a company´s fair value.

The market approach is one of the most common approaches to valuate a company. It is based on the principle of substitution and the premise that a rational investor will not pay a higher amount for a company than he would pay for a company with similar characteristics and utilities. As a result, application of the market approach usually includes the use of market multiples, calculated for comparable companies that are listed on stock markets or that have recently been sold or purchased.

Among M&A professionals, multiples are already an accepted tool. Almost 85% of equity research reports and more than 50% of all acquisition valuations are based on multiples. This approach is frequently used to translate the results of a DCF analysis into intuitive figures, in combination with those acknowledged methods to back them up or as an alternative to estimate the value of a company in an easier and faster way.

Besides the fact that multiple valuations can be completed faster and with fewer assumptions than complex valuation approaches, multiple valuation brings additional advantages:

1. Multiples are easy to understand and therefore simple to present to clients.

2. Trading multiples are regularly published and updated by financial newspapers, magazines and online platforms.

3. M&A professionals frequently communicate their beliefs about the value of firms in terms of multiples within their research reports.

4. The screening on multiples allows quick comparisons between firms, industries, and markets.

5. Multiples reflect the current mood of the market, since their attempt is to measure relative and not intrinsic value.

What are multiples?

A valuation multiple is an expression of market value of an asset relative to a key variable that is assumed to relate to that value. Multiples are therefore just standardized estimates of price and are created by dividing a measure of the company’s value by a measure of the company’s performance:

Creating a simple business valuation with multiples

How to do a business valuation with trading multiples!

1. Select comparable companies

The first step is to find comparable public companies. However, finding the right companies for the comparable set is challenging. Most analysts start by examining a company’s industry. A good way to do that is to use the Standard Industrial Classification (SIC) codes published by the US government. An alternative is to examine the key competitors of a company if they are listed in their annual report. Besides the same industry, the comparable companies should also offer similar products or services, be of similar size and should have a similar growth rate. You should also have in mind that it is almost impossible to find comparables that will match all of those criteria perfectly, but the goal is to find at least five companies that are a good comparison.

2. Choose the multiple

There are three types of multiples:

· Enterprise value multiples look at the whole capital structure of a company (debt and equity). The metric in the denominator must be a measure of the company’s performance that is available to all investors (equity investors and debt lenders). Common EV multiples include:

· EV / EBITDA

· EV / EBIT

· EV / Sales

· EV / Unlevered free cash flow

· Equity value multiples look merely at the equity portion of the capital structure. The metric in the denominator must be a measure of the company’s performance that is available to the shareholders only. Common equity value multiples include:

· Price / Earnings

· Price / Book Value

· Industry specific multiples provides measures of a company´s performance within a various industry. Some companies, like start-ups generate too less income in order to apply multiples that are based on EBITDA or sales. Nevertheless, those „rule of thumb“ – multiples should be used with caution as they are not a very accurate way of measuring the fair value of a company and represent a special case when valuing companies. Some examples of industry specific multiples include:

· Mobile network operators: EV / number of customers

· Hotels – EV / Number of beds

· E-commerce companies – EV / Clicks or Page impressions

Based on the company and its industry, certain multiples are preferred above others.

However, EBITDA is the most common metric used by buyers to assess the starting point for a valuation. EBITDA provides several advantages compared to other measures of a company’s performance:

· Takes the profitability into account

· Independent from capital structure

· Independent from company specific tax policy

· Internationally comparable due to the elimination of different depreciation & amortization accounting principles.

To calculate EBITDA, take the net income from the company’s financial statements. As the acronym suggests, add back interest, taxes, depreciation and amortization to calculate the company’s EBITDA. Some adjustments need to be made in order to normalize EBITDA – e.g.: One-time expenses or revenues, overly aggressive or conservative application of an accounting policy, etc.

3. Calculate the multiple

The next step is the calculation of the implied valuation multiple for each comparable company selected. To do that, the following variables are needed:

· Share price of the stock as at a current date;

· Outstanding number of shares for each company;

· Cash in the companies

· Outstanding long term debt

· EBITDA

With those data the enterprise value is determined as follows: Enterprise value (EV) = stock price x number of shares outstanding – cash + debt. Now the implied valuation multiple can be calculated simply by: Enterprise Value / EBITDA.

Those multiples need to be aggregated into a single figure using a central statistic, such as

the mean, the median, the harmonic mean or the geometric mean.

4. Apply and adjust

The comparable multiple from public companies can now be applied to the company’s normalized EBITDA to receive an estimate of the enterprise value.

The final step is to adjust the EV to even possible strengths and weaknesses. In some cases it is even necessary to discount the EV by 25% – 50% to account for the difference in a premium paid for larger companies. Good Judgment and experience are needed to select the appropriate discount to the enterprise value.

Final thoughts

Even though a thorough conducted discounted-cash-flow analysis delivers the most accurate „fair value“ of a company, multiples also merits a place in any M&A professionals valuation tool kit. Yet multiples are often misunderstood and, even more often, misapplied. Indeed, the ability to make right decisions in a multiple valuation like choosing appropriate comparables, selecting multiples that makes sense or even several adjustments to variables like EBITDA or the final enterprise value distinguishes sophisticated M&A veterans from newcomers.

Author:

Simon Fabsits, MSc

Dealbridge M&A Advisors Austria & Liechtenstein

Mezzanine capital as a financing opportunity for SMEs

Mezzanine capital as a financing opportunity for SMEs

Categorization

The term “mezzanine” originates from architecture and describes a middle floor between two main floors. In corporate financing, mezzanine capital characterizes a hybrid type of financing that occupies a position between equity and debt. In the case of mezzanine financing, the company in question generally receives equity on the balance sheet, for which, however, neither influence nor residual rights are granted to the capital providers. Depending on its form and structure, mezzanine capital has either more equity or more debt character.

Mezzanine capital as a financing opportunity for SMEs

Aims & Functions

The aim of mezzanine capital is to close the financing gap between equity and debt. On the one hand, borrowing can generate a short-term cash inflow if additional debt capital can no longer be raised due to a lack of creditworthiness. On the other hand, mezzanine financing also serves to improve creditworthiness in the medium and long term, provided that the additional capital is classified as equity on the balance sheet.

Typically, mezzanine capital is used in capital-intensive industries to finance the growth of SMEs, such as acquisitions, the expansion of product lines, the establishment of new distribution channels or plant expansions. Other situations in which mezzanine financing is resorted to include restructurings, real estate projects or leveraged buy outs (LBOs) by private equity firms. An important prerequisite for raising mezzanine capital is a positive cash flow profile of the company so that the demands of the capital providers can be serviced.

Characteristics

The risk profile and cost of capital of mezzanine capital as a hybrid form of financing are between those of equity and debt. Mezzanine capital is less risky for the investor than equity capital due to its priority in the event of bankruptcy and the fact that interest payments can be planned more easily and is therefore associated with lower expected returns.

Mezzanine capital as a financing opportunity for SMEs

The structuring of mezzanine financing is manifold and individual. However, all forms of mezzanine capital have the following basic characteristics:

· Seniority to equity capital; Subordination to debt capital.

· Higher capital costs / returns compared to traditional debt capital

· The capital is provided for a limited period – usually six to ten years.

· The fee for the provision of mezzanine capital is typically reported as an operating expense on the investor’s side and is therefore tax-deductible (the exception to this is silent partnerships).

Why mezzanine capital is interesting for SMEs

The decisive advantage of financing via mezzanine capital is its equity-like character due to its subordination. As a rule, this financing alternative is regarded by banks as equity in the balance sheet analysis and rating process. This leads to an improvement in the equity ratio and keeps the credit lines free for borrowing – with improved credit terms due to the higher credit rating. At the same time, however, the raising of mezzanine capital does not lead to a dilution of shares or a restriction of the decision-making freedom of the current shareholders.

In general, the structuring scope for mezzanine capital is greater and less restricted by law than, for example, for equity capital. Accordingly, mezzanine financing can also be structured more flexibly, particularly with regard to the following parameters:

· Type of instrument

· Interest rate

· Term

· Termination option

· Repayment modalities

· Ranking in the capital structure

· Profit or loss arrangements

Entrepreneurs must of course also be aware that mezzanine capital is associated with higher costs than debt capital and that parts of the increase in the value of the company and profits may have to be passed on to the capital provider.

Because no collateral is provided for the raising of mezzanine capital and because the capital provider is highly dependent on the future cash flows of the company, longer and more complex due diligence procedures are required when raising capital. This usually leads to additional, pre-contractual costs.

Conclusion

Mezzanine capital is typically provided by private equity companies, dedicated mezzanine funds or banks and – depending on the structure – has either more equity or more debt character. Particularly for growth financing for SMEs, mezzanine capital represents a genuine alternative to classic forms of financing, as the advantages (but also disadvantages) of debt and equity are bundled in one instrument.

Author: Simon Fabsits, MSc
Dealbridge M&A Advisors Austria & Liechtenstein