Now let's talk about what approaches or

what ways exist to implement validation.

Well, we know a lot about NPV from our corporate finance course.

And it's no wonder that this approach will be key here as well.

It's not the only one, but the major one, and it has some different faces here.

So I would put alternative, Approaches to validation.

I would start with the approach that is sort of preparatory.

This is the one that allows us,

because we know that the general logic goes like this.

If we identified all the value drivers, and if we not only identified them but

properly affixed some numbers to them, then we can proceed with the use of NPV or

whatever other technical approach to that.

So first, we have to somehow narrow down the ranges for value drivers.

And the first approach here will be the market position approach.

Now, we, to some extent, mocked at that before because it goes like this.

Let's start, I will give you just an example.

We start with the international economy, then we narrow that

down to national economy, then we go to the industry.

So that's the first path.

Now, in the industry, we go to strategy and

strategic, or sustainable, competitive advantage.

From this, we go to sales and costs.

Now, from here, we go to forecasts of,

let's say, earnings before interest and

taxes, and that will be the key value driver.

Now, what's the problem with that?

Because you can see, on this path,

you have to analyze too many things, events,

and trends that are, although linked to a problem, but

they are linked extremely indirectly, as the case of international economy.

So therefore, on this path we, at the first glance,

seems to be narrowing down our focus.

But at the same time, we see that our errors, they accumulate.

So this approach is good to have the big picture,

to just realize what we are doing, and not to say that this company is doing this.

if it's doing something else.

That might sound stupid, but sometimes, people who do not see the position of

the company in the market or the position of the target company in the market,

they may have some wrong judgements about the big picture.

Well, what's the alternative to that?

We said we can use historical data.

Now, the biggest problem with historical data is that there is

no assurance whatsoever that any trends that were observed in the past

will be the same trends in the future.

And you don't have to go to extreme cases, like you own the plant that makes

typewriters and that the world of computers is just about to start tomorrow.

And then you are having a huge problem.

Now, there may be some less drastic things that still are somewhat

hidden in historical data, and if we mis-observe some of these trends or

if we ignore something important, then we may arrive at a grossly wrong valuation.

Still, this is the thing that is always kept in mind.

Because it's not only us, let's say the people, the bidder,

who are interested in this valuation.

There are some other stakeholders,

maybe the valuation itself is performed by investment bankers who we hired.

But again, these people are interested in the fact that

this transaction takes place, and many other stakeholders may be interested, too.

So here, we talk about how we can narrow down the ranges of these value drivers.

Now, if we did that, now we can go to some more specified

approaches how to use them, and the next thing that is

extremely widely used is called spreadsheet approach.

So the idea is very simple, we take the company's

financial statements, and then from them,

we forecast components of cash flows and then we use this year.

That's it.

Now, what's good and what's bad about that?

Well, at the first glance, you see only the plusses.

So the clear plus is that you use financial statements.

And you know how to use them because you already took the accounting courses.

You took the course in corporate finance.

So this is something familiar to you.

Now another thing, which is also a plus,

that allows flexibility in, let's say, sensitivity analysis.

Just because you're just changing some of these numbers and

you arrive at some other value driver, so basically Excel does that for you.

Unfortunately, there are some minuses to that, too.

And the first minus is that the basis for

forecasts is obscured.

So this is the classic thing, and also another thing which is linked to that,

is that many numbers, And

from here the illusion of the right way.

So basically what I am saying is that you see only numbers.

And there are many of them.

These statements may have dozens of lines, and then you just work in behind these

lines, you stop seeing the key business of this company.

Remember, I give you an example in the previous episode about an airline,

and once I was involved in the evaluation of a small regional airline.

And I used the standard framework that was developed for

valuing airlines that included a spreadsheet of up to 1,500 lines.

And then, what I did, I said, well, wait a minute,

let's do it in a simple way, with use of this fuel cost and occupancy rate.

And that was the benchmark.

And all other refinements for that, they did not match.

Moreover, I found some mistakes in this model that dealt with 1500 lines.

It was a classic case of too many numbers,

they were obscuring what was going on with the company.

So although it seems, if not easy, but sort of natural,

you have to be kind of careful.

And I can tell that all people who do evaluation,

they always use some big picture cuff and pencil calculation.

They always help.

Now the next thing, which is close to that, and the one which we

are all sort of familiar, this is the so called formula approach.

Which is in essence the same, and this is like NPV or DCF, or

discounted cash flow valuation, whatever.

But here, instead of using spreadsheets models,

we use the formulas that we studied in corporate finance.

Remember all these annuities, perpetuities, growing perpetuities?

We will talk about in the next episode when I would

put up some of these formulas on the pages of this flip chart.

Now what are the big pluses of that?

The biggest plus is that this is explicit use, Of value drivers.

They're not very many.

And in the formula you see exactly.

And, for example, you know that cost of capital is an important value drivers,

and it always goes to formulas in a non-linear way.

So sometimes it can really influence the outcome very significantly.

However, EBIT, for example, goes linearly.

So if you make twice as much money, then the valuation will be just doubled.

What I mean, just, because sometimes if it would be non-linear,

then clearly, the effect could have been different.

Now, another thing is that by the same token

as a spreadsheet approach, here it facilitates,

Sensitivity, sensitivity analysis.

And another big thing that is close to express use

of value drivers is just link to core business.

You might remember, those of you who do corporate finance for your specialization,

that we talked about this triangle table.

We said that if you have some box first and

if you make some investments and then the box grows.

So we have the bigger base for investments next year.

So that is the most plain, vanilla approach to what the core business is.

We see that if it grows, it grows because of this and that.

Well, as always, there are some minuses here, too.

But these minuses, as far as I am concerned, they're sort of technical.

So here, you can kind of see that they are less

directly linked to financial statements.

I underline just less directly.

They clearly are linked, and

all the components of these value drivers are extracted

from these financial statements, plus the overall strategy of the company.

But this is not something that you put the cell on the Excel file.

Now, and as a result, that creates some potential problems.

But I would argue that this approach is,

as far as I'm concerned, sort of closer to the big picture.

And big picture here is important, and

you don't have to be really sort of thinking that spreadsheet

approach is more detailed and therefore more accurate.

These are the same, the facets of the same approach, but in seeing

the big picture and understanding what it is, the formula approach works better.

And the final thing that I would like to say a few words in this episode

is the famous investment banking approach, investment bankers approach.

That is completely different.

It does not deal with many numbers from these sheets.

It says, we take a comparable company, or

a comparable transaction, and we study that, applying the same ratios.

Let's say, if last month we had a transaction in the same industry, and

the company would cost $1 billion.

And the sales of this company was $100 million, so

we apply this factor of 10 of value to sales.

Whatever, this is a huge ratio, whatever.

And then if our company makes $50 million, we say,

well, the valuation benchmark will be half a billion dollars.

So that's what investment bankers do.

So we put a relation to

comparable, Companies or transactions.

But now you can see that, so what are the plusses of that?

The first plus is that it checks other methods, right?

And also that direct links with the likelihood of the transaction.

For example, if you believe that this is a great transaction, but

the market does not believe so, what is the use of going against the market?

You most likely will be crashed.

The biggest problem with that is finding,

The right comparison.

So the company that will be sort of similar to this target may be very

difficult to find, it may not exist, because all companies are different.

So the validity of your statement would be very much dependent on this.

But let me tell you something, that investment bankers,

these are the guys who watch huge amounts on investments of investors' money.

So these people, they sort of know better for

what companies and what amounts these guys are prepared to pay.

And therefore, it's extremely important because you always hire investment bankers

to implement this transaction.

And if you'd love to buy this company at this price,

they would say you know what, you're maybe right.

But right now, the market is not prepared, or it's not popular,

it's not trendy in the market, to engage in transactions of this kind.

For whatever reason.

One example would be if right now, people are willing to vote for

cash transactions, it may not be that high a likelihood of

engaging in the one that incorporates stocks.

You can say, well, this is not direct link to valuation, but indirectly,

it is and therefore, you can say, well,

now people are not willing to pay premier of these percentages for these companies.

They are sort of more conservative.

Now let's say, or this is the other period of time when people are crazy about and

they buy everything that's on the table.

So investment bankers' approach is really important, and

it's almost always used as yet

another approach to check other sort of numerical methods and

to understand whether you're in the ballpark or you're way off.

So here, I'm wrapping up this, and

we move to the overall approach of the free cash flow evaluation,

For which all the previous approaches they are part.

And then in the next episode we will put up, on this page of the flip chart,

some of the formulas that will look very familiar to us,

the students of corporate finance.

3.2. Alternative approaches to valuation

Mergers and Acquisitions – The Relentless Pursuit of Synergy

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