Financial criteria for acquisition evaluation

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Financial criteria for acquisition evaluation

Research conducted for TNT

Master Thesis International Economics & Business Anne M. Kiers

s1232266

Faculty of Economics Prof. Dr. C.G.M. Sterks

Prof. Dr. A. van Witteloostuijn 7 March 2006

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EXECUTIVE SUMMARY

TNT aims to apply a more straightforward and standardised approach in the evaluation of acquisition opportunities and wishes to do so through the determination of a set of financial criteria, which must be evaluated alongside more qualitative considerations, such as strategic and cultural fit. TNT has formulated an initial list of such financial criteria and now wishes to obtain objective advice on which financial criteria, or hurdle rates, must be employed in the assessment of acquisition opportunities, hence this research. On the basis of insights from theory and practice and taking into account specific considerations of TNT, a conclusion is drawn.

Valuation methods underlie the financial assessment of acquisitions and several of the financial criteria. The discounted cash flow (DCF) and economic profit valuations provide sound calculation methods for the value of a certain acquisition. Generally, first the stand-alone value is calculated and subsequently the various costs and benefits from synergies and the integration process are valued to attain the enterprise value. Additionally, multiples provide a means to calculate the value of a target firm on the basis of financial figures of comparable firms.

Through a review of literature on acquisition evaluation and interviews with experts at companies knowledgeable in the field of mergers and acquisitions (M&A), an initial conclusion can be drawn about which criteria should be employed for acquisition evaluation. A distinction can be made between criteria providing insight in the value and profitability of a certain project and criteria relating to broader issues, such as comparability to peers, which may be applied for cross-checking purposes. Taking into account the specific considerations of TNT Group M&A, a final conclusion is drawn about the appropriate list. The criteria are divided into hard and soft criteria, respective to the distinction described above. The hard criteria require a stricter application than the soft criteria, as the latter rather provide a cross-checking role, where deviations may be justified by underlying assumptions or case specific considerations. TNT is recommended to apply the following financial criteria for the assessment of acquisition opportunities.

Hard criteria:

1. The NPV of an acquisition must be positive.

2. The ROIC must exceed the relevant WACC within a certain period of time.

3. The IRR must exceed the relevant WACC plus a certain margin.

4. The profitability index must be larger than a predefined rate.

Soft criteria:

1. EPS must be accretive within a certain period of time.

2. The EV/EBITDA multiple in relation to the relevant trading multiple must not exceed a certain value.

3. The terminal value must not represent more than a certain proportion of total value.

The explicit value attached to these criteria is dependent on a great number of factors, which may vary per business case and over time. Rather than that this research provides a definite conclusion on the appropriate hurdle, the determination of the value of the criteria must be a decision of TNT Group M&A, based on strategic and internal considerations, as well as the experience and knowledge of the group.

As the leading rationale for any acquisition must be a strategic one, it must be prevented that through the formulation of a list of explicit criteria the focus lays too much on the fulfilment of these criteria. Financial criteria must play a guiding, but not exclusive role in acquisition evaluation.

It is crucial that the projections and valuations underlying these criteria are solid. Therefore, assumptions must be made carefully and rationally. Furthermore, additional research into the appropriate values of the hurdle rates, the determination of more qualitative criteria, and other valuation methods, such as Real options valuation, is recommended.

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PREFACE

The request of TNT to provide Group M&A with objective advice was a great challenge and opportunity for me.

Performing the research within TNT was for me the perfect way to combine theoretic knowledge with practical experiences. I especially enjoyed the interviews with TNT and other companies knowledgeable in the field of M&A. The practical insights I gained from this experience go far beyond what can be learned from textbooks.

I would like to thank everyone within TNT Group M&A for their enthusiastic support. Special thanks go to Reinout Croon, for the hours spend ‘playing’ with valuation models, teaching me the ins and outs, and for answering my never-ending list of questions. I have also been part of TNT Group FR&P, who have supported me in finishing my thesis.

At the faculty of Economics, Mr. Sterks and Mr. Van Witteloostuijn were my supervisors. Thank you for providing me with your advice and supporting me with your knowledge.

Dear mom and dad, thank you for supporting me throughout my studies and for giving me the opportunity to pursue and achieve my goals and ambitions.

Due to issues of confidentiality, certain parts of this research are not disclosed.

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TABLE OF CONTENTS

EXECUTIVE SUMMARY...1

PREFACE...3

TABLE OF CONTENTS...4

CHAPTER 1.INTRODUCTION AND METHODOLOGY...7

1.1 Introduction to TNT and TNT Group Mergers & Acquisitions...7

1.1.1 TNT ...7

1.1.2 The role of TNT Group M&A...7

1.2 From problem to research...8

1.2.1 Problem statement ...8

1.2.2 Research objectives ...8

1.3 Methodology ...9

1.3.1 Research framework ...9

1.3.2 Research design ... 10

1.3.3 Sampling design... 10

1.3.4 Data collection and analysis ... 10

1.4 Putting things into perspective ... 11

1.5 Structure... 12

CHAPTER 2.BACKGROUND:VALUATION METHODS... 13

2.1 Introduction... 13

2.2 Valuing a project with discounted cash flows... 13

2.2.1 The discounted cash flow method ... 13

2.2.2 Practical considerations of the DCF method... 14

2.2.3 The WACC as the appropriate discount rate ... 14

2.2.4 Terminal value ... 15

2.2.5 Sensitivity and scenario analysis... 15

2.3 Valuation in the case of acquisitions... 16

2.3.1 Value from acquisitions ... 16

2.3.2 Valuation in the case of acquisitions... 17

2.4 Valuation with Economic profit ... 19

2.5 Valuation with multiples ... 20

2.5.1 Enterprise value/ EBIT(D)A multiple... 21

2.5.2 Price-to-earnings ratio... 21

2.5.3 Other multiples ... 21

2.6 Conclusion... 22

CHAPTER 3.THEORY ON INVESTMENT EVALUATION... 23

3.2 Investment evaluation criteria... 23

3.2.1 Net present value and the profitability index ... 23

3.2.2 Internal rate of return ... 24

3.2.3 Payback period... 25

3.2.4 Return on invested capital ... 25

3.2.5 Earnings and earnings per share... 25

3.2.6 Market-to-book value... 26

3.2.7 Book rate of return ... 27

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3.2.8 Multiples for acquisition evaluation ... 27

CHAPTER 4.TNT AND HURDLE RATES... 29

CHAPTER 5.INVESTMENT EVALUATION IN PRACTICE... 30

5.2 Experts in the field... 30

5.3 Reactions to TNT’s hurdle rates ... 31

5.4 Other recommendations ... 31

5.4.1 Methods and criteria ... 31

5.4.1.1 Net present value ... 31

5.4.1.2 Valuation range... 31

5.4.1.3 Leveraged-buy-out valuation ... 32

5.4.1.4 Investment ratio... 32

5.4.2 Other considerations ... 32

CHAPTER 6.CRITERIA FOR ACQUISITION EVALUATION... 34

6.2 Discussion ... 34

6.2.1 Criteria reviewed positively ... 36

6.2.1.1 ROIC... 36

6.2.1.2 Internal rate of return ... 36

6.2.1.3 Net present value ... 37

6.2.2 Criteria reviewed neutrally... 37

6.2.2.1 Earning (per share)... 37

6.2.2.2 EV/EBITDA multiple ... 37

6.2.2.3 Terminal value in relation to total value... 37

6.2.2.4 Profitability index... 38

6.2.3 Criteria reviewed negatively... 38

6.2.3.1 Free cash flows ... 38

6.2.3.2 Payback period... 38

6.2.3.3 Payout of synergies ... 39

6.2.3.4 Market-to-book value... 39

6.2.3.5 Book rate of return ... 39

6.2.4 Preliminary conclusion... 39

6.3 TNT specific issues... 40

6.4 Final conclusion of the criteria for acquisition evaluation... 40

6.4.1 Criteria reviewed positively ... 40

6.4.2 Criteria reviewed neutrally... 40

6.4.2.1 Earnings (per share) ... 40

6.4.2.2 EV/EBITDA multiple ... 41

6.4.2.3 Terminal value in relation to total value... 41

6.4.2.4 Profitability index... 41

6.4.3 Criteria reviewed negatively... 41

6.4.4 Composition of the final list of criteria ... 42

6.5 Determination of hurdle rates ... 43

6.6 Other considerations in the light of acquisition evaluation ... 44

6.6.1 General considerations ... 44

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6.6.1.1 Strategic rationale ... 44

6.6.1.2 Importance of assumptions... 44

6.6.1.3 More than two options: flexibility... 44

6.6.1.4 Multiples other than EBITDA ... 45

6.6.1.5 Adjusted criteria... 45

6.6.1.6 Valuation range... 45

6.6.2 TNT specific considerations ... 45

6.6.2.1 Interaction between the purchase consideration and the hurdle rates... 45

6.6.2.2 Prioritisation among hurdle rates ... 45

6.6.2.3 Choice between “identical” opportunities ... 45

6.6.2.4 Short term expectations ... 46

6.6.2.5 Flexibility of hurdle rates ... 46

6.6.2.6 Credit rating ... 46

CHAPTER 7.CONCLUSION &RECOMMENDATIONS... 47

7.2 Recommendations ... 48

7.2.1 Recommendations to TNT ... 48

7.2.2 Recommendations for further research... 49

REFERENCES... 50

INDEX OF FIGURES AND TABLES... 52

INDEX OF FORMULAS... 53

INDEX OF APPENDICES... 54

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Chapter 1. INTRODUCTION AND METHODOLOGY

1.1 Introduction to TNT and TNT Group Mergers & Acquisitions

1.1.1 TNT

With its origins in the Dutch Royal PTT Post and the Australian TNT, TNT has developed into a global player, providing mail, express, and logistics services. Early 2005, TNT became the common brand name for all divisions of TNT, only leaving Royal TPG Post to adopt the name in the course of 2006.

On 6 December 2005, following a strategic review of its businesses and performance, TNT announced to focus its strategy on delivery network business. Three major grounds underlie this decision: TNT finds network businesses attractive, TNT excels in networks, and TNT can strengthen its mail and express networks as they are complementary (TNT Analyst meeting presentation, 6 December 2005). TNT therefore exits most of its logistics businesses and aims to strengthen its position in mail, express and freight management (TNT Press release, 6 December 2005).

Royal TPG Post collects, sorts and distributes mail across the Netherlands and beyond. With the liberalisation of the European mail market in mind, TPG Post continuously expands its network within Europe (TNT Annual report, 2004). European Mail Networks, one of the mail business lines, especially drives growth in this division (TNT Analyst meeting presentation, 6 December 2005). TNT Express provides business-to-business express delivery services. It draws on an extensive road and air network, especially strong in Europe and Asia. Freight management builds on TNT’s networks, and, although initially falling under the logistics division, is therefore retained as one of the businesses of TNT.

The sharpened strategic focus evolves from the strategy as formulated in 2004, in which TNT expresses three growth goals: accelerating growth in China, building on the leadership position of TPG Post in the postal industry, and expanding the business portfolio to include freight forwarding (TNT Mergers & Acquisitions framework, 2005).

1.1.2 The role of TNT Group M&A

TNT’s strategy and aim for growth leads to the need of acquisitions in its industries from a strategic perspective. The recent acquisitions of TG+ in Spain and of Hoao in China represent important steps in the pursuing of the focussed strategy in the field of mergers and acquisitions (M&A). As TNT aims to improve business performance through sharing of best practices, a framework for M&A has been developed. The framework clarifies the procedures for M&A, as well as the role of TNT Group M&A¹ and intents to facilitate and improve value creation through M&A activities.

The various businesses within TNT each determine an M&A strategy in line with TNT’s and their own, business- specific, strategies. TNT Group M&A takes a role in the process as soon as a certain initiative for an acquisition becomes more specific². It adopts a central position in the investigation phase and throughout the subsequent stages of the process. TNT Group M&A directly reports to the Board of Management (BoM) and the BoM (together with the Supervisory Board in the case of larger acquisitions) takes the final decision on the approval of acquisitions based on considerations of strategy, value and impact.

1 TNT Group M&A is the department leading all M&A activities of TNT.

2 Appendix A describes the M&A procedures within TNT and the role of TNT Group M&A.

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1.2 From problem to research

1.2.1 Problem statement

TNT Group M&A receives all acquisition proposals from the various businesses of TNT. TNT wants to apply a more straightforward and standardised approach to the evaluation of such proposals. The formalising of the process has taken the form of the TNT M&A framework. TNT wants to further develop the process by formulating a set of criteria to reach consistency in the evaluation of acquisition proposals. These criteria must be based on key financial figures. Evaluation of the criteria occurs alongside strategic and other considerations, such as cultural fit.

In a brainstorm session, TNT Group M&A has developed a preliminary list of nine financials that it considers important for the evaluation of an acquisition. TNT Group M&A has drawn on its own experience and knowledge for the compilation of this list. Also, it has attached critical values to these financials, converting them into a set of hurdle rates that have to be met in order for the acquisition to be financially attractive. TNT now wishes to get objective advice about which financial hurdle rates should be employed in the evaluation of acquisition proposals.

1.2.2 Research objectives

The objective of this research is to provide TNT with advice about which financial hurdle rates should be applied in the evaluation process of acquisition opportunities. The objective is converted into the following research question, supported by several investigative questions.

Research Question

What financial hurdle rates should TNT employ in the evaluation of acquisition opportunities?

Investigative Questions

1. What financial hurdle rates has TNT Group M&A formulated and what is their rationale?

2. What are TNT Group M&A’s thoughts with respect to the use of financial hurdle rates in the process of acquisition evaluation in general?

3. What does theory say about investment evaluation?

4. How do other experts conduct acquisition evaluation in practice?

5. Which financial criteria should be applied in acquisition evaluation on the basis of literature, expert knowledge and the considerations of TNT Group M&A?

6. Which values should be attached to these financials?

7. What recommendations can be made to TNT?

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1.3 Methodology

1.3.1 Research framework

The stepwise process adopted for this research can be depicted in a research framework (figure 1.1).

Figure 1.1: Research framework

Background valuation methods

Investment evaluation in

theory (IQ 3)

Recommendations to TNT

(IQ 7) Requirements

and considerations of

TNT (IQ 2)

Criteria to be applied in acquisition evaluation

(IQ 5)

Values to be attached to the

criteria

(IQ 6) Hurdle rates

developed by TNT Group M&A

(IQ 1)

Investment evaluation in

practice (IQ4)

Final list of hurdle rates for acquisition evaluation

“What financial hurdle rates should TNT employ in the valuation of acquisition opportunities?” is the research question that lies at the basis of this framework. The answer to this question is constructed from the answers on the investigative questions (IQ). Before the research is conducted, thorough understanding of valuation methods is required. This refers to the valuation of investment projects in general and of target companies specifically. Such valuation methods provide insight in the entire process of acquisition evaluation and underlie several of the possible hurdle rates.

Three pillars form the basis of this research: The theory on investment evaluation, the hurdle rates that TNT Group M&A has developed for evaluation of acquisitions and the methods applied in practice by other companies when assessing acquisition opportunities. These investigative pillars guide the decision about which financial criteria should be applied in the process of acquisition evaluation.

Apart from this, TNT Group M&A has certain demands and expectations from financial criteria in general and more specific from the use of a set of hurdle rates in the evaluation process. The list of criteria formed on the basis of the three pillars is assessed along these demands and expectations, tailoring the final list to TNT.

Subsequently, certain values can be attached to the criteria, creating a set of hurdle rates. The research concludes with the recommendations to TNT based on each of the previous steps in the research framework.

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1.3.2 Research design

Departing from a clear research question, this research is called formal. For the examination of theory on investment evaluation a literature study is performed. This study is descriptive and qualitative. The investigation of TNT’s views and thoughts and the analysis of those of other experts in the field of M&A is based on communicative methods of data collection. Again, it is descriptive and qualitative. The development of a final set of financial criteria and the determination of critical values is based on a theoretic literature study as well as on the results from the interviews.

1.3.3 Sampling design

As said before, the research consists of a literature review and of interviews with TNT and experts at other companies. The experts from other companies, which will be referred to as experts from this point on, are selected based on a judgmental non-probability sample. TNT Group M&A provided a list of companies and contact persons that they judged to have considerable knowledge in the field. These experts had a relationship with TNT Group M&A members from a business perspective. Furthermore, I drew on personal contacts for the interviews, again based on judgment on who is knowledgeable in M&A. I subsequently contacted each of the experts with the request whether they could answer several questions about acquisition evaluation practices in general, the practices they employ, and the TNT hurdle rates.

1.3.4 Data collection and analysis

For the purpose of this research, various information sources were consulted:

• academic textbooks,

• library of the Faculty of Economics in Groningen: academic articles,

• the internet: academic articles and other publications,

• the TNT Group M&A intranet and the TNT website,

• primary data from interviews with TNT Group M&A members, and

• primary data from interviews with experts in the field of M&A at other companies.

The data analysis is qualitative and non-statistical. At the basis of the research lies the preliminary list of nine hurdle rates expressed by TNT Group M&A. After having received this list, accompanied with a very short explanation of the criteria, the research was started with an assessment of the theory on acquisition evaluation. This consisted of a literature research.

A group discussion was subsequently organised with the members of TNT Group M&A. Throughout this session TNT’s underlying rationale of the criteria on the preliminary list was discussed and the group expressed their more general expectations and demands with regard to hurdle rates and their application in the acquisition evaluation process. Throughout the research process, there has been much interaction with each of the group members, also with regard to the more theoretical basis of this research.

The investigation of investment evaluation in practice was performed through interviews with experts with other companies in the field of M&A. The experts were contacted by telephone or email and were asked whether they could respond to several questions by means of an interview.

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The following companies provided a reaction:

• Akzo Nobel,

• Ernst & Young,

• Goldman Sachs,

• ING,

• JP Morgan,

• Kempen & Co,

• McKinsey & Company,

• Merrill Lynch,

• Philips, and

• Shell.

The interviews all took place via telephone, via email or at the company office of the experts. Summaries were prepared from each interview (appendix F).

The application of this data collection method entails the risk of a non-response error. Indeed, two contacted experts did not provide a reaction. The method also entails a response error. Even though the same agenda was used in each interview, the interviews proceeded differently, due to specific expertise of the person and due to time constraints. The focus in all of the interviews lay more on criteria applied in the evaluation process rather than on the value attached to them. Also, the actual hurdles TNT had expressed are confidential to TNT and therefore could not be revealed to all experts. Confidentiality issues played a role in general, as companies do not always give full disclosure of the practices they apply.

The three pillars of this research lead to an initial conclusion on the appropriate list of criteria. This list is subsequently tailored to the expectations and demands of TNT and a conclusion on the actual hurdles is formulated. This leads to the final recommendations to TNT.

1.4 Putting things into perspective

The hurdle rate approach to acquisition evaluation solely focuses on financials. This research aims for the same financial focus. In the actual valuation process of an acquisition, financials are generally the key ingredients.

However, the decision as to whether an acquisition should be pursued must under no circumstances be based on financial criteria alone. The principal consideration of undertaking an acquisition is always a strategic one, based on the premise of creating value for the company and its stakeholders. For this research it is assumed that all acquisitions are undertaken out of strategic considerations.

Furthermore, in this report only 100% acquisitions are considered. It does not refer to acquisitions of stakes less than a 100%, joint ventures and the like. Also, it is assumed that in each acquisition synergies play an important role. The realisation of synergies may be difficult in reality however. This relates to integration procedures and best practices in the process following an acquisition, which is beyond the scope of this research

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1.5 Structure

The report is build up of several chapters, related to the research framework (figure 1.1). First of all, the background of valuation methods is described in detail in chapter 2, as it is essential to understand the valuation process before further research is presented. Even though the nine hurdle rates expressed by TNT form the starting point of this research, first the theory on investment evaluation will be discussed in chapter 3, as it is more convenient for the purpose of understanding.

In chapter 4 the nine hurdle rates of TNT and the rationale behind them will be elaborated upon. The more general demands and considerations of TNT Group M&A with regard to financial criteria and their application as hurdle rates are also discussed here. The third pillar, investment evaluation in practice, will be reviewed in chapter 5. At the hand of various interviews with experts in the field of M&A it is investigated what acquisition evaluation approaches prevail in practice and which considerations these experts have with regard to the hurdle rates of TNT.

In chapter 6, the insights from the previous chapters are consolidated to determine the appropriate criteria for TNT to adopt in the process of acquisition evaluation and a conclusion about the appropriate hurdle for the financial criteria is presented. The overall conclusion is specifically tailored to TNT and results in recommendations to TNT, presented in chapter 7. Throughout this report, several expressions are abbreviated.

Appendix A provides a list of the abbreviations and their full description.

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Chapter 2. B^ACKGROUND: VALUATION METHODS

2.1 Introduction

Valuation methods play a key role in the evaluation of investment opportunities. Since an acquisition is an investment, such methods are relevant for acquisition evaluation as well. There are various techniques to determine the value of a certain investment. Most techniques are based on future cash flows, as theory tells us (Brealey et al. 2001). A certain project is appealing because of the cash it generates. This cash may then be distributed to the shareholders and debt providers, or reinvested in the firm.

For the understanding of this research, insight in valuation methods is required. In practice, the Discounted cash flow (DCF) method is most commonly used, followed by Economic profit measures and valuation through multiples. In this chapter the DCF method is examined, its use for acquisition evaluation will be discussed and a little light will be shed on Economic profit measures. Furthermore, the application of multiples in the valuation of acquisition opportunities is described.

2.2 Valuing a project with discounted cash flows

2.2.1 The discounted cash flow method

When valuing an investment using the DCF method, one projects future cash flows and discounts them to attain their present value, the value of those cash flows today. The DCF method combines the Profit & Loss account (P&L) and Balance sheet. Since cash flows represent the core of value, the focus lies on the operating side of a project, computing the value regardless of the financial structure (a target structure is assumed) and items that are of non-operating nature³ (Koller et al. 2005). First, forecasts must be made and P&L and balance sheet composed accordingly. It is important that valuation occurs on the basis of market values, although this may be difficult to compute precisely. DCF calculations may slightly differ per company. In this research the approach TNT takes is adopted.

A DCF valuation is presented in table 2.1. The entire case example can be found in appendix C.

Table 2.1: Stand-alone discounted cash flow valuation of target company

Actual Actual Forecast Forecast Forecast Forecast Forecast TV Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10

1 2 3 4 5

EBIT 37 37 38 38 38 38 39 39

Taxes on EBIT -11 -11 -11.3 -11.3 -11 -11 -12 -12

NOPLAT 26 26 26 26 27 27 27 27

Depreciation & amortisation 5 6 7 7 8

Capex -9 -9 -10 -10 -10

Investment in working capital -3 0 0 0 0

Free cash flows 20 23 23 24 25 300

Discount rate (based on WACC of 9%) 0.92 0.84 0.77 0.71 0.65 0.65

Present value 18 19 18 17 16 195

Enterprise value 283

3 E.g. marketable securities or non-liquid investment (e.g. non-consolidated subsidiaries) (Koller et al. 2005).

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After forecasts have been made, the valuation process is as follows:

1. Earnings before interest and taxes (EBIT) is taken from the P&L. Taxes on EBIT are deducted to arrive at Net operating profit less adjusted taxes (NOPLAT). NOPLAT is thus a purely operating figure.

2. Depreciation and amortisation (from the P&L) are added back to NOPLAT, since they are non-cash items (but are included in EBIT).

3. Capital expenditure (capex: the investment in fixed assets) and Investment in working capital are subsequently deducted, as they represent actual cash flows, to arrive at Free cash flows (FCF). FCF are the true cash flows from operations, available to all debt and equity providers, and thus the core of value creation.

4. Terminal value (TV) is subsequently calculated. Under a steady state assumption⁴, NOPLAT of the last year of the explicit forecast period is used, assuming no incremental growth from that point onwards.

A steady state formula is applied for the calculation of terminal value⁵, dividing NOPLAT by the weighted average cost of capital (WACC)⁶.

5. All FCF and the terminal value are then discounted to project their present value. Since these cash flows are available to all investors, they must be discounted at the weighted rate of return for all investors, the WACC.

The sum of the present values is the total enterprise value, €283 in this example.

2.2.2 Practical considerations of the DCF method

The DCF method projects the cash flows generated from a certain investment and computes the value of those cash flows today. As said before, FCF are what matters, as these are the cash flows available for consumption.

The method enjoys great recognition and is considered straightforward and relatively simple in its application.

Naturally, there are some drawbacks.

First of all, it projects cash flows on a year-on-year basis, but gives little insight in a firm’s profitability in a certain year. FCF are largely influenced by investment in working capital and capex. It can not easily be monitored whether large investments actually lead to higher generated value in later years. Low FCF in a certain year may be the result of either bad operations, or simply large investments.

Another often heard critique is the DCF’s dependency on the projection of future cash flows and on the discount rate used. It is argued that these items are too subjective, meaning that the calculated enterprise value is only a rough estimation of actual value. To minimise the impact of this problem, projections must be based on carefully considered assumptions regarding the future as well as regarding the discount rate.

Sensitivity and scenario analyses may be helpful.

2.2.3 The WACC as the appropriate discount rate

The WACC, the weighted average cost of capital, is the weighted rate of return for the debt and equity providers of a company. Since FCF are available to all investors, the WACC is intuitively the appropriate discount rate. An important assumption is that the WACC is based on the targeted capital structure and that this capital structure must remain fairly constant over the investment’s forecasting period (Koller et al. 2005).

If this is not the case, other valuation models might be more appropriate.

What companies must be thoughtful of is the application of the appropriate WACC for the calculation of value.

A mistake made often is that companies use their own WACC to value a certain project, even though the project differs greatly in capital structure, risk and thus required rate of return. Keeping a stern view on this, a company’s WACC should only be applied if the investment is an exact duplicate of the company’s operations.

4 A company reaches a steady state when its growth, margins, reinvestment rate and WACC are constant (Koller et al. 2005).

5 Chapter 2.2.5 provides further insights in terminal value.

6 Chapter 2.2.3 provides further insights in the WACC.

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TNT uses a generally acknowledged formula for the WACC to determine the appropriate WACC of the target company⁷. This is commonly done on the basis of TNT Treasury estimates and/or estimates from external advisors that may be involved.

Formula 2.1: WACC (Source TNT Group M&A)

D E

(D+E) (D+E)}

WACC = rd * { } * (1-Tc) + re * {

Key to symbols:

D = Debt rd = Required rate of return on debt Tc = Corporate tax rate E = Equity re = Required rate of return on equity

2.2.4 Terminal value

The terminal value of a company is the present value of all cash flows generated beyond the explicit forecast period (Koller et al. 2005). Within the forecast period, the projections are made on a year-on-year basis, allowing for changes in growth, margins and other factors that drive value. After this period, a steady state approach is adopted. The forecast period must be long enough for the company to reach a steady state. The steady state is a situation in which the company grows at a steady rate and has a constant reinvestment rate (Koller et al. 2005). Accordingly, a terminal value is calculated. Various calculation methods for terminal value exist.

TNT assumes a situation beyond the forecasting period in which still enough value for the debt and equity holders is generated, meeting the requirements of WACC, but no incremental value is created. NOPLAT remains constant and the firm invests just enough to offset the depreciation. A perpetuity formula is applied for the calculation of terminal value (formula 2.2), in which the NOPLAT from the last year of the explicit forecast period is taken.

Formula 2.2: Terminal value (Source TNT Group M&A)

NOPLAT Terminal value = WACC

TNT usually applies a projection period of 10 years, assuming that this is a close approximation of the time needed to achieve the steady state situation and a still reasonably predictable time period. The terminal value thus refers to the total value created beyond this 10-year period.

2.2.5 Sensitivity and scenario analysis

Predicting future cash flows means dealing with uncertainty. One is not sure about what will happen, but one is possibly able to make projections about what can happen. The DCF method highly depends on the assumptions made concerning the future, such as growth and margins. Sensitivity analysis gives insight in how a change of an assumption influences the calculated value of an investment and verifies the robustness of the DCF, by changing the assumptions and investigating their impact on calculated value.

In sensitivity analysis, key inputs are changed only one at a time, whereas they are generally interlinked.

Scenario analysis manages this problem. Different scenarios can be projected on the basis of economic and industry conditions, potential of the company, or various financial situations (Koller et al. 2005). The essence, and at the same time the difficulty, of a scenario analysis is that it entails a complete valuation construction.

TNT generally uses sensitivity analysis to evaluate how results are influenced by changes in underlying values.

7 Appendix D describes the derivation of the WACC formula.

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2.3 Valuation in the case of acquisitions

2.3.1 Value from acquisitions

Acquisitions are undertaken for various reasons, generally led by strategic considerations. The acquisition may be part of an offensive or defensive move. A common motive for acquisitions is growth aspiration, especially where organic growth of the acquirer is limited. Underlying every acquisition must be the rationale of value creation. The value creation of an acquisition is depicted in figure 2.1.

Figure 2.1: Valuation waterfall (Source TNT M&A framework)

90

130

320 450

300

130

Stand-alone value of target company

Revenue synergies Cost synergies Integration &

transaction costs 110

Value including synergies & costs (Enterprise value)

Purchase consideration

Value created

This acquisition entails certain cost and revenue synergies, integration and transaction costs. Other benefits and costs may arise specific to each case. The valuation of the project focuses on the stand-alone value of the target company and on the values of cost and revenue synergies, transaction and integration costs and other possible costs and benefits from an acquisition.

TNT’s strategy leads it to acquire only companies within its own markets. Strategic considerations are most important. As these acquisitions take place in TNT’s own business, synergies almost always play a significant role. Throughout this research, synergies are incorporated in the valuation and evaluation of acquisitions. In reality, however, they may not always be achieved.

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2.3.2 Valuation in the case of acquisitions

The valuation of an acquisition should focus on each of the waterfall blocks of figure 2.1. The valuation methods are essentially the same as presented in chapter 2.2.1. The forecasts of the P&L and balance sheet and the subsequent valuation are presented in tables 2.2, 2.3 and 2.4 respectively, and thus refer to the target company after it has been acquired. The entire valuation process can be described in the following stepwise procedure:

1. Determine the stand-alone value of the target company, as described in appendix C. The stand-alone value incorporates any possible stand-alone improvements. Stand-alone improvements are improvements that can be achieved by the company on a stand-alone basis, regardless of the acquisition.

2. Determine the total value of projected synergies and costs from the transaction.

3. Compute a new P&L and balance sheet, in which synergies, costs, the (possibly changed) capital structure, and the purchase consideration are reflected. The same example as presented earlier is assumed (explained in appendix C). The P&L and the balance sheet have been adjusted as follows:

• an increase in revenue growth (compared to a steady 2%),

• an increase in capex in years 1 and 2 (compared to a steady 3%), and

• a decrease in cost of goods sold (COGS) from 60% to 55% of revenues.

4. Compute the enterprise value of the target company including these changes by discounting FCF and the terminal value. The stand-alone value of the target was €283, the value including synergies and costs is now €416.

Table 2.2: Post acquisition Profit & Loss accounts of target company

Actual Actual Forecast Forecast Forecast Forecast Forecast TV Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10

Revenues 290 299 305 317 333 350 360

Revenues growth 2% 4% 5% 5% 3%

COGS (55% of revenues) -175 -179 -168 -174 -183 -192 -198

SG&A -74 -78 -81 -84 -88 -93 -95

Personnel expenses (12% of revenues) -34 -36 -37 -38 -40 -42 -43

Other personnel expenses (0.5% of revenues) -2 -2 -2 -2 -2 -2 -2

Management fee (5% of revenues) -13 -13 -15 -16 -17 -17 -18

Housing expenses (5% of revenues) -13 -14 -15 -16 -17 -17 -18

Other operating expenses (3.5% of revenues) -10 -11 -11 -11 -12 -12 -13

Car expenses (0.5% of revenues) -1 -1 -2 -2 -2 -2 -2

EBITDA 41 42 56 59 62 65 67

Depreciation PP&E (20% of PP&E) -4 -5 -5 -6 -8 -9 -9

EBIT 37 37 51 52 53 56 58 58

Interest expense (5% of debt at beginning of year) -0.3 -0.3 -1.5 -1.0 -0.9 -0.7 -0.6

Profit before tax 37 37 50 51 52 55 57

Income tax (30% tax rate) -11 -11 -15 -15 -16 -17 -17

Net income 26 26 35 36 37 39 40

Key to symbols:

COGS: Cost of goods sold EBITDA: Earnings before interest, taxes, depreciation and amortisation PP&E: Property, plant & equipment EBIT: Earnings before interest and taxes

SG&A: Selling, general, and administrative expenses

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Table 2.3: Post acquisition balance sheets of target company

Actual Actual Opening balance Forecast Forecast Forecast Forecast Forecast Dec-04 Dec-05 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10

Operating cash (3% of revenues) 7 8 8 9 10 10 10 11

Inventories (0.6% of revenues) 2 2 2 2 2 2 2 2

Trade receivables (13% of revenues) 35 36 36 40 41 43 45 47

Other current operating assets (1% of revenues) 3 3 3 3 3 3 3 4

Current assets 47 49 49 54 56 59 62 63

Net PP&E 23 25 25 32 42 43 45 47

Capex as % of revenues 4% 5% 3% 3% 3%

Capital expenditures 12 16 10 10 11

Goodwill 6 6 286 286 286 286 286 286

Total assets 76 80 360 372 384 388 393 397

Trade payables (6% of revenues) 17 17 17 18 19 20 21 22

Other current operating liabilities (8% of revenues) 23 23 23 24 25 27 28 29

Current liabilities 40 40 40 43 44 47 49 50

Debt 27 30 30 20 19 14 12 9

Total equity 9 10 290 310 321 327 332 337

Total equity & liabilities 76 80 360 372 384 388 393 397

Table 2.4: Post acquisition DCF valuation of target company

1 2 3 4 5

EBIT 37 37 51 52 53 56 58 58

Taxes on EBIT -11 -11 -15 -16 -16 -17 -17 -17

NOPLAT 26 26 36 37 37 39 40 40

Depreciation & amortisation 5 6 8 9 9

Capex -12 -16 -10 -10 -11

Investment in working capital -2 0 -1 -1 0

Free cash flows 26 27 35 37 38 448

Present value 24 22 27 26 25 291

A purchase price must subsequently be determined. Usually a price between the stand-alone value and the enterprise value (post acquisition) is decided upon, meaning that the acquirer pays more than the stand-alone value, because synergies are created, but does not want to give away all of the synergies. For this example, a purchase consideration of €320 is assumed. The purchase consideration must be incorporated in the new balance sheet. This example assumes that the acquisition is all-equity financed. The equity value of the company is calculated by subtracting the debt (on the acquisition date) from the purchase consideration⁸. On the balance sheet equity is adjusted accordingly. In these calculations, the debt is solely used for balancing purposes. In reality, a target capital structure for the “new” company is assumed and part of the acquisition may thus be financed with debt.

The asset side of the balance sheet is brought back to equilibrium by adjusting goodwill (and if applicable newly allocated intangibles). Goodwill is the amount paid for a target company above the fair value of its book assets (Dobbs et al. 2005). In this simple case it is calculated as the purchase consideration minus net working capital and net PP&E. It is assumed that goodwill is not impaired⁹. The adjustments require the addition of an opening balance in the balance sheet, which is the first balance sheet of the acquired company.

8 The value of the acquired company is the total value of its operations plus the total market value of non-operating assets (e.g. excess cash). The market value of all debt, securities, minority interest and other claims that are superior to equity is subsequently subtracted to calculate the equity value. (Koller et al. 2005).

9 Chapter 3.2.5 provide more insight in goodwill and impairment.

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As becomes apparent, the purchase consideration does not have any direct effects on FCF. A higher price will therefore not affect calculated enterprise value. The waterfall figure (figure 2.1) makes the proportions between the purchase consideration and the value visible and provides insight in the total value created. As also explained above, it is rather logical that a purchase price higher than the enterprise value should not be considered. Unless certain strategic possibilities play a role, to which no hard values can be attached, offering such a price means that the company destroys value. As, theoretically, every strategic consideration must eventually appear in the financial figures and is therefore always incorporated in the DCF valuation, acquisition evaluation must first and foremost be based on the calculated enterprise value.

2.4 Valuation with Economic profit

A second method for valuation which is also based on cash flows is the Economic profit measure. Economic profit is the incremental profit over and above the required return of WACC. It measures the spread between the return on invested capital (ROIC) and the cost of capital and multiplies this by the amount of capital invested.

ROIC is calculated as NOPLAT divided by the invested capital at the end of the previous year (formula 2.3).

Economic profit may subsequently be calculated (formula 2.4).

Formula 2.3: ROIC (Source Koller et al. 2005)

NOPLATt

Invested capitalt-1

ROICt =

Formula 2.4: Economic Profit (Source Koller et al. 2005)

Economic Profit = Invested capital * (ROIC-WACC)

The calculations of economic profit provide greater insight in whether and how much value is created than the DCF. The calculated value is identical to the DCF calculation, as the same financials are used.

The following example shows the economic profit valuation. The example is based on the same company as used for the DCF calculations (the same forecasted post-acquisition P&L and balance sheet) and hence results in the same value. The calculations are presented in table 2.5.

Table 2.5: Post acquisition Economic profit valuation of target company

NOPLAT 26 26 36 37 37 39 40 40

Invested capital (at beginning of year) 36 320 330 339 342 344 346

WACC 9% 9% 9% 9% 9% 9% 9% 9%

Capital charge -3 -29 -30 -31 -31 -31 -31

Economic profit 23 7 7 7 8 9 9

Discounted economic profit 7 6 5 6 6

PV forecasting period 30

PV terminal value 66

Present value 96

Invested capital (at valuation date) 320

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The stepwise procedure is as follows:

1. Take NOPLAT, calculated as EBIT minus taxes on EBIT, identical to the DCF valuation.

2. Project invested capital: invested capital is the capital invested for operations, such as working capital, property plant & equipment (PP&E) and goodwill. It refers to the book value of capital invested at the end of the previous year¹⁰. This is by definition equal to the sum of debt and equity.

3. Calculate capital charge: capital charge represents the costs over invested capital and is calculated as the WACC times invested capital.

4. Compute economic profit: economic profit is calculated as NOPLAT minus the capital charge (the result is exactly the same as the application of formula 2.3 generates).

5. Discount each year’s economic profit. Use a discount rate as employed in the DCF valuation (based on the same WACC). The sum of each year’s economic profit is the present value over the forecasting period.

6. Compute terminal value: Under a steady state assumption, terminal value is calculated as the economic profit after the forecasting period (equal to last forecasted year’s economic profit), divided by WACC times the discount rate.

7. Calculate enterprise value: enterprise value is the sum of the present values of step 5 and 6 and the initial invested capital. The initial invested capital is the purchase consideration, €320 in this example.

Total enterprise value is thus €416.

Both based on free cash flows, Economic profit and DCF methods generate identical valuation results. Only the approach differs. The economic profit method provides better insights in when and how value is created, as it specifically relates ROIC to WACC. The DCF may be perceived as more straightforward. The DCF is most widely used in practice and enjoys better understanding within TNT.

2.5 Valuation with multiples

Investors and financial managers often make use of multiples in the valuation of acquisition opportunities.

Multiples are valuation ratios, derived from competitors or the industry, which are then multiplied by the relevant key financials from the target company to calculate its value.

A general problem with the application of multiples in the valuation process is that a comparison is made between a company’s or industry’s data and the specific financials of the target company. Such a comparison only makes sense if the subjects have similar prospects, facing similar growth rates, ROIC and WACC. Even though companies within an industry may have comparable costs of capital, they may differ greatly on growth rate or ROIC, reducing the reliability of this approach. As also holds for the other valuation methods, multiples must be based on forward looking data, multiples should go beyond capital structure (make use of e.g.

EBIT(D)A¹¹), and multiples must be adjusted for non-operating items (Koller et al. 2005).

Some advantages of multiples are the simplicity and usefulness in relative comparison (Suozzo et al. 2001).

Also, it is a tool often adopted by investors and might thus be relevant for a company to consider in the (e)valuation process. On the other hand multiples may be regarded as too simplistic and static. Also, the fact that they depend on many underlying variables may make comparison actually more difficult (Suozzo et al.

2001).

10 In this example: invested capital = net operating working capital + net PP&E + goodwill. Invested capital is by definition equal to the sum of debt and equity. Net operating working capital = operating cash + inventories + trade receivables + other current assets – other current liabilities – trade payables.

11 EBITDA: Earnings before interest, taxes, depreciation and amortisation.

EBITA: Earnings before interest, taxes and amortisation.