Chapter 13: Return Analysis
Having completed pro forma estimates is a significant accomplishment, but it still doesn’t tell us how much money we can expect to make on the deal. Investors care about returns. Simply put, how much money can we expect to make off this leveraged buyout, if we put our money at risk in the deal?
“IRR analysis is an effective way to measure the profitability or returns of investments.”
A good way to measure estimated returns is by using an internal rate of return analysis or IRR analysis. IRR analysis is an effective way to measure the profitability or returns of investments. An easy way to think of IRR is as if it were the yield on a loan. When you lend a friend $100 dollars and he pays you back that $100 plus another $10 because you are such a nice person, you have realized an IRR of 10%. Another way that IRR is commonly described is the discount rate at which the net present value of all cash flows is equal to zero. We will not go into detail on that explanation, but it is good for you to know that IRR is commonly referred to as such. However, at the end of the day it is still just the $10 profit you made from risking your money. Keeping that in mind, let’s move on to building our IRR analysis for the target company, based on the pro forma estimates that you just created.
Just like in our example, where our friend paid us back the money we lent him, at some point in time investors are going to want to get their money back, plus a return on the investment. The only way to do that is to exit the investment by selling it to another buyer. A common practice for measuring the price paid for an investment is as a multiple of the company’s earnings. Measuring purchase price as a multiple of earnings provides some context when comparing the purchase price relative to other, similar companies. Using multiples of earnings can also be used to approximate a fair purchase price as well. Say, for example, you just won the biggest poker tournament the world has ever seen and with your winnings you decide you want to buy the casino. One of the first things you are going to want to know is how much do other casinos cost to buy. If you find out that all the other casinos are valued at approximately 10.0x earnings, there better be a good reason why the casino you are attempting to buy is seeking an implied 16.0x earnings as its asking price. Using multiples of earnings levels the playing field and lets potential buyers know how much they would be spending for each dollar of earnings the company is currently and expecting to generate in the future.
In our IRR analysis we use a conservative exit multiple of 8.0x EBITDA. For the purposes of this example, let’s assume that all the target company’s competitors that are publicly traded trade in a range hovering around 8.0x EBITDA. Based on the fact that similar companies trade around the same multiple of earnings, we can say that 8.0x EBITDA is justifiable exit multiple. EBITDA is an ideal figure for calculate multiples because it excludes any factors concerning capital structure or financing decisions as well as tax treatments. In essence, EBITDA does a good job of leveling the field for comparison so that potential investors can get down to the business of evaluating the operations and earnings power of a company.
We begin constructing the IRR analysis by calculating the implied enterprise value of our target company by multiplying the exit multiple of 8.0x EBITDA (D69), which we explained above, by the pro forma Year 1 EBITDA figure (F49). You can think of enterprise value as the amount of money that would be required to buy the target company outright. Enterprise value is equal to the sum of common and preferred equity, debt, and minority interests less any cash on the balance sheet and the market value of ownership interests in associate companies. Your formula in cell (F70) should look like the following: =F49*$D$69. Note that we are anchoring the exit multiple of 8.0x because we will continue to use this multiple throughout our IRR analysis.
“You can think of enterprise value as the amount of money that would be required to buy the target company outright.”
IRR analysis
In order to calculate the implied equity value of the target company, which is what we as equity investors are most concerned with, we must subtract the net debt from the implied enterprise value we just calculated. Net debt is simply the company’s outstanding short-term and long-term debt less cash and cash equivalents on the balance sheet:
net debt = short-term debt + long-term debt - cash and cash equivalents
In our IRR analysis, still in Year 1, we will calculate net debt by setting our formula equal to the outstanding debt balance of Year 1 (Q43) less the cash on hand ending balance of Year 1 (Q48). In our example analysis we are representing the net debt as a negative number because we are subtracting it from the implied enterprise value. For that reason, we need to place a negative sign at the beginning of the net debt formula. Your formula for Year 1 net debt in cell Q8 should look like the following: =-(Q43-Q48)
From here we can calculate the implied equity value, which is simply the result of subtracting net debt from implied enterprise value:
implied equity value = implied enterprise value - net debt
Since we have already taken the step to represent net debt as a negative number, all we need to do is sum the two figures to arrive at the target company’s implied equity value in Year 1. Your formula in cell (F72) should look like the following: =sum(F70:F71). Try using the keyboard shortcut ALT+EQUALS to calculate the formula in as few key strokes as possible. We can see that from the prospective initial equity investment of $4,500, our projections show that implied equity value has already grown to $5,166 by the end of Year 1. In other words, we expect equity value to have increased by over $660 million. But is just comparing the absolute implied equity value the only way to go about measuring performance?
The short answer is, No. We can use the internal rate of return to measure returns performance on a relative basis, which when combined with absolute returns figures, can give prospective investors a much fuller picture on a potential investment. When it comes to measuring performance, generally speaking, more is more. The more angles from which you can assess an investment, the more comprehensive your analysis and that makes potential investors more comfortable.
“We want to know what kind of returns on the investors’ money, in percentage terms, we are forecasting with the given assumptions of the model.”
Looking at the first year’s implied equity value, we want to calculate the internal rate of return for Year 1 in order to get an understanding of the target company’s pro forma performance on a relative basis. We want to know what kind of returns on the investors’ money, in percentage terms, we are forecasting with the given assumptions of the model. In order to do this, we will need to calculate the rate of return, which is a function of the amount of money put into the investment, the amount of money investors expect to get out of the investment (including periodic dividends and the lump sum upon selling the investment), and the amount of time taken to realize returns. In our example, we do not expect the target company to be paying out dividends over the explicit forecast range. Instead, the company will be focused on using earnings to pay down debt.
We can calculate the expected IRR by using the RATE function in our spreadsheet. In Year 1 (F74), we will use the following formula: =RATE(F68,0,-$F$12,F72). Let’s translate this formula into common language. The RATE formula is broken down into a few pieces. The first is the number of periods, which is understood to be years. We are in Year 1, so there is only one period so far and we are referencing cell (F68) because this cell has a numerical value of one. The second component of the RATE function is payment. As we mentioned, there are no paid dividends estimated for the target company in the forecasted periods, so the incremental payments are zero. (If we were calculating a rate of interest for a loan, we would enter the interest payments in this section and that would be used to determine the cost of the loan.) The next component of the RATE function is present value (of investment). This amount is entered as a negative number because the cash is leaving the bank account of the investor and going towards the purchase of the investment. (Note that this figure is anchored because we will be using the same number in all of the following years’ IRR calculations.) The final consideration in our rate of return formula is future value (of investment). This is the estimated pro forma dollar amount that an investor would sell the investment for and have the funds placed into their bank account. This figure is of course a positive number because it is money that will be received at the point of sale. These four components come together to calculate the forecasted internal rate of return for the target company in the pro forma Year 1. When computed, we see that the internal rate of return is projected to be approximately 14.8% if the company were sold one year after the initial investment.
Multiple of Money
Another metric often used to measure returns is the multiple of money:
multiple of money = implied equity value / equity investment
This metric is quick and easy to understand because it provides a relative measure of how much money was returned on an investment to how much money was actually invested. The major shortcoming of this statistic is that it does not take into consideration the time it takes to realize returns on investment. What good is a return of 2,000% to you as a business owner if it takes 200 years to realize that return? You will already be dead! Your great grandchildren may be appreciative though.
“Multiple of money provides a relative measure of how much money was returned on an investment to how much money was actually invested.”
Let’s go ahead and calculate the implied multiple of money in the returns analysis portion of our model, directly below implied IRR, which we just calculated. We begin by setting Year 1 (F75) equal to the implied equity value of pro forma Year 1 and then divide by the initial equity investment, which we originally assumed at the beginning of our model to be $4,500 million. In formula form, your equation should look like the following: =F72/$F$12. We will anchor the initial equity investment reference in our formula because it will be used in subsequent formulas to calculate multiple of money in the following pro forma years. Once you have the formula in place, you should have a resulting multiple of money figure of 1.1x.
Returns in the Future
Now that we have calculated implied equity value along with implied internal rate of return and the implied multiple of money for pro forma Year 1 we can apply the same formulas across the remaining pro forma years to determine what the implied returns are in the later years of the investment.
We can do this in a few keys strokes using the CTRL+R keyboard shortcut. First, highlight the area from pro forma Year 1 implied enterprise value down and across to pro forma Year 5 implied multiple of money. Once we have the desired area highlighted press CTRL+R. Your formulas should be applied across the pro forma years all the way to Year 5. All of our anchoring was put in place for the formulas created in the Year 1 calculations and for that reason we are able to apply the same formulas across the future years.
If we look at the results of our forecast, we see that implied equity value continues to build over the explicit forecast range, which should not be too surprising to us at this point. And naturally, the implied multiple of money also continues to increase over the pro forma years as equity values increase. What is a little more interesting, however, is that the implied IRR peaks in Year 3. Why is that?
As we mentioned, the multiple of money calculation does not take into consideration time or the time value of money. So, of course, as long as equity value increases the multiple of money statistic will continue to increase. (This is a positive thing!) However, IRR does take into consideration the timing of returns. For that reason, we see that the implied internal rate of return peaks in Year 3. It would take accelerated revenue growth or increased cost reduction (or both) to see increasing IRR after Year 3. For reasons like this, professional investors do not only rely on one metric to provide them with insight on the attractiveness of an investment. Investors will have to look at the calculations such as these and make a determination as to when it would be ideal to exit an investment. The decision will most likely be based on a number of considerations. The first will be whether or not a buyer can be located. After all, every transaction needs a buyer and a seller, but other considerations will include what other opportunities exist in the market and whether the potential returns from another investment outperform the returns of the current investment. This is a simplified view of an investor, as there are countless considerations that must be accounted for. However, the bottom line for every investor is – Where can I get the most for my money? These two ratios help an investor measure what they will get for their money in this investment from different angles.
“The bottom line for every investor is – Where can I get the most for my money? These ratios help them measure that.”