Private Equity Analysis Before a Leveraged Buyout

Professor Bilge Yilmaz on the science and subtle art of how PE values a company before it’s acquired

By Louis Greenstein

 

1. Long-Term Value2. Parallel Analysis 3. Multiple Options4. Essential Data 5. EBITDA or Not EBITDA?
A PE firm may buy a business and sell it next year, but on average it will own the business for five years. This model forecasts annual cash flow to help determine the business’s value in five years. But which measurement should a firm use?  
Analyzing comparable businesses helps determine the exit strategy—IPO, financial, or strategic—a firm should expect to execute in five years.
Most firms use EBITDA as a multiple. But if a business is looking at major capital expenditures, in some cases, EBITDA minus CAPEX may be useful. Or if lease expenses vary across firms, EBITDAR may be a better multiple.
 Data for the past few years helps PE firms understand drivers of a firm’s value.
EBITDA is a common measure, but it’s not always the best choice for making apples-to- apples comparisons of comparable businesses. 

Analyzing a company’s value for a leveraged buyout is a complex process with many moving parts. In a lecture drawing from Wharton private equity and finance professor and director of the Wharton Alternative Investments Initiative Bilge Yılmaz’s Finance of Buyouts and Acquisitions class, private equity firms use a model that looks at lots of data. “But you have to use some intuition, too,” he says.

A company’s value is determined using a valuation multiple such as EBIDTA. But how will the company stack up against others in its industry? Apples-to-apples comparisons can be tricky. “The challenge is how to choose your multiples,” says Yılmaz. EBIDTA is a common multiple, but it’s not always the right one. Say you want to buy a restaurant chain that owns its real estate. Comparable rent-paying chains will have a different EBIDTA, but their values might not be different. In this case, you’ll want to look at the competitors’ EBIDTAR. (The “R” stands for “rent.”)

In another example, Yılmaz describes how analysts use judgment as well as historical data. Say you plan to buy an autoparts supplier. The average firm value is around eight times EBIDTA. However, one that recently traded at seven times EBIDTA is now at 14 times its EBIDTA ; another has been trading at 10 times its EBIDTA consistently. “I need data for the last few years so I can map the multiples of these companies over time,” says Yılmaz. “Maybe the one that was trading at seven times had a lawsuit pending. Once it went away, the multiple went back up.” Or, conversely, a company that loses a patent could see its multiple drop and not rebound. While you can’t connect the event to the stock price with absolute certainty, you can use your instinct to make informed decisions.

The multiple you choose may also depend on your exit strategy. In a third example, imagine you’re buying a hospital chain for $33 billion and taking it private. “You’ll want to sell it at a significantly higher value,” says Yılmaz. “But who will buy it?” Typically, a strategic sale—e.g., to another hospital chain—is the most profitable exit strategy, because synergies may result in a higher price. But given the chain’s size, it’s highly unlikely another hospital chain could afford it, so a more reasonable approach may be to use a lower multiple and assume you will exit with an IPO.

The bottom line, according to Yılmaz: “There is no perfect measure. Pick so you can compare apples to apples, and stick with it.”

 

Published as “At the Whiteboard with Bilge Yilmaz” in the Fall/Winter 2017 issue of Wharton Magazine.

 

 

 

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