FINANCE

Advanced Session

PREPARATION COMMITTEE 1
 AGENDA
1 • Mergers & Acquisitions: An Introduction

2 • Fundamental Valuation: DCF analysis

3 • Relative Valuation: Trading multiples

4 • Relative Valuation: Transaction multiples

5 • Risk and return basics

PREPARATION COMMITTEE 2
Mergers & Acquisitions
An Introduction

PREPARATION COMMITTEE 3
 Mergers v/s Acquisitions?
What is a merger? What is an acquisition?
A merger is a deal to unite two An acquisition is a corporate action in which a
existing companies into one new company buys most, if not all, of the target
company. company's ownership stakes in order to assume
control of the target firm.

Company
A
Company
X
Company
X 🡪 Acquirer
C Company
Y 🡪 Target
X
Company
B
Company
Y

PREPARATION COMMITTEE 4
 Why do firms go for M&A?
● Horizontal integration : For greater market share & access to customers
Eg. Vodafone - Idea

● Vertical integration : moving up or down the value chain (acquiring your supplier or customer)
Eg. A steel company could acquire an iron-ore mining giant (backward integration)

● Technology & intellectual property :

Eg. Google’s acquisition of Motorola

● Financial reasons : tax savings; buying something cheap and selling it dearer

● Diversification
Eg. ITC’s acquisition of Savlon from Johnson & Johnson

● Eliminate competition/ Consolidation of industry

● Increase bargaining power

A larger combined entity will have more negotiating power than 2 smaller entities

PREPARATION COMMITTEE 5
 Types and Classifications of M&A
• Cash (reserves or through debt)
Method of Payment • Securities
• Combination of cash and securities
Attitude of • Hostile
Management • Friendly
• Accretive
Outcome of M&A
• Dilutive

Type Characteristic Example

Horizontal Merger Companies are in the same line of Walt Disney Company buys Lucasfilm
business, often competitors (Oct 2021)
Vertical Merger Companies are in the same line of Google acquired Motorola (June 2012)
production (e.g. Supplier-customer)
Conglomerate Merger Companies are in unrelated lines of Berkshire Hathaway acquires Lubrizol
business (2011)

PREPARATION COMMITTEE 6
 Identification of • Benchmark potential targets
target • Zero in on best fit

• Financial modelling (DCF)

Valuation of the
• Analyse similar precedent transactions, similar
target
Role of the companies (trading and transaction comps)

Investment Due diligence

• Comprehensive appraisal of a business undertaken by a
prospective buyer, especially to establish its assets &
liabilities and evaluate its commercial potential
Banker
• Negotiation with the other party
Ancillary
• Regulatory clearances – anti-trust, competition
responsibilities commission, other regulators

• Deal structure and design

Closing the deal
• Funding

PREPARATION COMMITTEE 7
 What is Valuation?
A valuation is the process of determining the current
worth of an asset or a company.

What is Types of Valuation Methodologies

valuation? Valuation methodologies are broadly ✔ Discounted Cash flow analysis
classified under two categories –
Absolute and Relative Valuation. The ✔ Comparable company analysis
different methods of valuation that are
commonly adopted have been shown ✔ Precedent transaction analysis
here.

PREPARATION COMMITTEE 8
DCF VALUATION

PREPARATION COMMITTEE 9
Introduction Free Cash Flows Cost of Capital Terminal Value

What is Discounted Cash Flow Valuation?

The discounted cash flow framework aims to work out Steps for conducting a DCF
the value of the firm today, based on projections of all Valuation
of the cash that it could make available to investors in
the future.

▪ Discounting becomes necessary due to the concept

of Time Value of Money. The value of a dollar
today is worth more than the value of the same
dollar tomorrow. Hence, expected cash flows of the 2.
1. Deducing
Calculation
future have to be brought to present terms. the Free
of Discount
Cash Flows
Rate
▪ This method is also known as “intrinsic
valuation”, as it derives from the fundamentals of
the firm.
3. Computing the
▪ The technique is widely used by companies, Terminal Value.
investment bankers and analysts to ascertain the
value of a firm during mergers and acquisitions.

PREPARATION COMMITTEE 10
 Introduction Free Cash Flows Cost of Capital Terminal Value Summary

Key Terminologies
What are Free Cash Flows?

Free cash flow represents the cash flow available for

distribution to all investors in the firm, i.e. equity-holders EBIT= Earnings Before Interest and Taxes
as well as debt-holders. Defined as: Sales – Cost of Goods Sold (COGS) – Operating
Expenses – Depreciation &Amortisation
• Most DCF analyses use 5 or 10-year projection periods.
Projecting cash flows over a longer period is inherently
more difficult.
CapEx = Capital Expenditure
Defined as (Property, Plant and Equipment + Intangible
Assets) at current period less (Property, Plant and
Equipment + Intangible Assets) at previous period.
How to compute Free Cash Flows to the Firm?
EBIT * (1 – Tax rate)
(+) Depreciation and Ammortization (D&A) Change in Net Working Capital
(-) Capital Expenditure (CapEx) Defined as (Current Assets – Current Liabilities) at current
period less (Current Assets – Current Liabilities) at previous
(-) Increases in Net Working Capital period
= Free Cash Flows

PREPARATION COMMITTEE 11
 Introduction Free Cash Flows Cost of Capital Terminal Value Summary

What is the Discount Rate?

The discount rate is a weighted-average of the
returns expected by the different classes of capital
providers (holders of both equity and debt). Thus,
it is also called the Weighted Average Cost of
Capital (WACC).

Key determinants of WACC

3.
2.Cost of
1.Cost of Equity Debt-Equiy
Debt
Ratio

Relative Proportions of Debt and Equity: The

costs of debt and equity are weighted by their
respective proportions in the total capital of the
firm.

PREPARATION COMMITTEE 12
Introduction Free Cash Flows Cost of Capital Terminal Value Summary

Calculation of Cost of equity

Equity-owners need to be compensated over and

above the risk-free rate of return because they Cost of Equity: The cost of equity can be calculated using the
are taking additional risk. This is known as the Capital-Asset Pricing Model.
market risk premium.

Also, different stocks have different level of risk-

measured by fluctuation in prices relative to Here, Rf is the risk-free rate, β represents the volatility of the
fluctuations in stock market (index). This is known company’s stock price in the capital markets, and (Rm – Rf) is
the market risk premium.
as beta.

So the total compensation for additional risk is

B(Rm – Rf) known as the equity risk premium.

Equity
Risk free Cost of
Risk
rate Equity
Premium

PREPARATION COMMITTEE 13
Introduction Free Cash Flows Cost of Capital Terminal Value Summary

Calculation of Cost of debt

Cost of Debt: It is the rate of interest that the company

pays on its borrowings.

The cost of debt used is the

The cost of debt is typically measured through long-term
treasury bond-rates. Since these Treasury bonds are
after-tax cost of debt.
issued by government, there is no risk of default. But the
bonds that are issued by company might have some risk,
so the debtholders need to be compensated for it. Hence,
A default premium is added to it.

Treasury Default
Cost of
bond Risk
debt
rate Premium

PREPARATION COMMITTEE 14
 Introduction Free Cash Flows Cost of Capital Terminal Value Summary

Why do we need Terminal Value? Calculation of Terminal Value

▪ Future cash flows cannot be estimated up to infinity. The terminal value (TV) is, thus, given by:

▪ Terminal Value is a proxy for cash flows beyond the

projection period, i.e., when the firm attains stable
growth.

What is Terminal Value? Here,

The terminal value (TV) captures the value of a
FCFn = FCF for the last 12 months of the
business beyond the projection period in a DCF analysis, projection period
and is the present value of all subsequent cash flows. g = Perpetuity growth rate (at which FCFs are
expected to grow forever)
WACC = Weighted-average cost of capital
How to compute this Terminal Value?
There exist various models for terminal value. The most
common model is the stable growth model, as shown in
the formula above. This model assumes that the
company’s cash flows will grow with a specific growth
rate defined as ‘g’, to perpetuity.

PREPARATION COMMITTEE 15
Introduction Free Cash Flows Cost of Capital Terminal Value Summary

Enterprise value

Present value of
cash flows in the
projection period

Present value of
the Terminal
Value

PREPARATION COMMITTEE 16
 Introduction Free Cash Flows Cost of Capital Terminal Value Summary

A Summary Example Advantages of DCF

The following table summarizes the process of DCF Valuation. ▪ Intrinsic valuation –
devoid of market bias
▪ Employs Time Value of
Money
▪ Highly suitable for
stable, low-growth
businesses
▪ Forward-looking
measure

Disadvantages of DCF
▪ Highly dependent on
estimates regarding
future cash flows and
growth rates
▪ Unsuitable for
high-growth firms and
start-ups
▪ Over-emphasis on
Terminal Value

PREPARATION COMMITTEE 17
 Difference between Enterprise Value and Firm Value

Value of the Firm = EV (Enterprise Value) + Non-operating assets = Equity Value + Net Debt

Firm value
PREPARATION COMMITTEE 18
RELATIVE
VALUATION

PREPARATION COMMITTEE 19
 COMPARABLE COMPANIES METHOD

● The economic rationale - law of one price: Identical assets should sell for the same price
● We value the given company using the current valuation of its peers/ comparable
companies.
● Characteristics of comparable companies:
● similar line of business
● similar size (can be judged in terms of market capitalisation/ revenue/ total assets)
● similar profile in terms of growth and risks are selected

PREPARATION COMMITTEE 20
 COMPARABLE COMPANIES METHOD

Select Comparable Companies

• Publicly traded companies that are similar to the
subject company; same or similar industry ● Advantages
● Provides reasonable estimate of the
target company’s value
● Readily available inputs
Calculate Relative Value Measures ● Estimates based on market’s value of
• Enterprise value multiples – EV/EBITDA, company attributes
EV/Sales or Price multiples – P/E, P/BV

● Disadvantages
● Sensitive to market mispricing
Apply Metrics to Target ● Sensitive to estimate of the takeover
• Judgment needed to select appropriate premium, and historical premiums may
metric
not be accurate to apply to subsequent
mergers

Estimate Takeover Price

• Takeover premium added

PREPARATION COMMITTEE 21
 Suppose an analyst has gathered the following information on the target company, the XYZ Company:
XYZ Company Average of Comparables
Earnings $10 million P/E of comparables 30 times
Cash flow $12 million P/CF of comparables 25 times
Book value of equity $50 million P/BV of comparables 2 times
Sales $100 million P/S of comparables 2.5 times
Example: P/E – Price/earnings, P/CF – Price/cash flow, P/BV – Price/ book value, P/S – Price/ sales

Comparable If the typical takeover premium is 20%, what is the XYZ Company’s value in a merger using the
comparable company approach?

Company Comparables’
Multiples
Estimated Stock
Value

Analysis Earnings
Cash flow
$10 million ×
$12 million ×
30
25
$300 million
$300 million
Book value of equity $50 million × 2 $100 million
Sales $100 million × 2.5 $250 million

Estimated takeover price of the XYZ Company using P/E multiple is = $300 million × 1.2 = $360 million.
Similarly, the value can be calculated using different multiples.

PREPARATION COMMITTEE 22
 COMPARABLE TRANSACTION METHOD

● With this technique of valuing a company for a merger or acquisition, you look at transactions that have
taken place in the industry that are similar to the transaction under consideration.
● Characteristics: Target of the old transaction has a similar business model, industry and financial
characteristics, client base to the company being evaluated. Also, it is preferable to compare
transactions that are close in size.
● Precedent transactions analysis is based on the premise that the value of a company can be estimated by
analyzing the prices paid by purchasers of similar companies.
● The purpose is similar to that of comparable companies analysis, except that examining prior
acquisitions can give a sense of the premium paid to gain control of the target (the "control premium").
Because of the control premium, transaction multiples are generally higher than trading multiples and
we do not add premium separately as in case of multiples method.

PREPARATION COMMITTEE 23
Comparable Transaction Analysis
Collect
Information on Calculate
Estimate Takeover
Recent Takeover Multiples for
Value Based on
Transactions of Comparable
Multiples
Comparable transactions
Companies

● Advantages
● Does not require specific estimation of a takeover premium
● Based on recent market transactions, so information is current and observed
● Disadvantages
● Depends on takeover transactions being correct valuations
● There may not be sufficient transactions to observe the valuations
● Does not include value of changes to be made in target

PREPARATION COMMITTEE 24
 Suppose an analyst has gathered the following information on the target company, the
MNO Company:
Average of Multiples of
MNO Company Comparable Transactions
Earnings $10 million P/E of past transactions 15 times
Cash flow $12 million P/CF of past transactions 20 times

Comparable Book value of equity

Sales
$50 million
$100 million
P/BV of past transactions
P/S of past transactions
5 times
3 times
Transaction Estimate the value of the MNO Company using the comparable transaction analysis, for various
Analysis multiples.

Comparables’
Transaction Multiples Estimated Stock
Value
Earnings $10 million × 15 $150 million
Cash flow $12 million × 20 $240 million
Book value of equity $50 million × 5 $250 million

Sales $100 million × 3 $300 million

PREPARATION COMMITTEE 25
 After all types of valuations are done, they are represented graphically through the football field
Football field gives details of the range of company valuation based on different valuation methods
dkjkakls
n

Valuation
summary

Football field

PREPARATION COMMITTEE 26
 ◼ The term price multiple based on fundamentals refers to a ratio that compares the share price with some sort of
fundamental monetary flow or value to allow evaluation of the relative worth of a company’s stock.
◼ If the ratio falls below a specified value, the shares are identified as candidates for purchase, and if the ratio
exceeds a specified value, the shares are identified as candidates for sale
◼ Earnings, BV, sales and CFs can be taken from past data ( making it trailing basis Price multiple) or from
forecasted fundamental values ( making it forward basis Price multiple)
P/S Price per share to SALES per share ratio

•Rationales: Sales always positive, P/S more stable than P/E, appropriate for many firms, explains stock returns
Price •Drawbacks: Sales ≠ Earnings & Cash flow, numerator & denominator not consistent, does not reflect cost
differences, can be distorted
Multiples P/CF Price per share to CASH FLOW per share ratio

•The measures of cash flow include free cash flow (FCF) and operating cash flow (OCF).
•Rationales: CF less easily manipulated, more stable than P/E, addresses quality of earnings issue, explains stock returns
•Drawbacks: can be distorted, FCFE more volatile and more frequently negative, increasingly managed by firms

P/E Price per share to EARNINGS per share ratio

•P/E of 20 means that an investor is willing to pay $20 for $1 of current earnings
•Generally a high P/E ratio means that investors are anticipating higher growth in the future
•Rationales: Driver of value, widely used, related to stock returns
•Drawbacks: Zero, negative or very small earnings, management discretion for earnings

PREPARATION COMMITTEE 27
 Enterprise Value (EV)
Understand EV- Cost of a takeover. EV is always positive, so takes care of negative earnings in P/E. Used when
companies differ in capital structure because unaffected by the capital structure
EV= Market capitalisation+ MV of P. Stock +MV of debt – Cash and cash equivalent
EV/ EBITDA
◦ Most common. EBITDA is a proxy for operating cash flow because it excludes depreciation and amortization.
EBITDA can be viewed as a source of funds to pay interest, dividends, and taxes. Because EBITDA is
calculated prior to payment to any of the company’s financial stakeholders, using it to estimate enterprise value
is logically appropriate. Since EBITDA is usually positive so it eliminates the negative earnings problem
associated with P/E
◦ Used in valuation of a company during mergers and acquisitions. Serves as a proxy for how long it would take
for an acquisition to earn enough to pay off its costs
EV/ Sales
◦ Gives an acquirer and idea of the cost of acquiring a company’s sales
◦ Of importance when valuing a company with negative EBITDA
PREPARATION COMMITTEE 28
RISK and RETURN

PREPARATION COMMITTEE 29
Risk and Return
● Most common measure of risk: Standard Deviation (sigma, σ) of possible returns
Total risk (σ) = systematic risk + unsystematic risk

● Systematic risk (market risk): Arises because of unpredictability in the market from
macro factors, economic instability, recession (external factors, uncontrollable) Cannot
be eliminated through diversification.
● Unsystematic risk: Arises because of firm-specific factors, peculiar to that security.
Can be reduced by diversification (increase number of negatively correlated securities
in the portfolio)
● Portfolio returns = , Portfolio risk =

● For 2 securities, the SD becomes =

30
Systematic risk (𝝱)
For well diversified portfolios, unsystematic risk disappears, Only the systematic risk
matters. How to measure this?
Beta ( 𝝱 ) denotes how much risky the security is if you
include it in your portfolio. It gives the contribution of that
particular security to the entire portfolio risk.

Beta of stock = covariance (return of stock, return on

market) divided by the variance of the market
Suppose 𝝱 is 1.75. It means, on average, when the market
rises by 1%, the stock price will rise by an extra 1.75%

31
Systematic risk (𝝱)
Case 1 (𝝱 = 1) Returns of stock vary proportionately
with the market returns. Stock has the same systematic
or unavoidable risk as the market as a whole.
Case 2 (𝝱 more than 1) Returns of the stock varies
more than proportionately with the market. The stock
has more systematic risk than the market and is an
aggressive investment. Adding this stock will increase
the portfolio risk but can also increase overall returns.
Case 3 (𝝱 less than 1) Stock has less systematic risk
than the market and is an defensive investment.
Investors use Beta to gauge how much incremental risk
a new stock adds to the portfolio. While a stock that
deviates very little from the market doesn’t add a lot of
risk to a portfolio, it also reduces scope for better
returns.

32
Going forward….more topics to brush up
● Basics of money and capital market economics
● Central Monetary policy
● Fixed Income securities
● Derivatives basics: Forwards, Futures, Options, hedging a portfolio

● Current affairs, recent M&As, recent IPOs (emphasize on Indian context)

● New budget FY25
● Focus on updated financial news of 2-3 sectors (both national and global)

33
Thank You

PREPARATION COMMITTEE 34