Intro to Precedent Transactions
Precedent Transactions Analysis is essentially a Comparable Company Analysis except instead of using where your target company's peers are being value at by the market in real time you use your peers valuations during an M&A transaction. You are valuing your company by what other companies were willing to pay for your peers (their valuations at acquisition or merger). If you would like to learn more about how share based transactions occur, click the link below and visit out supplementary videos page.
Prior to beginning this tutorial, we advise that you first go through the Comparable Company Analysis. Click the button below to go to the Comparable Company Analysis, or scroll down to begin the Precedent Transactions Analysis Tutorial and Model.
Step 1 - determining Relevant Transactions
You are seeking transactions where the target company being acquired or merged with is a peer of the company you wish to value.
You determine a company as being comparable based on both financial and qualitative characteristics:
- Business & Industry: do your peers sell similar products?
- Geography: do your peers operate in similar geographic locations?
- Size: do your peers have similar market caps?
- Transaction Type: does the type of transaction make sense in regards to your company? ex. the transaction you selected happened because of a bankruptcy, but your company is not in any risk of bankruptcy, thus it is not relevant.
You have to make sure that the M&A transaction is still relevant and so timeliness is a huge factor, the closer to the present that the deal occurred the better. Try to limit yourself to last 5 years.
How to find transactions:
- SDC Platinum - the industry go to transaction database
- Merger Proxies - discussion on how they came up with the valuation will include transactions used for the valuation
- News - websites like DealBook and the WSJ publish news about recent M&A activity (a link to dealbook is included below)
- Equity Research Reports - will include significant transactions within the same industry
- 10-k's - will include sections on major transactions
STEP 2 - DETERMINING THE MULTIPLES TO MEASURE
Multiples are created by dividing a measure of the company's value, such as, Enterprise Value or Market Capital (typically use Price as it is simply Market Cap. divided by Shares Outstanding) by a measure of the company's performance, such as EBIT or Sales.
There are three types of multiples:
- Enterprise Value Multiples: these look at the whole capital structure of a company (its Debt and Equity) and place Enterprise Value in the numerator of the multiple. To create a enterprise multiple you must use a financial metric in the denominator that similarly is attributable to the full capital structure of the company, such as, EBITDA. The metric in the denominator must be a measure of the company's performance that are available to all investors and so must be prior to any distributions to investors such as, interest expense or preferred dividends. Some common EV multiples include:
- EV / EBITDA
- EV / EBIT
- EV / Sales
- EV / Unlevered Free Cash Flow
- Equity Value Multiples: these look merely at the equity portion of the capital structure and place Price in the numerator of the multiple. To create a equity value multiple you must use a financial metric in the denominator that similarly is attributable to simple the stockholders of the company, such as, Earnings per Share. The metric in the denominator must be a measure of the company's performance that are available to the shareholders and must be after any distributions to investors, such as, interest expense or preferred dividends. Some common Equity Value multiples include:
- Price / Earnings Per Share
- Price / Book Value Per Share
- Industry Specific Multiples: these multiples provide more accurate measures of a companies performance within their various industries. Some examples of industry specific multiples include;
- Oil & Gas - Total Reserves / Annual Production
- Retail - Sales / Total Square Footage
- Airline - Total Passenger Revenue / Available Seat miles
For Precedent Transactions because of the limited data available, it is most common to use the purchase Enterprise Value against the target's Sales, EBITDA, or EBIT as well as the Price to Earnings multiple (where price is the equity value paid for the target, and Earnings is Net Income of the Target).
STEP 3 - COLLECTING THE DATA
Once you have determined the multiples you will be using for your analysis, you must collect the data to create the metrics...note that the above sources of data were for SELECTING TRANSACTIONS, now you need to find the specific data regarding the individual transaction...transaction data from the databases will not be comprehensive and may be faulty, use the sources listed below!
Sources of Data:
- 10-k's - will include sections on major transactions
- Merger Proxies - will include all data about a specific public transaction
Follow the link below to search the SEC's database (EDGAR) for the company specific documents listed above.
STEP 4 - Spreading the Comps
Below you will find a very basic Precedent Transaction model for you to practice the three steps above.
The model derives the EV/Sales and EV/EBITDA multiples are derived for each transaction by dividing each target's respective Enterprise Value (as implied by the purchase equity value plus net debt) by its Sales and EBITDA values for that year. The P/E Multiple for each transaction is found by dividing Equity Value paid for each target by the target's Net Income in that year (an OVERSIMPLIFIED way of deriving Price-to-Earnings). The Min, 1st Quartile, Median, 3rd Quartile, and Max are derived for the transactions' P/E multiple, EV/Sales, and EV/EBITDA multiples.
You must note, that typically this step of the process is the longest, as creating the multiples for the individual companies means scrubbing and adjusting all of their financial metrics to be on an "apples to apples" basis. This is typically done company by company and the clean worksheet shown below is an oversimplified version of the phase when you compare against your target company.
A further discussion on how the implied share price for the company being valued is determined follows the model.
Now Simply go ahead and input the data into the cells with blue font (blue font is an indicator that the inputs are supposed to be changed), and continue reading!
The Implied Share Price
Above you inputted data available to everyone in the public and like magic the model spit out an implied share price range for your target company...well not quite.
The range being shown on the graph for the respective valuation multiples is being derived by taking the 1st Quartile, Median, and 3rd Quartile EV/Sales, EV/EBITDA, P/E multiples derived from the precedent transactions and multiplying them by the company you are valuing's financial performance metrics.
For example. Look at the 1st Quartile P/E multiple derived from the Precedent Transactions. Now multiply that number by the Net Income of the company you are valuing divided by the its Shares Outstanding (essentially Earnings Per Share). The result should be the bottom limit on the P/E's implied share price for the company you are valuing.
The calculation using the EV/Sales, and EV/EBITDA multiples required some more computation as its numerator is Enterprise value so simply multiplying one of the EV/EBITDA multiples by the company you are valuing's EBITDA or Sales, would result in the company's Enterprise Value. The Enterprise Value is the value of the firm available to all investors. To back into the Price per Share (value of the firm available only to Equity, or specifically common stockholders), you must subtract the company's Net Debt (Total Debt minus Cash & Equivalents) from the Enterprise Value. The resulting number is now equivalent to Equity Value, and when divided by the company's shares outstanding it results in its implied share price.
The Precedent Transactions implied price ranges provide an idea of where the company should be trading at (Price) or being valued at as a whole (Enterprise Value) based on what its peers were purchased for.
A very important concept about Precedent Transactions Analysis is that you have to understand that in a Merger or strategic Acquisition the purchase price will include a purchase premium. The idea is that in a strategic M&A deal their will be synergies from the deal that warrant valuing the target above its market implied value (this difference is called the purchase premium). So the valuations that result from Precedent Transactions should typically be higher than from other types of valuations.
Some pitfalls of the Precedent Comps include but are not limited to:
- it can be difficult to find true comparable transactions because data is limited and some companies that may fall into your peer group are not public (and their transaction data need not be filed), and/or your company is simply operating in a completely unique space.
- market conditions and sentiment at the time of the transaction may have affected the purchase valuation
Although, although you may feel like a master at Precedent Transactions Analysis, now that you've read the guide and actually filled in a model, you are not! Keep in mind that the above model is extremely simplified for the purpose of getting the concept across. You are certainly more prepared than any of your peers probably are, and hopefully have developed a working knowledge of how a precedent comps works. Finally note that the above model is merely a piece of what should be used when conducting any valuation. You should create full-blown operating model, with balance sheet, statement of cash flows, and income statement projected out as well, and audit each precedent transaction's financials individually. Please continue learning with our other models.