Let's get started. We're going to talk M&A fundamentals today.

We've got a lot to cover in just an hour.

Let's just start off with a little introduction from myself and a little bit of chat about what we're going to be covering.

So first of all, my name is Deborah Taylor. I'm a trainer at Financial Edge.

I've been training analysts going into investment banking and private equity now for about seven years.

Before that, I spent nearly 10 years working in investment banking.

I worked at Barclays for nearly a decade, and whilst I was at Barclays, I specialized in equity research, working on accounting and valuation issues, and M&A was a perennial topic of interest. I loved looking at deals, trying to analyze whether deals are good deals or bad deals.

And that's going to be one of the key questions we ask today.

So hopefully I can share some of my experiences with you as we're going through this session.

Okay, I'm going to share my screen now, and let's talk a bit about what we're going to cover.

Okay.

Right. We're going to talk about M&A deals, how we analyze deals, what sorts of information you need to analyze a deal, and what tools we have in our toolkit for appraising a transaction.

And fundamentally, the question that we want to be able to answer as analysts is, is this going to be a good deal or a bad deal, particularly from a shareholder's perspective? Okay? So that's the question we're trying to get to.

We're going to take about an hour to cherry-pick some of the key topics which analysts need to focus on. An hour is not enough to fully appraise a transaction, so I will just remind that we're going to cherry pick topics today.

Let's start off just with a little bit of background for M&A deals. So what we're going to cover today is talking about the information that we need when we're appraising a deal, and also the tools that we have in our toolkit for appraising a transaction. Okay? However, a little bit like if you were trying to analyze a company, the starting point is always understanding the strategy, understanding the business. And it's the same with an M&A deal.

When we're looking at M&A deals, we always have to start off with what is the strategic rationale for the transaction. Okay? And this cuts through all the numbers, understanding why is this company trying to buy another business. It could be that it's looking to make some kind of access into new markets and products.

Maybe it's trying to make rapid expansion by buying up a competitor in a different market or a different product.

We often describe that as horizontal integration. Okay? It could be that it's looking to have more control over its supply chain. It's buying up its competitors or its suppliers.

We often describe that as vertical integration.

Maybe they want access to know-how.

There's a particular piece of know-how or even some resource that they need to be able to expand their business. Okay? So, that is also a common way of doing it because ultimately by buying a business that's already doing that, you reduce your risk compared to having to do it organically.

A final and important type of motivation for M&A that we're really seeing more of at the moment, particularly in the tech space, is a defensive move. Looking to buy up a competitor that maybe is a threat to your business.

And sometimes when it comes to defensive M&A, it means that the benefits of the transaction might have to play out over a longer time horizon.

Yeah, they're a threat to your business further down the line.

You buy them now, it might make the metrics look a little bit less flattering than for some of the other rationales for doing a transaction.

Okay, so those are some of the example reasons that companies do M&A deals. And before we dive into any numbers, I want to give you an example of a company that has done a recent acquisition. I'm just going to show it on the screen.

I'm going to show you the announcement of a deal in the European markets. Okay? So in the European markets, Carlsberg announced a deal, it was a couple of years ago now, to acquire Britvic PLC.

Now they both operate in the beverages space. Okay? So they operate in beverages. Carlsberg specializes in alcoholic drinks. Britvic is a non-alcoholic, ready-to-drink beverages. Okay? Now, if you scroll down through their deal announcement, there is on the second page, and I've highlighted it in green, the strategic rationale for this transaction. Okay? And as I said, it's always a starting point in our analysis, and we're going to keep dipping into this as a case study example as we're going through our materials. So I will just highlight some of the strategic rationale here. Okay, so the first thing that they highlight is the acquisition is being made to enhance Carlsberg top and bottom line growth profile. They're looking to drive up revenues and also profits, and that's through the growth profile in Western Europe.

Britvic is a UK-based drinks company.

Carlsberg is based in Europe, and it has much more exposure to the rest of the world, Eastern Europe and Asia included. Okay? So the geographic overlap for these two businesses works really nicely. The Britvic acquisition will be transformative for Carlsberg's UK business, creating considerable opportunity for the development of brands and people from both organizations, and a highly attractive multi-beverage supplier of scale. Yeah. Scale is really important.

As you grow a business, you can get economies of scale, so your costs of your businesses reduce proportionately as you're growing your business. So we often refer to those as cost synergies that drive improved profitability after the acquisition.

They're going to benefit from an efficient supply chain and distribution network.

And the other thing they highlight is that Britvic acquisition will further strengthen Carlsberg's close relationship with PepsiCo.

Now, PepsiCo, the US beverages company, also has large bottling operations.

And it seems from this disclosure that Carlsberg and Britvic both use the bottling operations of PepsiCo.

So it strengthens that relationship, and again, would help them to benefit from things like economies of scale.

The fact that if you're purchasing more from a supplier in terms of units, you get a lower per unit cost. Okay.

The final thing they highlight in the strategic rationale section is that Carlsberg has clear plans to increase sales and marketing investments in Britvic in order to accelerate growth.

So again, they're talking about growth.

Sales and marketing will help drive revenue increases post-acquisition.

Okay, so that's a little bit of the highlights, just cherry-picking the highlights for this particular deal. Okay.

Interestingly, when we scroll down in their deal announcement, they then go on to say that the Carlsberg has identified annual cost savings and efficiency improvements in the region of GBP100 million, which Carlsberg expects to be delivered over five years following the Britvic acquisition.

This is a key data point when we're doing M&A analysis, knowing a little bit about what the synergies are going to be.

Cost savings and efficiency improvements are a type of cost synergy.

Okay? Reduction in cost. When you squish together these two businesses, the combined costs are less than the two standalone businesses were originally. Okay? So that's an example of synergies.

We do have other types of synergies that sometimes arise, for example, revenue synergies, the ability to cross-sell between the two businesses and drive up the combined revenue of the business.

I think it's quite important, quite significant, that in this transaction they focus on the cost synergies even though the strategic rationale talks a lot about the revenue benefits.

Yeah, they talk about growth in revenues from the transaction, which would indicate to me that there's going to be revenue synergies. They have not quantified those.

So that's quite an interesting point for this transaction.

Sometimes companies don't quantify the revenue synergies because they're much harder to control than cost synergies, and they don't want to commit to a number and then risk disappointing the market. So it could well be that they're just committing to the ones that they can control, and behind the scenes, there is an expectation of revenue synergies, and certainly that's what would be implied from the strategic rationale that they've discussed.

Okay, so that's our starting point.

Before we dive into any other analysis is to say, okay, what is the reason they're doing the deal? What are the benefits of the transaction? Okay. Now we've done that, we can start to understand some of the other elements associated with an M&A deal and how we appraise a deal.

So the next thing we need to do is understand valuation in an M&A context. How do we value companies when they're doing an M&A deal? Yeah. And also how do we understand the actual offer terms, bearing in mind that different transactions will have different ways in which the offer is communicated.

Then we have to understand how the transaction is being financed.

And as we will see, that is a critical driver of not just the metrics, but also success of the transaction.

And then the next thing we will look at is deal analysis, what kind of tools we have in our toolkit for appraising an M&A deal.

Okay, so those are the things we're going to cover.

Let's dive straight in to our first topic, which is valuation in an M&A context.

Okay. Now, hopefully, you're already familiar with how we value companies in a normal traded environment. Okay, so if I was looking to identify the market capitalization of a company, I could simply look and see, well, what's their traded share price, how many shares do they have today, multiply the two.

That gives you their market capitalization. Okay.

But that market capitalization reflects the price of shares traded on a minority basis if I want to buy a few shares.

That's quite different to an M&A context where you're looking to buy all or most of the shares in the company.

We usually expect that an offer that's being made for a company includes something called a control premium. A control premium, that's the additional amount you have to pay per share for acquiring most of the shares of a company.

You have to convince most of the shareholders to sell.

The shareholders know that you'll have access to things like synergies if you're acquiring control of a business, as they expect a premium to be paid. You might be interested to note that usually control premiums for acquisitions of public companies usually range somewhere between 20% and 40% above the traded share price. Okay, that might seem quite high to you, but that is actually the norm, 20% to 40% premium over the traded share price because remember, you have to convince most or all of the shareholders to exit.

That premium can be even higher if you have, for example, a very unique business, with some assets which are very valuable. It could be that there's a tricky shareholder to negotiate with, maybe a family or a government.

Okay, so that will affect the size of the control premium.

Now, once we've identified what kind of offer price can be paid for this business, okay, and that's on a per share basis.

We then multiply that by the number of shares outstanding. Okay? Now remember, I'm sure you've covered in your basic valuation work, that when we talk about shares outstanding, we don't just care about the shares outstanding today, we care about diluted shares outstanding.

Diluted shares outstanding includes the promise of shares to things like employees through restricted stock units and through stock options. That still applies in an M&A scenario, but even more so because if someone is coming along and buying a business that has stock options or RSUs, they are buying out those stock options and RSUs at the offer price.

So effectively, those dilutions and stock options, those stock options and RSUs become even more dilutive in an M&A scenario.

So we take the offer price per share, we multiply it by the number of shares outstanding, and that gives you acquisition equity value.

And remember that acquisition equity value will be higher than the market capitalization because of the effect of that control premium.

We can then take that acquisition equity value, and we can then add to that the net debt of the company that's being bought and any other liabilities which crystallize as a result of the transaction. For example, there might be a pension liability that requires a top-up payment, if there's a change of control.

And so any other liabilities which crystallize, we add those to acquisition equity value, and that gives us something called the acquisition enterprise value. And remember that acquisition enterprise value is going to be larger than the traded enterprise value because of the effect of that control premium baked into that, plus any liabilities which crystallize as a result of the deal.

Now, that's a useful bit of information because that acquisition enterprise value, we can use that in a new type of multiple.

We can use it for an acquisition multiple.

We can compare it to the EBIT or EBITDA of the target to give an acquisition multiple, which will be a higher multiple than we usually see in the traded markets within that sector. Usually because of, again, the control premium.

We see it keeps coming back in to the metrics that we're looking at.

Okay? One thing that you need to be aware of that's different in an M&A context versus a traded context is that we usually use LTM or trailing multiples when we're talking about M&A deals.

That's last 12 months historical information rather than forward earnings in our multiples. And the reason for that is that we might be looking at this transaction, looking at the acquisition EV multiple, and wanting to compare it to transactions in the private market.

Maybe there's been some private companies bought and we want to calculate an acquisition EV multiple for those deals.

We can only do that on a trailing basis because we don't have consensus earnings forecasts for private companies.

So it expands our universe of companies that we can include in our analysis by using trailing multiples.

Okay, so just be aware of that. We're now going to go into a workout where we just demonstrate the calculation of acquisition equity value and enterprise value. Just in case you did join a little bit late, I'm just going to copy and paste the link in the chat again to the materials, okay, so that you can access those. We're going to go into our Excel spreadsheet now, M&A analysis workout.

Okay. And I would encourage you to work alongside me as we're doing this.

Okay. If you go to the M&A analysis tab, that's the third tab along, we're going to start looking at a workout, workout number two. We're going to calculate the equity purchase price for a company, Hom and Colon Pharma, using the information below.

We're told their current share price, that's 5.06.

We're told the offer premium is 30%.

And remember, that's well within the normal range that we usually see for M&A deals. And we're told their basic shares outstanding.

That's the number of shares they actually have outstanding outside the company today, and that's in millions, 261.18 million. Okay.

We're told some information about the company's stock options.

They do have some stock options in their stock option plan.

And we're told that the strike price for the options outstanding is 0.756. Okay. And we have the disclosure with the number of options on the screen.

Okay. And we can see that the latest number outstanding in the blue line, 843,500. In millions, that's 8.4315. Okay. And that's the number of options that we will be including in our equity value calculation.

But let's start off by pulling down some of the information that we've been given.

We start off with the current share price from above and the offer premium of 30%.

We can immediately take that information to calculate the offer price on a per share basis, and that's always the way we quote it. For public company acquisitions, we quote it on a per share basis. Now, I always like to include per share prices for two decimal places. That's the usual convention.

So my offer price is 6.58.

But in terms of the amount, the dollar amount or the sterling amount that they're paying for this acquisition, we need to now identify how many shares they are buying. Okay.

Now, we've been told the number of options outstanding, or we can see it in the disclosure, is 8.43 million, and the strike price on the options is 0.756. Okay. So when a company's coming along and buying this business, they're buying out not just the existing shares, but also the options.

And what we do with our dilution calculations is essentially calculate what's the free shares which are being created as a result of this or given away as part of this transaction. Yeah.

Because some of those options, there's a strike price, they have to hand over some cash, and it's really the discount that provides the free options.

So we're going to use the treasury method formula, which is the formula we use when we're doing normal valuation. The only adjustment we make here is instead of using the traded share price, we're going to use the offer price.

So what I'm going to do is take the number of options.

I then need to calculate the discount offered by the options relative to the offer price. So I take my offer price.

I deduct the strike price and divide by the offer price.

And that's basically the percentage discount offered by the options, multiply by the number of options, and that tells me how many free shares are being offered as part of the acquisition.

And as you'd expect, because it's a very deeply discounted set of options, we've got dilution of 7.5, which compared to the number of options of 8.4, you can see there's a lot of dilution coming from those options.

What we now do is we add that to the basic shares outstanding to give the diluted share count. So this is effectively how many shares are being bought out as part of the deal.

And we take the diluted share count, multiply it by the offer price, and that gives us the equity purchase price. That's the kind of dollar or sterling amount that's being paid for this acquisition.

Okay. I'll just pause.

Right. Let's keep moving.

We're going to go straight onto Workout 3 and calculate an acquisition enterprise value for this company. Okay? And to do this, we always go to the latest available balance sheet.

If it's in the US, it's usually a quarterly balance sheet.

In Europe, it's often a semi-annual balance sheet.

So we find the most recent information on net debt and any other liabilities which crystallize.

Now, if I scroll down in this workout, I can see that we already have been given some clues as to which information we're going to need.

This company doesn't have any standard debt, but it does have some debt-like obligations. It has debt-like obligations under finance leases, and those are current and non-current obligations.

We're going to need both of those. We need to include the numbers in millions.

These amounts are disclosed in thousands.

So I'm going to take those numbers and pop them in and scale them at the same time.

Okay, so we have 1.54 of non-current leases and 0.111 of current leases.

We also need to include the cash and cash equivalents, which we have up here. And again, we're going to convert those into millions.

So 234.9 million.

So 234.872.

We also need the equity value from our previous question.

So grab the number that we just calculated before.

And when we add together our equity, our liabilities, and then subtract our cash and cash equivalents, that gives us the acquisition enterprise value, which is 1,533.9 million.

Okay? And that is the number that we would be including in our acquisition multiples. So if we wanted to calculate an acquisition EV multiple, that is the number that we would take.

Okay. I'm just going to repost the link. Someone says they're not seeing the link.

I'm just going to repost it in the chat.

Ah, okay. See if this works better.

Can I just check that you can see the links, the materials now? I think technically it's not a link to Excel, it's a link to the website which has the download on it. Great.

Wonderful.

Okay, so we've done some calculations there.

Let me just put that into context. Let's go back to our case study transaction.

We said that we were looking at the Carlsberg acquisition of Britvic.

Okay.

We can see at the top, the transaction summary that's provided for the deal. If we go to the second bullet point, under the terms of the deal, shareholders will be entitled to receive 1,315 pence for each share. So that's the offer price. Okay? Just note in the UK, we quote offer prices and share prices in pence. It always seems a bit weird, but that's the convention.

Okay.

And the offer price includes 1,290 pence in cash and a special dividend payment of 25 pence per share. Okay? But in cash amounts, it's 1,315 pence.

Okay? So that is our offer terms, and because it's a public company, it's always quoted in terms of pence or price per share. They then go on to explain to us what this means in the actual, in currency amounts.

So for example, the ordinary share capital of Britvic, yeah, at that offer price, the acquisition equity value is 3.3 billion pounds on a fully diluted basis, just like we calculated.

And an implied enterprise value of approximately 4.1 billion pounds. Okay? So just like we calculated, that's the acquisition enterprise value.

They do then go on to go a step further and say, "Well, this gives you an implied enterprise value multiple of approximately 13.6 times Britvic's reported adjusted EBITDA." So that's their trailing, their historic EBITDA, compared to the acquisition EV. And that's a really useful data point because it immediately allows us to get a sense of how expensive this transaction is. We could take that 13.6, compare it to traded multiples in the beverages space within the UK and Europe and say, "How does this compare?" If we see other companies in the sector trading on around 12, 11 times, that doesn't seem crazy expensive. Now, if we see them trading on single-digit multiples of EBITDA, that's a bit more concerning. Why are they paying so much? There's got to be some kind of rationale.

So you can see already that we're kind of building up the narrative around the transaction, even without having calculated any actual metrics ourselves yet.

Okay. So that's the first stop, is to make sure we can calculate our acquisition equity value and enterprise value. Let's go back to our slides.

Okay, the next thing we need to be able to do is understand how the deal is being financed. Okay? And there are two key options here.

You can finance with debt, or if you're a public company making the acquisition, you can finance with equity.

Just one point of note is if you're financing the deal with debt, we still refer to that as a cash deal, okay? Because the shareholders receive cash. And that's absolutely the case in the Britvic deal.

As we will see, it was a debt finance deal, yeah, but they talk about it as being a cash deal because that's what the target shareholders receive.

When you offer equity as part of the consideration, the target shareholders, they receive shares in exchange for the shares they already hold.

Okay? So we refer to debt finance deals still as cash deals.

So what are the key considerations when you're thinking about how the deal is financed? Well, the main considerations for debt financing. Well, first of all, we know that in general, debt is a cheap source of finance. Yeah. It's often a preferred source of finance for deals because it is cheap, and it's cheap because debt investors take on less risk. But it's also cheap because there is a tax shield that comes with interest.

When I pay interest, as a company, I get a tax deduction, and that makes it even cheaper as a form of financing. Okay? However, there is a restriction with debt.

The amount I can borrow is not unlimited.

It depends on the debt capacity of the business.

And that, as we'll see, that becomes an important bit of analysis that we do, is to say, "Well, how much can be borrowed to finance this transaction?" We normally simplify our analysis, at least in the early days, to make sure that we are using an EBITDA multiple.

So, like a debt to EBITDA multiple.

In the same way that if I went to the bank and I said, "Can I borrow some money for a mortgage?" They would often say to me, "Well, what's your earnings? We will lend you a multiple of your earnings." So it's very similar to that. But that provides a constraint. Yeah.

Because if we can calculate the EBITDA of the combined business, what we refer to as the pro forma EBITDA, that allows us to calculate the maximum consolidated debt that we can then compare with the debt of the two businesses on a standalone basis to work out how much can be borrowed to finance the transaction. If they take on any more than that, there is a risk to credit ratings, and public companies in particular want to avoid that risk. They want to avoid any kind of negative impact on their credit ratings.

Okay, so that's the financing on the debt side, but generally, it's cheap and it's therefore usually the preferred source if you can borrow enough. Okay? So it's usually preferred.

However, sometimes the deal does need to be financed with equity, and that's particularly the case for larger transactions.

But why is it not the first port of call for financing a transaction? Well, it's normally more expensive than debt, and shareholders sometimes get a little bit irritated by equity being used in the transaction because it means dilution for them.

The fact that if you're offering shares to target shareholders, their percentage ownership in that business is going to be reduced. Okay? It also does result in a bit of share price volatility, and it increases uncertainty for the target shareholders. They don't know how much they're getting in value terms.

Because if the acquirers' share price rises and falls in reaction to the news of the deal, then that means what they're getting as consideration is also rising and falling. So it's generally not the preferred route, but if the deal is large, particularly relative to the size of the acquirers, you've got a big target relative to the acquirer, it's more likely there will be at least some equity in the financing.

Okay? So usually if it's a larger deal, there will be some equity.

If companies can finance with debt, they will usually prefer to go down that route. It's cheaper, and, as we will see, optically, it makes the deal look a bit more attractive in terms of some of the metrics at least.

Okay, so that's the financing of the transaction.

Once we have an idea of the financing of the transaction, we can put together something called a sources and uses of funds table.

It's just a way of laying out our understanding of the economic flows in the transaction, and it becomes a really critical document to prove that the deal can go ahead.

So the sources and uses of funds has to balance.

So whatever we know is going to be paid for, for example, the equity purchase price. In this example, a very simple sources and use of funds table.

So let's say the equity purchase price of the target is 100 million.

We have to have enough financing for that deal to go ahead.

So let's say, for example, we're going to issue 40 million of equity, and we then know that we have 60 million of debt being issued as well.

Usually, the debt is going to be a plug.

It's usually the maximum we think we can borrow in order to make the deal go ahead. Okay? Let's build an example, very simple sources and uses of funds table in our workout file. We are going to go into Workout 5, where we are going to look at a very simple sources and use of funds calculation, for the acquisition of Nordstrand PLC, which is a company that was acquired for 2,000.

The acquirer used 30% of equity financing to complete the deal.

And we're going to assume that Nordstrand net debt was not refinanced.

We'll come back to that in a minute.

There were no advisory fees and no cash was used in the acquisition.

Construct the sources and uses of funds table.

Now, in this deal, it's such a simple deal.

All we have is the equity purchase price of 2,000, and that is the only use of funds.

Okay. Now, in terms of the equity financing, we're told it's 30% equity financed. Just a key note is that that 30% is always with reference to the purchase price, not the total use of funds. So 30% of the equity purchase price, which is 600, is the equity financing, and that means that the debt financing becomes a plug figure.

We know that the total use of funds is 2,000, so we need 1,400 of debt financing.

And when we add those together Our total source of funds equals our total use of funds.

Okay, so that's a very simple source and use of funds table.

Okay? In reality, it becomes a little bit more complicated. Yeah. Here's a bit more realistic at a source and use of funds analysis. Okay.

We still have the same basic principle that we need to make sure that the source of funds is equal to the use of funds. Okay? But that we have more sources and more uses.

So we still have equity issuance and long-term debt being used to finance the deal. This time we'll also have acquirers cash being available. So cash in the acquirers balance sheet is also available to finance the deal. We'll come back to the revolving credit facility.

On the left-hand side, the use of funds still includes the equity purchase price, but we are now going to allow some times for refinancing the target's net debt.

And that is because if you come along and buy a target, it may well be that that company has bank borrowings or bonds in issue, which have a change of control clause. And the acquisition triggers the need to repay that debt. Now clearly if the target also has cash in their balance sheet, that cash can be used to pay down some of the debt.

So it's the net debt that needs to be covered by the acquirer when they come along and make the acquisition. Okay, so we include the net debt as a use of funds that needs to be repaid by the acquirer, and they need to have financing available for that.

Now we are never going to cover refinancing of net debt with equity issuance, so that's always going to be financed by long-term debt. Okay? So we take new debt to refinance the old debt, and that's important. It's one of the reasons why the equity issuance is also with... is always with reference to the equity purchase price.

We'll see that in an example.

Now, transaction fees, they need to be covered as well.

That's the advisory fees, the financing fees, they all need to be covered.

They're paid in cash when the deal closes, so they're another use of funds. It may be that there are also some other claims which crystallize as a result of the transaction, and they need to be financed as well. So they're another use of funds.

The final one we need to talk about though is the operating working capital adjustment. Now what happens is you agree what the value of the operations are, at a point in time, but businesses are not static and they're quite often quite seasonal, so their operating working capital will grow and fall as the year progresses. Now if the deal is to close at a time when working capital is slightly bloated, maybe you're buying, I don't know, a toy manufacturer and you're about to close in Q3 as they're ramping up to the festive season, they will have additional working capital that needs to be financed.

And so typically, the revolving credit facility and the source of funds is just a temporary facility that's available to fund short-term working capital needs. Okay? So those are some of the sorts of things that we come across in our sources and uses of funds. Let's go back to our example in our workbook, just so that we can have a look at those, some of those in practice.

Okay, so Workout 6, we're asked to restate our answer to the previous workout, so the Nordstrom deal, assuming that the net debt of 1,200 needs to be refinanced. Okay, so we're now going to allow for 1,200 of refinancing of debt, and that means that the total use of funds in this deal is now 3,200.

Now, everything else in the deal is going to be the same in terms of the financing, in the sense that it's still a 30% equity finance deal.

So we're going to take 30% of the equity purchase price.

So it's still 600 of equity financing, and that means our debt financing, it continues to be a plug, and it's a plug that's increasing because we need more financing from debt to cover the transaction.

Okay? If we go down to Workout 7, we've got exactly the same.

Okay, this time we're going to include refinancing of the net debt of the target, and we're also going to allow for transaction fees of 40.

So the total use of funds this time, 3,240. It's still 30% equity financed with reference to the equity purchase price. So it's still 600 of equity financing.

So again, it's the debt financing that has to come to the rescue to ensure that there is enough financing for this deal.

So the debt financing has now grown to 2,640.

Okay, so that's our sources and uses of funds analysis.

Right. So what do we do with all of this? Well, the next thing we need to do is make sure that we are familiar with the equity financing terms. We talked about the cash component.

What about the equity financing component? Well, now that we have our source and use of funds, we can identify how much equity is issued to do the deal.

Let's say for example, we have a deal which is going to be 100 million of equity financing. If we know the acquirer's share price, let's say it's $2 per share, that tells us that the acquirer has to issue 50 million shares to do the deal.

That 50 million of new shares can be compared to the target's existing share count. Let's assume they have 25 million shares at the moment, then that gives us a new metric which is the exchange ratio.

The exchange ratio, how many new shares the target shareholders receive in exchange for the shares that they currently hold.

Okay. So now we have all of the information that we know that we need to do acquisition EB calculations, how to build a source and use the funds table, and how to understand the exchange ratio.

We are now going to start looking...

for the rest of this session, we're going to be looking at how we analyze a transaction And one of the key metrics that is the kind of go-to metrics that working out is a deal, a good deal, or a bad deal is EPS accretion.

Okay, so is EPS going to go up or down as a result of the transaction? Because shareholders, they want their earnings per share to grow over time.

Now, the way that we do this is effectively through consolidating or combining the net income of the acquirer and the target.

So the first thing we have to do is say, okay, well, what are the earnings of the target? If they're a public company, we can take their EPS and their shares outstanding, and we can multiply those together to give their net income. I'll just follow the year one figures here.

We can then do the same for the acquirer.

We find their EPS and their shares outstanding and multiply those to give the acquirer net income. And we can then say we're going to squish together these two businesses. We've got 8,100 of net income from the target, 9,939.3 from the acquirer, but that's not all. We have some transaction effects.

We have two transaction effects that we have to allow for when we're combining the net income.

Firstly, there's the synergies, things like the cost savings or the revenue synergies from combining those businesses.

Now, the actual amount of those synergies is-- we've been given here 675, but when the company's generating those synergies, they're generating more profit, and that means more taxes.

So we need to allow for the fact those synergies are going to get taxed, and we calculate the post-tax synergies by taking the pre-tax amount, multiplying it by one minus your tax rate.

We then can calculate the amount of interest that's going to be incurred on the deal debt. So we take the amount of debt that is going to be used and the source of funds, we multiply it by the interest rate they can borrow at, but again, we have to remember tax, because when a company pays interest, they get a tax deduction. So the amount of interest on the debt multiplied by one minus your tax rate gives you your post-tax interest.

And we can then combine all of those to give pro forma net income.

It's the acquirers net income, the targets net income, the synergies on a post-tax basis, less the interest on deal debt, and that gives you a pro forma net income. However, we also need to think about the share count, okay? Because if there is equity financing in the consideration, we need to add any new shares issued as a result of the equity financing to the acquirers existing share count to give pro forma shares outstanding. That's basically just the number of shares outstanding after the deal.

Once we have pro forma net income and pro forma shares outstanding, we can calculate pro forma EPS. We can compare that to the acquirers current EPS forecasts, and that tells us whether or not this is a good deal or a bad deal from an EPS accretion or dilution perspective.

And we can see here that even by year three, this is not an EPS accretive deal, and therefore it's less likely to be viewed by the market as a positive for this company.

Let's do a little workout. We're going to do an example of an EPS accretion calculation, and we're going to do that in Workout 18.

So into our workout file, let's have a look at Workout 18.

Okay, so here we have a company, Gardemon, which is acquiring 100% of Fornabu. And we're asked to calculate the EPS accretion or dilution for this transaction.

Now, here we have some numbers for both the acquirer and the target.

So we have their current share price, and we have their diluted share count, and we're told that the acquisition premium is 25%. Okay? Now, this is a deal which is going to be 50% equity financed and 50% debt financed, and we have to allow for that in our calculations.

We've got some tax rate information, we've got some synergy information, and we have EPS for the acquirer and the target.

The first thing that I'm going to do is work out how much is being paid for Fornabu. That's its acquisition equity value.

We need to take the share price of the company, we add on the 25% premium, and we multiply it by the diluted shares outstanding. That means the purchase price of this company is 5,625.

Okay? The other thing that I'm going to do just to kind of set ourselves up is to identify the net income of the acquirer and the target.

So that's their EPS multiplied by their share count, and we do that for both companies.

And I get net income of 1,242 for Gardemon and 340 for Fornabu.

Now let's add together those net income figures.

So the combined net income before any adjustments is 1,582.

But we now need to allow for some transaction adjustments because we need to allow for the synergies and the interest, and both of those are on a post-tax basis. So my synergies I've been told are going to be 50.

We need to tax adjust those. We need to make sure we use the right tax rate.

Now, the marginal tax rate, the definition of that is the tax rate that's suffered on the next dollar of profit. Okay? And what we're trying to do here is work out how much tax they suffer when they generate additional earnings from the synergies.

So it's the marginal tax rate that I use in this calculation.

So take that 30% and use that to calculate post-tax synergies of 35.

In terms of the deal debt, I'm going to deduct the interest on that. I need to calculate the amount of interest.

I know that the equity purchase price is 5,625.

I multiply that by 50% because that's the amount of debt financing.

I'm then going to multiply that by the interest rate of 5%, and I need to allow for a tax adjustment.

So multiply that by one minus your marginal tax rate.

Again, we're talking about a change in profits here, so it's how much extra tax I'm going to save as a result of this transaction.

Okay. And I get interest saving on a post-tax basis of 98.4. I can then add all of those together to give my pro forma net income. So if I was combining both of these businesses, this is what the net income of those businesses would look like, 1,518.6.

The next thing I'm going to do is calculate the pro forma shares outstanding.

I start off with the acquirers current shares outstanding of 600.

I then need to allow for the new shares issued in the transaction, and remember, this is a 50% equity financed deal.

So I'm going to take my equity purchase price, multiply it by 50%, and that's basically the amount of equity financing needed. And I divide that by the current share price of the acquirer to tell me how many new shares need to be issued.

And it's 93.8.

If I then add those together, that tells me the pro forma share count this deal, which is 693.8.

If I divide my pro forma net income by my pro forma shares outstanding, I get pro forma EPS, which I'm going to increase to two decimal places just to make it a little bit more normal. I usually have my EPS to two decimal places.

Oh.

For some reason my shortcut's not working.

Okay, I think I'll just leave it at 2.2.

Okay, my EPS accretion, I'm going to take my pro forma EPS, divide that by the EPS of the acquirer, and then deduct one, and that allows me to calculate my percentage change.

Which again, for some reason my formatting's not working, so I'm just going to change my display. There we go.

Okay, so I have 5.7% EPS accretion, and that looks good, doesn't it? You know, the fact that basically by doing the transaction, if I was a shareholder of the acquirer, the earnings attributable to me as a shareholder are going up by 5.7%. That makes it look like a great deal, doesn't it? But what happens if I change my financing mix? What if I change my financing mix, so instead of being 50% equity financed, it becomes 100% equity financed? Same deal, same synergies, same offer price.

What happens to my EPS? It goes down.

What happens if I change my equity financing to 0%, so it's now all debt financed? My EPS accretion goes up to 14.3%. Double digit EPS accretion.

Okay. And this is important. It's the fact that we know that debt is a cheap source of financing.

The more debt you have in your financing mix, the more attractive the deal looks from an EPS accretion and dilution perspective. Okay, so just be aware of that.

The EPS accretion is widely used as a metric, but we have to be a little bit cautious. There's plenty of deals where you can end up with EPS accretion just because of it being cheaply financed.

It doesn't necessarily mean on its own that it's a good deal.

Okay, so that's our first metric done. Tick.

But it's not the only metric. Okay.

The next metric that we're going to look at is debt capacity, which we kind of touched on when we were doing the financing mix.

What we do as analysts is we build a calculation that says, okay, well, as a result of the deal, what is the combined debt to EBITDA multiple? Or we can work backwards and say, if we know what the maximum debt to EBITDA multiple is, what is the maximum debt capacity? So here we have an assumed multiple of three times, which is very much at the top end of what you would expect for a public company.

Most public companies aim for about two and a half times.

Three times is really at the top end.

And you can calculate the combined EBITDA of the businesses.

So this is 1,200.

Multiplying those together tells the maximum debt capacity, 3,600.

If I know the net debt of the acquirer and the target, I can then work out how much debt they can borrow to finance the transaction and use that as a sense check in my analysis.

Let's have a look at a workout. Let's put that into practice.

We're going to do workout 23.

Okay, so workout 23. Aha has acquired 100% of Tegan, and using the assumptions below, we're going to calculate the combo net debt to EBITDA ratio. We've assumed that Aha did not use any cash in the transaction, and the net debt for the target was refinanced.

Okay. So the first thing we need to do is calculate the EBIT for both companies and also the EBITDA. So just build those calculations.

We're told that the synergies on a pre-tax basis are going to be 120.

The acquisition price is 1,100, and it's 100% debt financed. Okay. We have the debt and the cash of both the acquirer and the target, and I'm immediately going to use that to calculate their net debt.

Right, the next step is to build some calculations that say, well, hang on, how much debt is going to be issued by the equity of the target? What's the combined net debt of these businesses, and what does that give us as a combined net debt to EBITDA ratio? So the first thing is how much debt is being issued to finance this deal.

We know the acquisition price is 1,100, and there's nothing else that needs to be financed. We're multiplying that by 100% debt financing because that's basically how much debt is going to be issued, and that is 1,100.

Okay.

Now, what is the combined net debt after the transaction? Well, both companies going into the transaction have net debt, okay? And we need to add those together.

And then on top of that, we add on the debt issued to finance the transaction. So that give us combined net debt of 2,225.

We then take the combined EBITDA of the businesses, and that's the EBITDA of the acquirer and the target. And don't forget the synergies.

Those synergies are also important.

So we add the synergies in, and that gives us combined EBITDA of 1,004. Okay. And we sometimes refer to that as pro forma EBITDA.

Now we can calculate net debt to EBITDA after transaction and identify whether there's any risk from this transaction in terms of credit ratings. Now, as I mentioned, most public companies will target about two and a half times to maintain an investment-grade credit rating.

So actually, we see there a combined net debt to EBITDA of about 2.2 times. Not too worried about that. No major concerns.

They can comfortably afford to take that on. Okay? And so, that gets the thumbs up from us for this transaction.

Okay? So that's our second tool in our toolkit.

We've looked at EPS accretion and dilution.

We look at the combined net debt to EBITDA. Okay.

I think we've got time for one more tool in our toolkit, and I'm going to go straight to it. And it's my favorite one out of all of these, although it's kind of a subtle one to use. Okay.

So, the final one is return on invested capital.

Now, return on invested capital is an important metric regardless of M&A.

In any business, when you're making investment decisions, your main goal is to ensure that your return on invested capital, that's the profits that you're generating return-- compared to your invested capital in your business, is exceeding your cost of capital, the cost of your financing. Okay. That is an essential for investments to make financial sense.

In the same way that if I wanted to borrow from the bank at 5% to invest in a project which is gonna generate a 4% return for me, there is absolutely no point doing that transaction. Yeah, there's no point borrowing at 5% and generating a return of 4%.

I need to exceed my cost of capital to make that investment make sense. Okay? So we can apply that in an M&A scenario and say, "Hey, well, do you know what? If we can compare the return on invested capital, from my acquisition to the cost of capital of the target, then that gives me assurance that this is a deal which is creating value." The only little careful thing that we have to do when we're doing this analysis is to say, "Well, how do we calculate return on invested capital in an M&A context?" What we need is to know what the benefits are from the transaction, of what we're going to generate, and that's the target's net operating profits after tax, or what we sometimes refer to as EBIT or taxed EBIT.

Okay. So the profits from the target on an operational basis plus any post-tax synergies. Okay.

That together is the total additional profits operationally on an after-tax basis generated by the acquisition.

We can compare that to the acquisition invested capital. So that's the acquisition enterprise value plus any transaction cost.

And if we have got a return on invested capital exceeding our cost of capital, not necessarily immediately, but usually by the time that those synergies have been fully realized, then that is a good signal in terms of this transaction. Okay? So let's have a look in our workout file. We're going to do our final workout now, which is, we're going to do Workout 30.

Okay. So Workout 30. Printer has acquired Fax for 2,000.

The forecast synergies are 50, 100, and 200 in the first three years of the transaction respectively.

The synergies are expected to stay flat after year three.

We're going to calculate the return on beginning invested capital one year post-deal, and see how that compares to Fax's cost of capital, which is 7%. Okay. So the first thing that we need to do is to identify Fax's NOPAT. And we start off with their EBIT, which in year one is 150.

And we tax those at their effective tax rate.

We're taxing all of their profits, so we want the effective tax rate here.

And if we take that tax rate against those profits, that gives us a NOPAT of 105.

Now, in year one post-deal, we have synergies of 50.

Now, those synergies will create extra profits which get taxed.

And remember, synergies, where we're changing profits, increasing profits, it's the marginal tax rate that we need. So we'll grab the marginal tax rate of 35%, and the synergies on a post-tax basis is 32.5.

Okay.

So when we combine that with the NOPAT, so the synergies plus the NOPAT, all on a post-tax basis, we get 137.5, and that will be our numerator in our return on invested capital calculation.

Now, we're told that the acquisition equity value is 2,000, and we know that the net debt of the target is 400. If we add that net debt to the equity value, that gives us the acquisition EV.

We're ignoring transaction costs just to keep the numbers nice and simple. Okay.

And that gives us an acquisition enterprise value of 2,400.

So what is the return on invested capital from this transaction? Well, the NOPAT divided by the acquisition EV, if we convert that into a percentage, 5.7% is our return on invested capital.

And if we compare that to WACC, the WACC of Facts, that's the WACC of the targets, it doesn't immediately look like a great deal, okay? Because we've got a cost of capital of 7% and we're generating a return of 5.7%. However, there is one thing that we've done here, which has been a little bit mean about the synergies.

Because when we buy that target, we're not just buying the synergies in year one, we expect those synergies to go up over time, and we usually need to allow for full accretion of those synergies.

So my kind of usual approach would be to look at this on a three-year basis and identify whether at least by year three have they achieved a return on capital exceeds the target's cost of capital. So if I change those forecast synergies to 200, and ideally I'd also be using the NOPAT of the target by year three as well, that gives us synergies feeding through into our return on capital. And look, now we have got a much better justification for this deal. Return on invested capital of 9.8%, exceeding the cost of capital, and we are all happy with this transaction.

Okay? So those are our three tools in our toolkit that we wanted to look at today.

EPS accretion and dilution, pro forma debt capacity, and also return on invested capital. Let's just check in with the Britvic acquisition, because they actually include some of these metrics in their own financial rationale. Okay.

So here we have the financial rationale.

The first thing they said is that Carlsberg expects the return on invested capital will exceed a weighted average cost of capital of 7% in year three. So they've used that as one of the key justifications. They are going to generate a return on invested capital from this acquisition which exceeds the cost of capital. Okay? Secondly, they highlight that the deal is expected to be adjusted earnings per share accretive for Carlsberg by mid-single digits, okay, percentages, that's 5 to 7% usually, okay, already in year one. And by double-digit percentages, so at least 10%, in year two. And remember that there's further synergies expected by year three. Okay? So really positive in terms of EPS accretion, positive in terms of ROIC, but what about the debt? Well, the Britvic acquisition will be paid for in cash and is fully debt-financed. That immediately makes me think, hmm, some of that EPS accretion is coming from debt financing, because debt is cheap.

But also, Carlsberg will increase its net interest-bearing debt to EBITDA target to below 2.5 times. So it's relaxing its current target leverage.

That is a little bit of a red flag, particularly from a rating agency's perspective. And I can tell you now that the market response to this transaction was not very positive, and it was mostly to do with the level of debt that's going to be realized as a result of this transaction.

And in fact, here is an update from Fitch.

They did affirm their investment grade rating, but they highlighted a negative outlook.

And in the second paragraph, it does say that the negative outlook reflects the impact on Carlsberg's financial profile from the fully debt-funded acquisition for 3.3 billion pounds, as well as the weaker consumer environment.

They expect the transaction to raise EBITDA net leverage to 3.2 times with only gradual de-levering to 2.7 times. So this is a stretching deal from the credit perspective. Okay? So we have good numbers in terms of ROIC, good numbers in terms of EPS accretion, but the market did not like it because of debt concerns.

So we really need kind of everything to come together to tie up nicely with a little bow for the market to really love an acquisition.

So that is us at the end of our webinar. There was a lot in there. Apologies, I've gone a few minutes over.

Just one thing to highlight is that the workout file that we had, it does have a little case study acquisition which I strongly encourage you to do as a follow-up.

See if you can work through the numbers on this deal, M&A cash deal one.

The solution file is also provided to you in the same link that I gave you at the start of this session. Okay? I hope you found that session useful. I have had no questions coming in on the Q&A.

I will hold back for a few minutes before closing the webinar, just in case you've got any questions that you want to ask, okay? I'm very happy to take those.

But if you are comfortable, then please do feel free to go.

Thank you so much for joining, and I wish you a very enjoyable rest of the day and a lovely weekend.

Thank you so much. Thank you for listening.

Thank you, Ike.

Take care. Bye.