Andrew Greta's Business Development Blog

Here's another piece from the archives providing a basic primer on EVA (a performance metric that calculates the creation of shareholder wealth as opposed to accounting income). While the translation from GAAP accounting to the language of value creation can be tricky, EVA targets the heart of fundamental value creation which is the key to successful long-term sustainable business development deals.

Labels: Finance, Valuation

Discounted cash flow (or DCF) is one of the cornerstones of modern finance. The theory is simple. Discount a series of future cash flows at an interest rate that accounts for the risk-impacted time value of money and we can directly compare the net present value (or NPV) of multiple projects on an apples-to-apples basis regardless of variations or choppiness in their individual cash flow profiles.

C = Cash Flow
t = Time Period
r = Discount Rate

Used properly the NPV can provide objective and powerful insight into the projected dollar value created by an investment (as opposed to simply its percentage return) which can help corporate leaders make good value-creating (or destruction-avoiding) economic decisions. Used recklessly, “curve-fit”, bastardized DCF models spun up by I-bankers and corporate financiers alike have been used to justify all manner of wildly unrealistic valuations in the name of aggressive deal-making.

To see how it’s possible to corrupt such a seemingly pure financial principle, we need to dissect the equation and examine the primary variables to see how even small manipulations or faulty assumptions can yield wildly different NPVs based on the same underlying facts.

Drinking the Cash Flow Kool-Aid

Let’s say we’re considering buying business that makes Frammitz Valves and has the following historic cash flows:

Without digging into the business fundamentals, your average desktop finance jock sees a pretty substantial growth trajectory. Cash flows doubled between year 3 and 4, and had a more modest, but still impressive, 50% growth between year 4 and 5. Being a “responsible” finance practitioner, they might haircut that growth rate to 35%, forecast it out and voila! We get a chart that looks something like this:

Eagerly, they run off to report their findings to management and recommend paying up to $10,000 for the business and accompanying 5-year cash flows since that more than clears an assumed 20% cost of capital.

Unfortunately, what our hapless modeler failed to realize that while Frammitz Valves were a new and innovative product a few years ago, the market has been largely saturated and future revenues will likely slow considerably to and simply service the current demand at a maintenance level.

What looked like a positive NPV project at $10,000 ends up destroying over $5,000 of value because they failed to do the hard work it takes to understand the underlying business fundamentals.

WACCy Discount Rates

Theoretically speaking, the weighted average cost of capital (or WACC) represents the minimum return required by investors as a blend of both debt (interest payments) and equity (shareholder returns) financing. In practical terms, WACC is the “hurdle-rate” that informs investors whether an opportunity will provide adequate compensation for a given level of risk considering other investment alternatives available.

Because changes in WACC (or discount rate) dramatically affect the results of our DCF equation, it’s the subject of ridiculous shenanigans in the finance community. You can’t afford to pay $5,000 for those cash-flows at a 20% hurdle rate? Well, maybe those cash flows aren’t quite as risky as we thought. Let’s just trim that down to 18% and wow – suddenly we’re NPV positive! I’ve even seen discount rate “sensitivity” tables calculated out to the 100^th decimal place as if you can precision-bomb an anthill from lunar orbit.

At my alma mater, GE, WACCs were pegged at 14% corporate-wide, full stop. While maybe not theoretically rigorous from an academic perspective, the policy served a useful purpose by neutralizing the “creative finance” crowd and allowing apples-to-apples evaluations of opportunities based on a consistent metric across the board.

And truth be told, if you’re clearing a hurdle rate by mere millimeters and tweaking the dials by fractions of a hair to justify a razor-thin valuation, it’s probably time to kill the deal, move on, and look for an investment you can vault over with several feet to spare while hungover and wearing lead shoes.

Terminal Disease

In our Frammitz example above, we considered cash flows and NPV for a 5-year investment. But isn’t it reasonable to assume the business will survive longer? And if so, how do we take into account those future cash flows without extending out to an infinitely long Excel model?

One stupid-simple approach is to slap a “terminal value” on to the end of the forecast which is supposed to account for all future cash flows into eternity. One of the most widely abused and corrupted methods is the “growing perpetuity”.

According to this approach, the present value of an infinitely growing stream of cash is simply the initial cash flow divided by the difference between the discount rate and growth rate:

In other words, if I expect a $2,000 year-5 cash flow to grow at say 10%, by using by 20% discount rate, the value of that perpetuity is $20,000 ($2,000 / 0.10). Is that figure too low? No problem, just tweak the growth rate to 12% and holy explosive growth! I show $25,000 instead for a 20% bump in my valuation estimate. And who can argue? How the heck does anyone really know at what rate the business is going to grow at for eternity?

Which is the whole point of this folly. Businesses don’t operate forever (does anyone remember one time Dow Jones Industrial Average components Standard Rope & Twine Company or U.S. Leather?). Nor are cash flow growth rates consistent and predictable.

Reality Dose

DCFs can be an important addition to a valuation toolkit providing an objective viewpoint on true economic value creation – but only if used with reasonable care. Remember the basics:

• A DCF model is only as good as the cash flows forecast. Take some time and do the hard work to understand the business fundamentals before forecasting out historic growth rates like a blind chimpanzee with a crayon.
• Use a consistent WACC across projects. If you find yourself tweaking a discount rate to justify an investment, you’re better off looking for something more comfortably profitable at a reasonable hurdle.
• Avoid growing perpetuities in the terminal value calculation. One rule of thumb is that terminal values should never be more than 60% of total present value. Another method is to use an exit metric consistent with your entry philosophy and make a reasonable assumption about what price you could sell the business for in year 5.

Labels: Valuation

Valuation Overview:

One of the central questions of business development is “how much should I pay” for a business acquisition, partnership, asset, or piece of intellectual property. The answer isn’t something you can boil down to a one-size-fits-all computer model (a fact which keeps us BD professionals gainfully employed). But what’s always true is you’ll need to pay more than the stand-alone price (i.e. the current market cap for a public company, or the top bid in a competitive auction for a private one).

But if we pay more than the stand-alone value, how do we make a return on the deal? If it’s already “fairly” priced, where’s the upside? Since 70% of acquisitions end up destroying shareholder value, it’s clearly a question that CEO’s worldwide either don’t ask or just don’t understand. And I’m sure some of the others simply get lucky by playing the “greater fool” theory and re-selling their purchases to someone even more gullible or idiotic then themselves.

But if you believe that doing business is about more than rolling the dice on betting on random market outcomes, the real secret to generating positive investment returns is by operating an acquired business or asset in a way that’s more productive (faster, cheaper, stronger, or bigger) than anyone else in the market could and creating true economic value.

If you want to be one of the winners, a good valuation analysis should cover the following areas at a bare minimum:

1) Business Review

The first step to determining value is to understand the target business, what their fundamental drivers are and what the strategic fit as an acquisition or business partner really is (a good starting tool is the “business model napkin” as explained in an earlier post). Why are you uniquely situated to realize more value from the business than it currently generates or can be tapped by your competitors? This is your value hypothesis that gets tested and either confirmed or negated in the following steps.

2) Comparable Analysis:

One way of quickly gaining an appreciation for general valuation is the same one real estate appraisers rely on to value property – looking at the “comps”. While not a precise measure (due to variations between businesses and differences in how each buyer assesses economic value), this quick and dirty approach can give some idea of how the general market values companies and sectors to get an initial read. Appropriate metrics can vary by industries, but typically some combination of EBITDA (earnings before interest, taxes, depreciation, and amortization) and revenue multiples, along with price-to-book, and price-to-earnings are typical starting points to establish a reasonably robust range.

3) Financial Review:

Now it’s time to dig into the company financials, understand the ratios and revenue-expense trends to establish a baseline financial pro-forma model. Most rookie desktop analysis starts with the past 3-5 years of operating history and forecasts forward on an average trend line – and I’ve seen that approach accepted by execs as high as the CFO. The best financial analysts dig under the hood instead and ask the tough questions about current and future circumstances to develop a more robust approach? Is 2006 truly a banner year for truck manufacturing, or are buyers simply front-loading their orders ahead of changing diesel emissions laws? Are these high lease revenues sustainable for the next 5-years or do the contracts expire in 3-months?

4) Valuation Model:

Here’s where your value hypothesis gets integrated into your baseline pro-forma to determine the premium you can pay for an acquisition and still generate positive economic value. Are you consolidating back office operations and generating massive savings through headcount reductions? Or are you buying a ready-made distribution channel to boost revenues? A valuation model is only as good as the assumptions you make so be careful and make sure the synergies are grounded in reality and realizable. Output metrics can include return on equity (ROE), return on investment (ROI), and return on total capital (ROTC) over a reasonable investment horizon of 5-years or so. Discounted cash flow models (DCFs) and their ilk (IRR, NPV), can be useful as well, but be careful! It’s too easy to make small tweaks to a discount rate or perpetuity growth assumption and see wide (and unrealistic) swings in valuation. The rule of thumb is that if your terminal value is more than 60% of your total present value, go back to the drawing board.

5) Sensitivities:

Finally, once you’ve got a solid valuation model along with a good comparable analysis you should be able to start narrowing a reasonable valuation range. From here, stress test it by identifying the key assumptions that drive value and doing a worst-case scenario. Items like sales growth and synergy levels are good starting points, and a “recession” case isn’t a bad idea if your business is particularly impacted by the normal business cycle. Then be sure to articulate any non-quantifiable “special case” issues which might sway a decision. Does the acquisition look weak in isolation but prevent core business erosion as a defensive play? Is it a key piece of intellectual property or branding that will have spillover benefits to other areas of your business?

Walk away if the picture doesn’t work instead of force-fitting a bad, value destroying deal. There will be more opportunities along shortly, but don’t expect it to be easy pickings. Identifying and creating value takes hard work, creativity, and a willingness to make tough decisions. The low hanging fruit was eaten long ago and today’s nectar goes to those willing to search hard, be selective, and diligently execute truly unique value-creating ideas.

Labels: Business Development Basics, Valuation