###### Model Misspecification

Model specification involves selecting the independent variables to include in the regression and... **Read More**

Discounted cash flow analysis, comparable company analysis, and comparable transactions are valuation techniques used by companies to value companies’ mergers and acquisitions.

Discounted cash flow (DCF) analysis derives an estimated company’s estimated value by discounting the expected free cash flows to the present. Free cash flow is used in the analysis because it represents the cash available for investments. The first step of estimating free cash flows is creating a pro forma financial statement. An analyst will choose an appropriate time horizon for the first stage. She/he will then include only the years that have a high probability of generating accurate estimates of free cash flows for the company, which will later be discounted to their present value.

The analyst will then get the terminal value by estimating the expected second stage free cash flow at the end of the first stage. The terminal value will be discounted back to its present value. The estimated value of the company is calculated by adding the present value of the first stage expected free cash flow and the present value of the company’s terminal value.

- Expected changes in the cost structure and operating synergies can readily be modeled.
- The model provides an estimate of intrinsic value based on forecast fundamentals.
- Any changes in estimates and assumptions can be factored in by customizing and modifying the model.

- Applying unprofitable free cash flow within the first stage is difficult.
- There is a great degree of uncertainty when estimating free cash flow into perpetuity.
- Changes in discount rate estimates caused by capital market developments can affect acquisition estimates.
- The terminal value estimate can differ depending on which method was used.

When using this approach, an analyst will define a group of other companies similar to the target company. The group contains companies that are in the same industry as the target company or a related industry. The next step will be to compute various relative value measures based on the current market prices of the comparable companies in the sample. The value measures are often based on enterprise multiples. An enterprise value is the market value of equity and debt minus the value of investments and cash. The industry under observation determines the specific ratios an analyst will use. The mean, median, and range for the metrics selected are reviewed and applied to the corresponding estimates to get the target’s estimated company value.

Each metric is likely to produce its own distinct estimate of the target’s value. Analysts expect these values will converge to increase the confidence in the overall estimate. The acquisition value is calculated by estimating the takeover premium. The takeover premium is the difference between the estimated value or market price of a company and the actual price paid to acquire it. It is expressed as a percentage and is calculated as follows:

$$\text{PRM}=\frac{\text{DP}-\text{SP}}{\text{SP}}$$

Where:

\(\text{PRM}=\) Takeover premium.

\(\text{DP} =\) Deal price per share of the target company.

\(\text{SP} =\) Stock price of the target company.

Calculation of relevant takeover premium involves compiling a list of takeover premiums paid for companies like the target.

- It provides a reasonable approximation of the target company’s value about similar companies in the market.
- Required data is already available.
- Unlike the DCF method, the comparable company analysis method estimates of value are derived from the market.

- It is sensitive to market mispricing.
- The analysis could be inaccurate because it is difficult to factor in any specific plans for the target.
- The use of this method results in a market-estimated fair stock price for the target company.
- Premium data that is available may not be accurate or timely for the target company being evaluated.

This method uses details from past takeover transactions for comparable companies to estimate the target’s takeover value. Using this method, we start by collecting a sample of relevant takeover transactions. The sample should be limited to companies in the same industry as the target. Once the transactions have been identified, the analyst will look at the relative value multiples. Unlike the comparable company analysis, comparing the market against target multiples, comparable transaction analysis compares the multiplies paid to similar companies.

- The takeover premium does not need to be computed separately since it can directly be derived from comparable transactions.
- Takeover value estimates are derived from values recently established in the market.
- Litigation risk is reduced by using prices established through other recent transactions.

- There is a risk that past transaction values are inaccurate.
- There may be few comparable transactions to use in calculating the takeover value.
- The analysis may not be accurate because it is difficult for an analyst to incorporate any specific plans for the target in the analysis.

## Question

Comparable company analysis and comparable transaction analysis are similar in many ways. However, the key differentiator is

most likelythat:

- Comparable company analysis compares companies that are similar to the target while comparable transaction analysis does not.
- Comparable transaction analysis derives valuation from details of recent takeover transactions for comparable companies, while comparable company analysis use relative valuation metrics for similar companies.
- Comparable company analysis discounts free cash flows estimated with pro forma financial statements.
## Solution

The correct answer is B.Both methods differ on how the estimates are calculated.

A is incorrect.Both approaches select a sample that is similar to the target.

C is incorrect.This refers to discounted cash flow analysis.

Reading 18: Mergers and Acquisitions

*LOS 18 (g) Compare discounted cash flow, comparable company, and comparable transaction analyses for valuing a target company, including the advantages and disadvantages of each.*