LBO Valuation Skills

A lot of people visit this blog and my website Corpfin.Net searching for information about leverage buyout (LBO) models, private equity models, and business valuation mechanics.  Both sites provide discussions of those topics and free access to easy- to- use, cloud-based financial models with which to do those analyses.

Unfortunately, many visitors move on from my sites without actually trying the models.  In my mind, reading about financial analysis techniques without actually doing an analysis is about as effective a learning method as reading a golf instruction book and never swinging a club.  In finance, like many other endeavors, the nuances and sensitivities of the game are best realized and understood through execution. 

One of the issues that may be at work for those not trying our models is the lack of a real-world corporate finance deal to analyze and compare one’s results to.  Accounting educators have for years addressed this issue by having students do practice sets (keeping the books for a fictional business through the completion of a one-month or longer accounting cycle) where the correct answers are known and the students mastery of the subject matter can be evaluated.  Unfortunately, as far as I know, no such curriculum is in place for financial forecasting and business valuation skills building. 

Which brings me to the point of this post: 

In the past I was involved as an advisor in the sale of small, privately owned insurance industry claims processing company.  After assisting the client in developing a five-year forecast for his firm, I used the Corpfin.Net LBO model to advise the client on pricing.  The client took my recommendations and (happily) realized that selling price.    

For those who would like to test their LBO analysis skills against an actual result, I propose that you sign-up for a free account on Corpfin.Net and e-mail me at tgf@corpfin.net, asking me to copy my insurance industry client’s forecast to your member directory (the forecast is titled “LBO Valuation Skills”).  Using that forecast, create an LBO valuation (about eight assumptions) and let me know the selling price you come up with.  If you would like a critique of your work, let me know and we will arrange to get together (for free) either on line or through e-mail to go through the details.

I am thinking about recognizing, in some way, those who either do a good job initially in estimating the selling price, or who demonstrate a basic understanding of the subject matter after a critique.  Please let me know if this idea of recognizing basic LBO valuation skills is appealing to you.    

Public Company Analysis and Valuation Model - Apple Inc.

Before I buy a company’s stock I like to make my own estimate of its long-term financial prospects and value. 

As part of my analysis I use a company’s historical financial statements (available on the web for free at sec.gov, Google Finance, Yahoo Finance and MSN Money) as a base to forecast earnings potential, cash flow and balance sheet position.

With the exception of sec.gov (which provides for download of historical data into a spreadsheet - no formulas - for selected public companies) the above sites do not provide a means to forecast future operations.  Because of this void, I developed a web-native public company analysis model for use in forecasting both future operations and estimating a company’s intrinsic (fundamental) value.

Let’s consider a financial forecast and intrinsic value analysis of Apple Inc. (AAPL) using our software.  Click here to access the forecast and valuation model.  Please feel free to change the forecast and valuation assumptions to create your personal Apple analysis - just remember to save your changes by clicking the Save button on the relevant pages.

(If you would like to save your work for future use, please sign up for our free public company analysis model membership before you begin your Apple analysis.  Aside from quantifying an individual company’s financial prospects, using the public company model is a great way to practice / learn financial forecasting and business valuation concepts that are applicable to both public and private businesses).

Financial Forecast

Apple’s historical income statements and balance sheets, plus a few assumptions, create the first draft of a five-year financial forecast. The first draft is principally a momentum forecast - a forecast based on my initial sales forecast and Apple’s historical income statement and balance sheet metrics. (This draft is provided “as is” and solely for demonstration purposes, not for trading purposes or advice).

Change any or all of the first draft assumptions to see how the changes impact future results. The output of the model consists of the primary historical and forecasted financial statements - annual income statements, including earnings per share (EPS); balance sheets; cash flow statements; and documentation detailing the key assumptions underlying the forecast.

Intrinsic Valuation

Once a working forecast for Apple is developed, you can perform an intrinsic valuation of the company by clicking on Step 5 of the forecast menu. The purpose of this module is to estimate the intrinsic or fundamental value of the company’s common stock - that is, the value a share should have, based on your financial forecast and valuation assumptions, not to be confused with its current market or trading value.

The intrinsic valuation component analyzes the value of a company based on the theoretical sale of the company to a buyer (at the beginning of year two of the five-year forecast) who re­capitalizes the company, owns it for four years and then sells it. That buyer realizes the operating results depicted in the financial forecast and receives all of its investment return from the future operations of the company.

The intrinsic value estimate is determined by calculating the pre-tax amount the buyer pays to the current equity owners (shareholders), in aggregate and per share, to buy the company. This type of analysis is particularly relevant to public company merger and acquisition transactions.

In order to generalize the purchase and sale transaction across a potentially infinite range of “deal” attributes, the intrinsic valuation analysis assumes that the buyer purchases the assets of the company and pays off all of its liabilities at the closing. Therefore, the owners (shareholders) of the public company receive a payment equal to the enterprise value of the company, less the amount of liabilities assumed and paid-off by the buyer.

The output of the intrinsic valuation component consists of the Estimated Intrinsic Valuation Summary; primary historical and forecasted financial statements -  annual income statements, balance sheets and cash flow statements -  showing the company’s financial performance before and after the pro forma sale by the owners; and documentation detailing the key assumptions underlying the analysis.

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The private company corporate finance models on my website (www.corpfin.net) are just as easy to use as this public company model. Our other models include Start-Up. Established and Early Stage business forecast models; and LBO Valuation, Private Equity Placement and Single-Year models.

In the future I will post analyses of other widely held public companies (e.g. Cisco, Yahoo!, Google, GE, Oracle, etc). If you sign up for our free public company analysis model membership you will be able to save your work on our server, and you will have access to additional public company financial analyses as they are published.

Please let me (tgf@corpfin.net) know your suggestions for other public companies to feature.

Strategic Buyer Purchase Valuation

Recently I was asked by a strategic buyer to estimate the purchase price of an acquisition candidate which was being sold through an auction run by an investment banking firm.  Based on the financial forecast (unrealistically optimistic) provided by the acquisition candidate, I used the Corpfin.Net LBO model to estimate the purchase price that private equity groups might submit as their first round bids.  The strategic buyer bid that estimated purchase price and made it into round-two of the auction.

As a result of qualifying for round-two, the strategic buyer was given access to the acquisition candidate's management and records and, based on that input and analysis, revised the round-one forecast to fit its (the strategic buyer's) outlook for the business.  The question at that point was: what should the strategic buyer's final bid be, knowing that its investment hurdle rate (required pretax rate of return); sources of acquisition funds; and debt recourse obligations are very different from those of the usual private equity buyer?     

To calculate the suggested round-two strategic buyer purchase price bid I used the Corpfin.Net LBO model and reset the required pretax rate of return target and the cost of those funds.  Specifically, I set the required rate of return on both equity and subordinated debt to equal the strategic buyer's hurdle rate; and set the current-pay interest rate on subordinated debt to 0%. 

The revised required rates of return assumptions reflect the reality that all strategic buyer acquisition funding in excess of senior bank debt is equity investment (due to use of corporate cash and/or debt with recourse provisions to accomplish the acquisition).   

The zero current-pay interest rate assumption on subordinated debt ensures that all cash generated by the acquired business is taxable and either reduces senior debt or is invested with a return equal to the senior debt interest rate.   This assumption eliminates the optimistic assumption in some analysis methods that cash generated by an acquisition's operations is reinvested at the (higher) investment hurdle rate.  

The round-two purchase price bid resulted in the strategic buyer being asked to participate in final sale negotiations.

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Please see the Corpfin.Net LBO model tutorial and our LBO model blog post for additional information about LBO valuation.

If you are a business looking to buy another business please consider using the Corpfin.Net LBO model in your purchase valuation.  If you have any questions about the model, please contact me at tgf@corpfin.net.

Public Company Analysis and Valuation Model - Apple Inc.

[Check out our new, free membership plan at Corpfin.Net]

Before I buy a company’s stock I like to make my own estimate of its long-term financial prospects and value. 

As part of my analysis I use a company’s historical financial statements (available on the web for free at sec.gov, Google Finance, Yahoo Finance and MSN Money) as a base to forecast earnings potential, cash flow and balance sheet position.

With the exception of sec.gov (which provides for download of historical data into a spreadsheet - no formulas - for selected public companies) the above sites do not provide a means to forecast future operations.  Because of this void, I developed a web-native public company analysis model for use in forecasting both future operations and estimating a company’s intrinsic (fundamental) value.

Let’s consider a financial forecast and intrinsic value analysis of Apple Inc. (AAPL) using our software.  Click here to access the forecast and valuation model.  Please feel free to change the forecast and valuation assumptions to create your personal Apple analysis - just remember to save your changes by clicking the Save button on the relevant pages.

(If you would like to save your work for future use, please sign up for our free public company analysis model membership before you begin your Apple analysis.  Aside from quantifying an individual company’s financial prospects, using the public company model is a great way to practice / learn financial forecasting and business valuation concepts that are applicable to both public and private businesses).

Financial Forecast

Apple’s historical income statements and balance sheets, plus a few assumptions, create the first draft of a five-year financial forecast. The first draft is principally a momentum forecast - a forecast based on my initial sales forecast and Apple’s historical income statement and balance sheet metrics. (This draft is provided “as is” and solely for demonstration purposes, not for trading purposes or advice).

Change any or all of the first draft assumptions to see how the changes impact future results. The output of the model consists of the primary historical and forecasted financial statements - annual income statements, including earnings per share (EPS); balance sheets; cash flow statements; and documentation detailing the key assumptions underlying the forecast.

Intrinsic Valuation

Once a working forecast for Apple is developed, you can perform an intrinsic valuation of the company by clicking on Step 5 of the forecast menu. The purpose of this module is to estimate the intrinsic or fundamental value of the company’s common stock - that is, the value a share should have, based on your financial forecast and valuation assumptions, not to be confused with its current market or trading value.

The intrinsic valuation component analyzes the value of a company based on the theoretical sale of the company to a buyer (at the beginning of year two of the five-year forecast) who re­capitalizes the company, owns it for four years and then sells it. That buyer realizes the operating results depicted in the financial forecast and receives all of its investment return from the future operations of the company.

The intrinsic value estimate is determined by calculating the pre-tax amount the buyer pays to the current equity owners (shareholders), in aggregate and per share, to buy the company. This type of analysis is particularly relevant to public company merger and acquisition transactions.

In order to generalize the purchase and sale transaction across a potentially infinite range of “deal” attributes, the intrinsic valuation analysis assumes that the buyer purchases the assets of the company and pays off all of its liabilities at the closing. Therefore, the owners (shareholders) of the public company receive a payment equal to the enterprise value of the company, less the amount of liabilities assumed and paid-off by the buyer.

The output of the intrinsic valuation component consists of the Estimated Intrinsic Valuation Summary; primary historical and forecasted financial statements -  annual income statements, balance sheets and cash flow statements -  showing the company’s financial performance before and after the pro forma sale by the owners; and documentation detailing the key assumptions underlying the analysis.

*****

The private company corporate finance models on my website (www.corpfin.net) are just as easy to use as this public company model. Our other models include Start-Up. Established and Early Stage business forecast models; and LBO Valuation, Private Equity Placement and Single-Year models.

In the future I will post analyses of other widely held public companies (e.g. Cisco, Yahoo!, Google, GE, Oracle, etc).  If you sign up for our free public company analysis model membership you will be able to save your work on our server, and you will have access to additional public company financial analyses as they are published.

Please let me (tgf@corpfin.net) know your suggestions for other public companies to feature.

Start-Up Financial Forecasting

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Introduction

Start-up and early stage businesses underperform or fail largely because they run out of money (cash and credit).  In some instances entrepreneurs start businesses that will never generate the profit margins needed to pay for committed fixed assets and recurring operating expenses; and sometimes they run out of money after starting-up because they do not completely explore the possible financial consequences of what appear to be very sound operating decisions.

For example, starting a new retail store and spending most available funds (cash and credit) on fixtures and space improvements can place a great strain on remaining funds to pay employees, suppliers, rent, etc; and to weather the period it takes to build a profitable clientele.  Likewise, growing too quickly relative to a start-up’s available funding - evidenced by too high an investment in accounts receivable and inventory - can cause the same financial strain.

In any case, it is tragic to see promising businesses die, causing family wealth to be decimated, because of financial issues and obstacles that could have been identified and possibly overcome before operating plans were executed.

Financial Forecasting

Businesses are dynamic financial systems.  Changes in financial viability arise because a set of actions (operating initiatives) create effects (balance sheets and cash flow) that, in turn, cause other effects.  A primary task of sound financial management is forecasting the possible financial effects of business initiatives before the initiatives are undertaken and, based on forecasted outcomes, rebalancing choices to best protect the sustainability of the business. 

Forecasted income statements, balance sheets and cash flow statements are the financial dashboards that can assist entrepreneurs in exploring the financial effects (the “what-ifs”) of business initiatives.  Financial managers need to have a feel for the financial effects of business decisions - how decisions are monetized into the dashboards, and insight into the impacts on the dashboards after the decisions are implemented. 

The goal is to identify the unintended financial consequences of planned business initiatives; and to develop action plans, in advance, to mitigate their negative effects.

Forecast Software

If you do not already have a method to produce forecasts for your start-up or early stage business, please consider Corpfin.Net’s  web-based, easy-to-use business financial planning software.  The software helps create five-year financial forecasts, and 12 monthly forecasts for each of the five forecast years. 

Our start-up forecast model is used by businesses that have no operating history.  Our early stage model is used by businesses that have very limited (i.e., less than 12 months) historical financial information. 

Because start-up and early stage businesses have little or no historical financial history, we use SIC code financial data to help create the first draft of a forecast.  The models create a first draft forecast using a few user sales assumptions and the financial metrics for businesses in the primary industry in which the start-up or early stage business expects to compete.  The user can modify that draft’s assumptions to customize the forecast to suit her unique business circumstances. 

The major benefits of using the SIC code data are first, it provides guidance with respect to the profitability and asset investments by mature businesses in the industry of interest; and second, it is a very quick and easy way to get the financial planning process started. 

Our five-year forecasts are documented with eleven reports which include:

• An S I C extract showing the financial data on which the first draft forecast is based.

• A narrative report that is organized in a manner to help present the key elements and results of the forecast to a third party.

• Multiple versions of forecast financial statements (income statements, balance sheets and cash flow statements) and forecast assumptions reports.

• Comprehensive financial metric reports.

Our single-year model is nested within the five-year forecast models and enables the user to create single year forecasts (i.e., split a single year's forecast into twelve (12) individual monthly forecasts) for any year's forecast.  Reports generated by this model are similar to those documenting the five-year forecast.

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The cost of one month’s use of our software is $50, a minor amount when you consider the potential benefits of identifying unintended financial consequences before a business initiative is implemented.  Please see www.corpfin.net for additional details.   

Analysis of Carl Icahn’s Bid to Acquire The Clorox Company

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On July 16, 2011 the Wall Street Journal published an article concerning Carl Icahn’s bid to acquire the outstanding common shares of The Clorox Company (CLX) for $76.50 per share.  With approximately 140 million shares outstanding (including Mr. Icahn’s current holdings), the bid values the equity of company at $10.710 billion.

I did a forecast of CLX’s future operations, assuming a 3.0% growth in revenues for fiscal years 2011 through 2014; and operating margins of 19.0% in 2011 and 19.8% for fiscal years 2012 through 2014.  

Given that forecast and other assumptions (see link below), I calculated a financial buyer’s estimated pretax rate-of-return resulting from buying CLX in a hypothetical asset purchase in which the CLX shareholders receive pretax proceeds of $76.50 per share.  My buyout analysis indicates that pretax return to be approximately 15%.   The return would be lower if the buyer were required to issue warrants to subordinated debt providers. 

If the financial buyer’s pretax rate-of-return objective were 25%, the estimated purchase price of the shares would be approximately $67.00.  Click here to access the reports related to this buyout analysis at Google Docs. The “Overview” narrative report describes the valuation method and results.

[Note:  If you sign in to Google Docs using your Google account information, Google Docs allows you to view, print and download the buyout analysis reports]

Buyout Analysis of American Eagle Outfitters (AEO)

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On 3/11/11 Bloomberg published an article commenting on the possible attractiveness of American Eagle Outfitters, Inc. (AEO) to private equity investors.

I did a quick LBO analysis of American Eagle assuming 3% annual sales growth; gross margin and operating earnings percents in line with history; and an EBITDA exit multiple of 10.0 four years after the purchase.

Assuming a private equity investor required a pretax rate of return of 25% and made an equity investment equal to 20% of the total purchase price, I forecast the net pretax proceeds to AEO shareholders in this scenario to be approximately $3.7 billion, or about 18% above the company’s current market cap of $3.13 billion as reported by Google Finance on 03/11/11.

Click here to access PDFs of the various buyout analysis reports at Google Docs.

[Note:  If you sign in to Google Docs using your Google account information, Google Docs allows you to view, print and download the buyout analysis reports]