Underwriting

Why Underwriting?

Underwriting aids us in understanding the intrinsic value of the target company and pricing the company under various scenarios & methodologies.

Underwriting Process

1. Gathering Historical Financials

2. Building the Financial Statement Model

3. Finding Adjusted EBITDA

4. Deriving valuation from the three methodologies

5. Building the Valuation Football Field

6. Customizing the Financial Statement Model for Specific Transactions

Model Building Concepts

There are three components of every financial model which correspond to each of the steps in order of building the model.

Descriptive portion of the model - the portion of the model with the last 3 to 5 years accounting data for the financial statement. The historical data is considered descriptive analytics.

Predictive portion of the model - the portion of the financial model projecting forward for the explicit projection period including terminal year. The projections are based upon previous years performance with ratios held constant or sensitized (drivers). The pro forma data is considered predictive analytics.

Prescriptive portion of the model - the portion of the model focused on optimization. This is where you find out the ROI & sensitize assumptions to determine how to achieve the highest ROI (ex. LBO model, football field's median line recommended valuation price). The optimization data is considered a prescriptive analytic.

Financial Modeling & Valuation Steps:

1. Gather Historical Financials

2. Build the Financial Statement Model

3. Find Adjusted EBITDA

4. Derive Valuation from the Three Methodologies Using Adjusted EBITDA

5. Build the Valuation Football Field

6. Customize the Financial Model for Specific Transactions & Find the Prescriptive Analytic

1. Gather Historical Financials

Once the M&A mandate is won, we must now underwrite the deal. In order to underwrite the financial product, M&A, one needs to gather historical financials. This typically means trailing 3 years at minimum and ideally last 5 years. This will aid us building a financial statement model, explicit forecast, and ultimately a valuation football field to determine a final purchase price.

A Note on Accounting: Attribution & Proving Out ROI

Being able to attribute cost to investment and marketing decisions via accounting is important in terms of being able to compute and prove out ROI of investment decisions. Accounting ultimately equals attribution. Without proper cost and revenue attribution its much harder to compute/trust ROI.

Accounting is about the proper attribution of revenue and cost in order to be able to prove out ROI of a set of investment decisions aka a business. Without proper attribution, business intelligence derived from data science and analytics is less/not possible. Accounting via its system of attribution rules allows us to score an investments ROI. Accounting is ultimately the standardized rules of attribution. The rules of attribution lead to the formation of the standardized integrated financial statement model which will be the basis for ROI analytic analysis.

2. Build the Financial Statement Model

Once we have historical financials we can build the financial statement model which will be the basis for modeling various scenarios ultimately driving valuation.

3. Find Adjusted EBITDA

After receiving the financials for the target, the investment banker must calculate adjusted EBITDA. EBITDA and Total Owners Benefits (TOB) are proxies for cash flow but not true cash flow of the business as there will be CAPEX and working capital deducted to get to true cash flow. Total Owners Benefit adds back taxes, interest, depreciation and owners benefit. This analytic will be the basis for extrapolating a valuation using the three methodologies.

4. Derive Valuation from the Three Methodologies Using Adjusted EBITDA

After arriving at adjusted EBITDA, the investment banker will determine public comps and extrapolate a multiple for the target company adjusting for size of the company. From there, precedent transactions will be spread to determine a mean multiple.

DCF Method:

Most Accurate Benefit Stream That Reflects the Nature of the Economics of the Enterprise: Free Cash Flow Free Cash Flow = Cash flow from operations on SCF financial statement - CAPEX. CF Operations includes taxes and working capital already removed.

Getting from EBITDA to FCFF = tax effecting EBITDA(1- tax rate), adding back depreciation(tax rate), removing CAPEX, removing working capital

5. Build the Valuation Football Field

Finding the midpoint of the valuation methodologies can be used for determining valuation but the range is often communicated to the client or potential buyers.

6. Customize the Financial Model for Specific Transactions & Find the Prescriptive Analytic

After building out the financial statement model, we can build the transaction specific model related to particular buyers that have expressed or may have interest.