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##### Subject 7. Target Company Valuation
There are three basic valuation techniques companies use in an M&A transaction to gauge a company's fair value.

Discounted Cash Flow Analysis

Discounted cash flow analysis is based on a pro forma forecast of the target firm's expected future free cash flows, discounted back to the present. This is very similar to the FCFF approach discussed in Study Session 10 and will not be discussed here.

• It's relatively easy to model changes in expected cash flows and cost structure of the target company.
• The estimate of intrinsic value based on future (not current) fundamentals is provided by the model.
• The model is easy to customize (e.g., change assumptions and estimates).

• It's difficult to apply the model if the growth of free cash flows is out of sync with the growth rate of profits. For example, the free cash flow may be negative for a fast-growing target firm due to large capital expenditures.
• Estimates of cash flows and earnings are highly subjective.
• Discount rate can change over time.
• The terminal value is sensitive to the growth rate and WACC.

Comparable Company Analysis

Steps:

1. Define a set of comparable companies. For example, they are in the same industry, have a similar size and capital structure.

2. Calculate various relative measures based on the current market prices of the comparable companies in the sample. The valuation can be based on:

• Enterprise multiples. Enterprise Value (EV) is the total company value minus the value of the cash and investments. Enterprise multiples include EV to free cash flow, EV to EBITDA, and EV to Sales. EV is discussed in Study Session 10.
• Equity multiple, such as P/E, P/B and P/Sales.

3. Calculate descriptive statistics, such as mean, median and range, for the relative measures chosen in step 2, and then apply these values to the target firm. If the valuation estimates are significantly different when using different metrics, the analyst must apply judgment to decide which estimates are the most accurate.

The value of the target firm is then equal to the multiple times the appropriate variable. For example, if P/E is used, then: target value = EPS x P/E.

4. Estimate a takeover premium. It is the amount by which the takeover price for each share of stock must exceed the current stock price in order to entice shareholders to relinquish control of the company to an acquirer.

TP = (DP - SP)/SP

TP: takeover premium; DP: deal price, SP: stock price.

The TP is derived from average premiums paid in recent takeovers of companies that are similar to the target firm.

The takeover price is the sum of estimated stock price and the takeover premium.

• It makes sense that similar assets should be valued on a similar basis.
• Easy to get required data.
• Estimates are derived from the market value rather than assumptions and estimates about the future.

• It is based on the market's valuation.
• It yields an estimate of fair stock price but not a fair takeover price. The analyst still needs to estimates a fair takeover premium.
• It is difficult to incorporate any specific plans for the target (e.g., merger synergies or changing capital structures).
• Historical data may be outdated or not appropriate for the target firm valuation.

Comparable Transaction Analysis

This is similar to the comparable company analysis, except that it all of the comparables are firms that have recently been taken over. The steps are similar: identify a set of recent takeover transactions, calculate various relative measures based on deal prices and then calculate the descriptive value metrics (mean, median and range). There is no need to calculate the takeover premium as it is already included in the price.

• There is no need to estimate takeover premium as it is derived from the comparable transaction.
• Estimates are derived from the market value rather than assumptions and estimates about the future.
• Using prices of recent transactions reduces the litigation risk for both companies' board of directors and managers regarding the merger transaction’s pricing.

• What if the values in recent transactions were not accurate?
• There may not be enough data (comparable transactions).
• It is difficult to incorporate any specific plans for the target (e.g., merger synergies or changing capital structures).

Learning Outcome Statements

g. compare the discounted cash flow, comparable company, and comparable transaction analyses for valuing a target company, including the advantages and disadvantages of each;

CFA® 2023 Level I Curriculum, Volume 3, Module 18