Accretion and Dilution
Hi guys, was hoping for your help for three questions please:
1) For an M&A deal financed with debt, cash and equity, if PE of buyer is less than PE of seller, how can the deal be accretive?
2) Also, just another quick q. If you have the PE multiple, would you multiply that to the Net Income of a company to get the equity value. Then add minority interest and Debt and Subtract Cash to get Enterprise Value?
3) Also, you can't use DCF to value a bank or financial institution because interest expenses are critical for the operations of a bank. But, what if you used LEVERED FCF instead of UNLEVERED FCF, to factor in interest expenses, can you use DCF to value a bank then?
All help would be really appreciated.
Thank you so much!
P/E multiples only matter in a stock deal. For cash and debt, you use earnings yield so compare the cost of financing to the earnings yield from the target 1/(P/E). So the answer here would be more on the 'it depends side' i.e. the financing split of each.
Yes, P/E = equity value/Net Income so Net Income*P/E will give you Equity Value. The adjustments to EV are correct.
Not entirely sure. I'll let somebody else chime in.
Thanks Jutch93. Makes sense.
Also, another quick q please:
For company valuations, negative change in working capital (negative net working capital) is good right? This is because this means that current liabilities are increasing at a faster rate than current assets and so it means the company is spending less cash. This means it has a higher FCF and therefore higher DCF valuation. Is the methodology correct here?
Thanks so much!
You've got it the wrong way around. Negative NWC (with regards to the fact that you subtract it) would be where assets are greater than liabilities (remember an increase in an asset is a use of cash). I'd still be concerned if a company's liabilities was greater than it's assets as it can be a sign of illiquidity which can lead to financial distress. But from a cash flow perspective, it's positive.
Yep sorry, I meant current assets are increasing faster than current liabilities. Thanks for that.
So yeah, from a cash flow perspective it's good. From a liquidity perspective, it's bad.
Thanks for your help! Really appreciate it!
Please don't confuse people, if you don't know the answer. Below quote from investopedia for your reference:
"Working Capital = Current Assets - Current Liabilities
The working capital ratio (Current Assets/Current Liabilities) indicates whether a company has enough short term assets to cover its short term debt. Anything below 1 indicates negative W/C (working capital). While anything over 2 means that the company is not investing excess assets. Most believe that a ratio between 1.2 and 2.0 is sufficient. Also known as "net working capital".
Also, cash is sometimes not included as part of working capital, as it's not truly "working". Now, imagine a retail chain store company. They have little receivables as most people pay in cash (or get the payment 2 days later whilst using card), some inventory assets, and massive payables to suppliers (large retail businesses with economies of scale can negotiate up to a few months payment period since getting an invoice. In that case you have a negative working capital, where your suppliers are funding your business, which is nothing dangerous from the liquidity perspective in that case.
I won't even mention such names as Starbucks, that implemented an idea of pre-payments where you actually pay for the coffee before you even show up at the coffee place. It's not gonna change your EV valuation, but it's healthy from cash flows perspective where you get cash before you deliver the product (with almost no inventory on balance sheet).
There is a difference between net working capital and working capital. Net working capital in this case refers to operating working capital. When calculating NWC for FCF you never include cash and debt because it's non operating and debt refers to a company's financing activities, not operating. I was also referring to it from a cash flow perspective, you're using balance sheet ratios. I'll admit I got the positive/negative NWC the wrong way around, I just think of it whether or not I add or subtract.
What I was saying is that you could have loads of cash tied up in assets (uses of cash) which is larger then your liabilities which means that although your NWC is positive, you subtract it. The cash flow statement shows cash inflows and outflows if you've got more cash tied up then retained then it's reducing your cash flows, hence subtracted.
I should have clarified I meant illiquidity from a balance sheet perspective, taking into account your liabilities and assets which can be an issue if your liabilities are greater than your assets (imagine if you have short term debts that you cannot meet, your example doesn't hold up here since WC includes both cash and debt) then this is an issue.
Also your example is quite the exaggeration, a few months for A/P? I've never seen that before.
Banks use fcfe instead of fcff (levered vs unlevered)
@Jutch93" In Levered and Unlevered FCF models, debt is considered as capital which makes sense when it is applied to non-financial service firms with interest as the cost of capital. For banks and other FIGs, debt is seen more as raw material (think COGS) and hence take on different properties.
Estimating free cash flow for banks are also tricky because of reinvestment. Two key components for reinvestment are net capital expenditure and working capital. Unlike manufacturing firms that invest in things like PPE, financial service firms invest primarily in intangible assets like brand name and human capital. As such, these investments are categorized as operating expenses and banks have relatively low PPE and have little depreciation. As for WC, it is also tricky as a large portion of the bank's balance sheet falls into either one CA/CL, changes in either can be both large and volatile which makes WC meaningless and may have no relationship to reinvestment/future growth. The difficulty in measuring reinvestment for FIGs means it's hard to measure cash flows and future growth of cash flows.
In Damodaran's paper "Valuing Financial Service Firms" he proposed 3 methods to value FIGs, Dividend discount models, Cash flow to equity Models as d3athletejumper mentioned and Excess return models. In practice, people usually use dividend discount or excess return models.
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