Tuesday, February 8, 2011

Bridge to Value

One graph I've seen which I thought was clever was a breakdown of change in EV. This brings together many other details I've learned about M&A, LBO's and transactions in general.

Previously, I mentioned a framework for PE deal success, but it is easy to cut into more detail if necessary and really define and put a mathematical value to "synergies".

For example: After a transaction, we've increased sales by 21%. How does that affect EV? Well on one hand, you've immediately realized a 21% increase in revenue. After you account for associated costs with that increase in revenue (ie. You've sold more widgets, but it still costs you money to make those widgets), what do your future growth prospects look like as a result of this new growth (ie. Should you trade at a higher multiple? Have you gone from "boring" to "exciting"? Or is it just general market conditions?)

Previously, you had:

Market Cap = $100
Shares outstanding = 100
Price per share = $1

Debt = $100 (@ 5%)
Excess Cash = 0

EV = $200

Revenue - $100
COGS - $40
GPM = $60

Op Ex - $20
EBITDA = $40

DA - $10
EBIT = $30

Interest = $5

Tax = 40%

NOPAT = $18
NI = $15


EPS = 15 cents

P/E = ($1/$0.15) = 6.67x

EV/EBITDA = ($200/$40) = 5.00x

Let's tell a story: The 21% increase comes from opening a new line of products. You are selling 10% more products by introducing a new product line and this new product line actually increases your revenue per unit (across the board) by 10% (110% x 110% = 121%). All margins are the same.

What should we do? Bring everything down to the EBITDA level:

Revenue - $121
COGS - $44 (10% more products at same costs)

GPM = $77

Op Ex - $22

EBITDA = $55

DA - $10
EBIT = $47

Interest = $5

Tax = 40%

NOPAT = $28.20
NI = $25.20

EPS = 25.20c

(Magic happens - Which we will explain shortly)

New Price per share = $1.80

Market Cap = $1.80 x 100 shares = $180
Debt = $100
EV = $280

P/E = ($1.80) / ($0.2520) = 7.14x
EV/EBITDA = ($280 / $55) = 5.09x

So a lot is going on. The price of the equity and the enterprise has changed, but how can we do a cross section such that we know exactly where all the value is being driven from?

How much of this value is because of leverage (hint, we didn't change amount of leverage)?
How much of this value is simply because we are operationally better?
How much of this value is because we have a "brighter future" (better growth prospects)?

Step 1: Value from leverage arbitrage:
No change = 0

Step 2: Value from "synergies":
Total EBITDA level changes: $40 to $55 or $15
At a multiple of 5.00x (previous multiple), value increased is $75

Step 3: Value from "Brighter future"
Brighter future (higher multiple) due to either market conditions or expected future growth:
$55 at 5.00x versus at 5.09x = $55 x (5.09 - 5.00x) = $5

Total value created: $75 + $5 = $80 (note total increase in value of EV / Market Cap)

Next step, look closer at Step 2:
Change of $40 to $55 is created by:
$21 in Revenue (Price +10%, Volume +10%)
$4 in COGS (Volume + 10%)
$2 in Opex (Volume +10%)

For a $21 increase in revenue, keeping margins constant we would have expected an increase of:
$8.4 in COGS (40% of revenue) and $4.2 in Opex (20% of revenue). COGS is lower by $4.4 and Opex is lower by $2.2 versus what is expected.

Note we mentioned we can sell products for 10% more across the board.
This created value for existing product base (at EBITDA level) of
$110 - $40 - $20 or $50 versus $40 creating $10 of additional EBITDA level value (makes sense, increase topline growth by 10% without changing expenses / sales volumes results in increase of EBITDA by 10% of revenue)

Also, selling an additional 10% at old price we would expect:
$10 (additional sales) - COGS ($4) - Opex ($2) or $4

But selling new products at new price: Gain $1 (similar to math shown above)

Total change in EBITDA: $10 + $4 + $1 = $15
At 5.00x
$55 or ($10 + $1) x 5.00x of EV is generated from selling at a higher price
$20 ($4 x 5.00x) of EV is generated from selling new products (higher volume)

Above is what the bridge would look like if a PE firm had 60% ownership and management had 40%.

Note, this framework is iterative and can be applied across multiple product lines to help do a break out and sum of the parts analysis for companies to see where value is hidden in undervalued divisions.

Also note that as an interesting aside, if you were actually to build out a proper DCF model of this (using some basic business assumptions holding margins constant etc.), your short term growth rate would have to be adjusted upwards in order to come to the same intrinsic valuation that would justify the higher multiple.


Megan Bingley said...

Don't ever change.

Joshua Wong said...

"You gotta love what you do, chief."

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