Asset-based Valuation Valuation for Acquisitions and Mergers
Applying Relative, Asset Oriented, and Real Option Valuation Methods to Mergers and Acquisitions
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Transcript of Applying Relative, Asset Oriented, and Real Option Valuation Methods to Mergers and Acquisitions
Applying Relative, Asset Oriented, and Real Option Valuation Methods to
Mergers and Acquisitions
You earn a living by what you get, but you build a life by what you give.
—Winston Churchill
Exhibit 1: Course Layout: Mergers, Acquisitions, and Other Restructuring Activities
Part IV: Deal Structuring and
Financing
Part II: M&A ProcessPart I: M&A Environment
Ch. 11: Payment and Legal Considerations
Ch. 7: Discounted Cash Flow Valuation
Ch. 9: Financial Modeling Techniques
Ch. 6: M&A Postclosing Integration
Ch. 4: Business and Acquisition Plans
Ch. 5: Search through Closing Activities
Part V: Alternative Business and Restructuring
Strategies
Ch. 12: Accounting & Tax Considerations
Ch. 15: Business Alliances
Ch. 16: Divestitures, Spin-Offs, Split-Offs,
and Equity Carve-Outs
Ch. 17: Bankruptcy and Liquidation
Ch. 2: Regulatory Considerations
Ch. 1: Motivations for M&A
Part III: M&A Valuation and
Modeling
Ch. 3: Takeover Tactics, Defenses, and Corporate Governance
Ch. 13: Financing the Deal
Ch. 8: Relative Valuation
Methodologies
Ch. 18: Cross-Border Transactions
Ch. 14: Valuing Highly Leveraged
Transactions
Ch. 10: Private Company Valuation
Learning Objectives
• Primary learning objective: To provide students with knowledge of alternatives to discounted cash flow valuation methods, including– Market Approach
• Comparable companies• Comparable transactions• Same industry or comparable industry
– Asset oriented approach• Tangible book value• Liquidation value• Break-up value
– Replacement Cost approach– Weighted average method
• Secondary learning objective: Enable students to understand how real options apply to M&As
Applying Market-Based (Relative Valuation) Methods1
MVT = (MVC / VIC) x VIT
WhereMVT = Market value of target companyMVC = Market value of the comparable company C2
VIC = Measure of value for comparable company CVIT = Measure of value for company T(MVC/VIC) = Market value multiple for the comparable company
1Comparable companies may include those with profitability, risk, and growth characteristics similar to the target firm; they are not necessarily found in the same industry as the target firm. Risk may be measured by the beta and the D/E or D/TC ratios.
2To identify comparable firms, calculate correlation coefficients with respect to revenue, profit, or cash flows of firms in the same or similar industries.
Relationship Between DCF and Market Multiples
Perpetuity DCF Model and P (price per share)/E (earnings per share) ratios:
P = E / ke (perpetuity model), dividing both sides by E gives
P / E = $1 / ke, which is the amount investors are willing to pay for $1 of earnings in
perpetuity
ex. If E = $1, the earnings payout ratio is 100%, and ke is 10%, then
P / E = $1 / .10 = $10 per dollar of earnings
Constant Growth DCF Model and P/E ratios:
PV = E (1 + g) / (ke – g) (constant growth model), dividing both sides by E
P / E = $1(1 + g) / (ke – g), the amount investors are willing to pay for $1 of
earnings growing at a constant growth rate g.
ex. If E = $1, the earnings payout ratio is 100%, ke is 10%, and the earnings growth rate
is 5%, then
P / E = $1 x 1.00 x (1.05) / (.10 - .05) = $21 per dollar of earnings.
Key Point: When comparing firms with different P/E ratios, which is more attractive depends on the expected earnings growth rate, payout ratio, and rate at which earnings can be reinvested.
Market-Based Methods: Comparable Company Example
Exhibit 8-1. Valuing Repsol YPF Using Comparable Integrated Oil Companies
Target Valuation Based on Following Multiples (MVC/VIC):
Comparable Company Trailing P/E1 Forward P/E2 Price/Sales Price/Book
Average
Col. 1 Col. 2 Col. 3 Col. 4 Col. 1-4
Exxon Mobil Corp (XOM) 11.25 8.73 1.17 3.71
British Petroleum (BP) 9.18 7.68 0.69 2.17
Chevron Corp (CVX) 10.79 8.05 0.91 2.54
Royal Dutch Shell (RDS-B) 7.36 8.35 0.61 1.86
ConocoPhillips (COP) 11.92 6.89 0.77 1.59
Total SA (TOT) 8.75 8.73 0.80 2.53
Eni SpA (E) 3.17 7.91 0.36 0.81
PetroChina Co. (PTR) 11.96 10.75 1.75 2.10
Average Multiple (MVC/VIC) Times 9.30 8.39 0.88 2.16
Repsol YPF Projections (VIT)3 $4.38 $3.27 $92.66 $26.49
Equals Estimated Mkt. Value of Target3 $40.73 $27.44 $81.54 $57.22 $51.73
1Trailing 52 week average. 2Projected 52 week average. 3Billions of Dollars.
Key Points: 1. Firm valuation differs significantly depending on valuation multiple used.
2. Valuation estimates require addition of a purchase price premium.
Market-Based Methods:Recent Transactions’ Method1
• Calculation similar to comparable companies’ method, except multiples used to estimate target’s value based on purchase prices of recent transactions of comparable companies.
MVT = (MVRT / VIRT) x VIT
Where
MVT = Market value of target company TMVRT = Market value of the recently acquired comparable company RTVIRT = Measure of value for recently acquired comparable company RTVIT = Measure of value for target company T(MVRT/VIRT) = Market value multiple for the recently acquired comparable company RT
• Most accurate method whenever the transaction is truly comparable and very recent.
• Major limitation is that truly comparable recent transactions are rare.• Valuations based on this method already include a purchase price premium
1Also called precedent method.
Market-Based Methods:Same or Comparable Industry Method
• Multiply target’s earnings or revenues by market value to earnings or revenue ratios for the average firm in target’s industry or a comparable industry.
MVT = (MVAF / VIAF) x VIT
WhereMVT = Market value of target firmMVAF = Market value of average firm (AF) in target firm’s or comparable industryVIAF = Measure of value for average firm in target firm’s or comparable Industry VIT = Measure of value for target company T(MVAF/VIAF) = Market value multiple for the average firm in target firm’s or comparable industry
• Primary advantage is the ease of use and availability of data.• Disadvantages include presumption industry multiples are actually comparable and
analysts’ projections are unbiased.• Requires addition of purchase price premium
PEG Ratio
• Firm A and Firm B have P/Es of 20 and 15, respectively. Which is more attractive?• PEG Ratio used to adjust relative valuation methods for differences in growth rates
among comparable firms.• Helpful in determining which of a number of different firms in same industry exhibiting
different growth rates may be the most attractive.
(MVT/VIT) = A and VITGR
MVT = A x VITGR x VIT
Where A = Market price to value indicator relative to the growth rate of value indicator (e.g., (P/E)/ EPS growth rate) MVT = Market value of target VIT = Value indicator for target (e.g., EPS) VITGR = Projected growth rate in value indicator (e.g., EPS)1
• Firms whose PEG ratios > 1 considered overvalued; PEG ratios < 1 considered undervalued
1Valid for VITGR > 0. For VITGR = 0 or < 0, firm value will not change or will decline.
An analyst is asked to determine whether Basic Energy Service (BES) or Composite Production Services (CPS) is more attractive as an acquisition target. Both firms provide engineering, construction, and specialty services to the oil, gas, refinery, and petrochemical industries.BES and CPS have projected annual earnings per share growth rates of 15 percent and 9 percent, respectively. BES’ and CPS’ current earnings per share are $2.05 and $3.15, respectively. The current share prices as of June 25, 2008 for BES is $31.48 and for CPX is $26. The industry average price-to-earnings ratio and growth rate are 12.4 and 11 percent, respectively. Based on this information, which firm is a more attractive takeover target (i.e., more undervalued) as of the point in time the firms are being compared?
Industry average PEG ratio:1 (MVT/VIT) / VITGR = A = 12.4/11 = 1.1273 BES: Implied share price = A x VITGR x VIT = 1.1273 x 15 x $2.05 = $34.66CPX: Implied share price = A x VITGR x VIT = 1.1273 x 9 x $3.15 = $31.96Answer: The difference between the implied and actual share prices for BES and CPX is $3.18 (i.e., $34.66 - $31.48) and $5.96 ($31.96 - $26.00), respectively. CPX is more undervalued than BES at that moment in time and therefore is the more attractive takeover target.
1Solving MVT = A x VITGR x VIT using an individual firm’s PEG ratio provides the firm’s current share price in period T, since this formula is an identity. An industry average PEG ratio may be used to provide an estimate of the firm’s intrinsic value. This implicitly assumes that the target firm and the average firm in the industry exhibit the same relationship between price-to-earnings ratios and earnings growth rates.
Applying the PEG Ratio
Asset-Based Methods:Tangible Book Value
• Tangible book value (TBV) = (total assets - total liabilities - goodwill)
MVT = (MVC / VICTBV) x VITTBV
WhereMVT = Market value of target company TMVC = Market value of the comparable company CVICTBV = Tangible book value for comparable company CVITTBV = Tangible book value for target company T(MVC/ICTBV) = Market value multiple for the comparable company
• Often used for valuing – Financial services firms where tangible book value is primarily cash
or liquid assets– Distribution firms where current assets constitute a large percentage
of total assets
Valuing Companies Using Asset Based Methods: Practice Problem
Ingram Micro distributes information technology products worldwide. The firm’s share price on 8/21/08 was $19.30. Projected 5-year annual net income growth is 9.5% and the firm’s beta is .89. Shareholders’ equity is $3.4 billion and goodwill is $.7 billion. Ingram has 172 million (.172 billion) shares outstanding. The following firms represent Ingram’s primary competitors. Note that Synnex Corporation can be viewed as an outlier.
Market Value/ Tangible Book Value
Beta Projected 5-Year Net Income Growth Rate
(%)
Tech Data .91 .90 11.6
Synnex Corporation .70 .40 6.9
Avnet 1.01 1.09 12.1
Arrow .93 .97 13.2
Based on this information, what is Ingram’s tangible book value per share (VIT)? What is the appropriate industry average market value to tangible book value ratio (MVIND/VIIND)? Estimate the implied market value per share for Ingram (MVT) using tangible book value as a value indicator. Based on this analysis, is Ingram under-or-overvalued compared to it 8/21/08 share price?
Asset-Based Methods: Liquidation Method
• Value assets as if sold in an “orderly” fashion (e.g., 9-12 months) and deduct value of liabilities and expenses associated with asset disposition.
• While varies with industry, – Receivables often sold for 80-90% of book value– Inventories might realize 80-90% of book book value
depending on degree of obsolescence and condition– Equipment values vary widely depending on age and
condition and purpose (e.g., special purpose)– Book value of land may understate market value– Prepaid assets such as insurance can be liquidated with
a portion of the premium recovered.
Asset-Based Method: Break-Up Value
• Target viewed as series of independent operating units, whose income, cash flow, and balance sheet statements reflect intra-company sales, fully-allocated costs, and operating liabilities specific to each unit
• After-tax cash flows are valued using market-based multiples or discounted cash flows analysis to determine operating unit’s estimated enterprise value
• The unit’s equity value is determined by deducting operating/non-operating liabilities from estimated enterprise value
• Aggregate equity value of the business is determined by summing equity value of each operating unit less unallocated liabilities held at corporate level (e.g., debt) and break-up costs (e.g., accounting and investment banking fees)
Replacement Cost Method
• All target operating assets are assigned a value based on what it would cost to replace them.
• Each asset is treated as if no additional value is created by operating the assets as part of a going concern.
• Each asset’s value is summed to determine the aggregate value of the business.
• This approach is limited if the firm is highly profitable (suggesting a high going concern value) or if many of the firm’s assets are intangible.
Weighted Average Valuation MethodAn analyst has estimated the value of a
company using multiple valuation methodologies. The discounted cash flow value is $220 million, comparable recent transactions’ value is $234 million, the comparable company average P/E-based value is $224 million and the firm’s break-up value is $200 million. The purchase price paid for the recent comparable transaction included a 20% premium. The analyst has greater confidence in certain methodologies than others. Estimate the weighted average value of the firm using all valuation methodologies and the weights or relative importance the analyst gives to each methodology.
Estimated
Value ($M)1
Relative
Weight
Weighted
Avg. ($M)
264 (DCF Method)
.30 79.2
234 (Recent
Transactions
Method)
.40 93.6
268.8 (Comparable Co. P/E Method)
.20 53.8
240 (Break-up Value Method)
.10 24.0
1.00 250.6
1Note that the DCF, P/E-based (comparable company), and break-up values were increased by 1.2 to reflect the 20% premium reflected in the recent comparable transactions estimate.
Real Options as Applied to M&As
• Real options refer to management’s ability to adopt and later revise corporate investment decisions (e.g., acquisitions)
• Options to expand (i.e., accelerate investment)– Acquirer accelerates investment in
target after acquisition completed due to better than anticipated performance of the target
• Options to delay (i.e., postpone timing of initial investment)– Acquirer delays completion of
acquisition until a patent pending receives approval
• Options to abandon (i.e., divest or liquidate initial investment)– Acquirer divests target firm due to
underperformance and recovers a portion of its initial investment
Alternative Real Option Valuation Methods
• Develop a decision tree for which the NPV of each “branch” represents the value of alternative real options. The option’s value is equal to difference between the NPV including the real option and the NPV without the real option.
• Treat the real options as financial options and value using the Black-Scholes method.– Option to expand or delay are valued as call options and added to
the NPV of the investment without the option.– Option to abandon is valued as a put option and added to the NPV
of the investment without the option.
Key Points: Total NPV = NPV Without Option + Option Value and
Option Value = Total NPV – NPV Without Option
Microsoft Real Options Decision Tree in 2008 Attempted Takeover of Yahoo
Base Case: Microsoft Offers
To Buy All Yahoo Shares in 2008
Option to expandcontingent on
successfulIntegration of Yahoo
& MSN
Option to postponecontingent on
Yahoo’s rejection of offer
Option to abandoncontingent on
failure to integrateYahoo & MSN
Purchase Yahoo online search only. Buy
remaining businesses later.
Enter long-term searchpartnership.
Implemented in 2010.
Offer revised price for all of Yahoo if
circumstances change
Spin off combined Yahoo andMSN to Microsoft
shareholders
Divest combined Yahoo & MSN.Use proceeds to pay dividend
or buy back stock.
Embedded Options
Microsoft & Yahoo Transaction Outcome
• 2008 offer price for all of Yahoo = $38 per share• Offer rejected by Jerry Yang (founder) and board of
directors• Microsoft withdraws offer and Yahoo share price
drops to $16 per share• Jerry Yang later fired• Microsoft and Yahoo agree to online search
partnership in 2010 in which MSN and Yahoo combine search businesses
Discussion Questions
1. Does the application of the comparable companies valuation method require the addition of an acquisition premium? Why or why not?
2. Which is generally considered more accurate: the comparable companies or recent transactions method? Explain your answer.
3. What key assumptions are implicit in the comparable companies valuation method? The recent comparable transactions method?
4. Explain the primary differences between the income (discounted cash flow), market-based, and asset-oriented valuation methods?
5. Under what circumstances might it be more appropriate to use relative-valuation methods rather than the DCF approach? Be specific.
Things to Remember…
• Alternatives to discounted cash flow analysis include the following:– Market based methods
• Comparable companies• Recent transactions• Same or comparable industries
– Asset based methods• Tangible book value• Liquidation value• Break-up value
– Replacement cost method– Weighted average method
• Firm value must be adjusted for both non-operating assets and liabilities.
• Real options should be considered in M&A valuation when clearly identifiable and when would add significantly to investment’s value