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Learning Objectives¹

Applying Relative, Asset Oriented, and Real Option Valuation Methods to Mergers and Acquisitions Chapter 8. Learning Objectives¹. Primary learning objective: To provide students with knowledge of alternatives to discounted cash flow valuation methods, including

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Learning Objectives¹

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  1. Applying Relative, Asset Oriented, and Real Option Valuation Methods to Mergers and AcquisitionsChapter 8

  2. Learning Objectives¹ • Primary learning objective: To provide students with knowledge of alternatives to discounted cash flow valuation methods, including • Market Approach – Similar to real estate valuations • Comparable companies • Comparable transactions • Same industry or comparable industry • Asset oriented approach • Tangible book value • Liquidation value • Break-up value • Cost approach • Weighted average method ¹ See Website, Chapter 8, Alternate Valuation Ratios, Table 7, which discusses several alternate Equity Valuation and Enterprise Valuation Ratios.

  3. Applying Market-Based (Relative Valuation) Methods1 MVT = (MVC / IC) x IT Where MVC = Market value of the comparable company C IC = Measure of value for comparable company C IT = Measure of value for company T (MVC/IC) = Market value multiple for the comparable company 1Comparable companies may include those with profitability, risk, and growth characteristics similar to the target firm.

  4. Relative Valuation¹ • Value of asset is compared to values assessed by the market for similar or comparable asset. • Requirements: • Identify comparable assets and market values • Convert market values to standardized values creating price multiples. • Compare relative values controlling for any differences. ¹ Damodoran, Corporate Finance, New York University, Chapter 7

  5. Relative valuation is pervasive • Most valuations on Wall Street are relative valuations. • Almost 85% of equity research reports are based upon a multiple and comparables.¹ • More than 50% of all acquisition valuations are based upon multiples • Rules of thumb based on multiples are not only common but are often the basis for final valuation judgments. ¹ Another study indicates 10:1 in favor of relative comps.

  6. Relative valuation is pervasive • While there are more discounted cash flow valuations in consulting and corporate finance, they are often relative valuations masquerading as discounted cash flow valuations. • The objective in many discounted cash flow valuations is to back into a number that has been obtained by using a multiple. • The terminal value in a significant number of discounted cash flow valuations is estimated using a multiple.

  7. Valuation Ratios versus DCF¹ • Do both • Both entail use of value estimates, professional judgment, quality of information and purpose of valuation. • Acquisition of specific, known asset or company, and good data, Comps may be better. • Acquisition of general, non-specific or unknown asset or company, DCF may be better. ¹ See Titman, Valuation-The Art and Science of Corporate Investment Decisions, 2011, pgs. 291-2.

  8. Market-Based Methods: Comparable Company Example

  9. Valuation ExxonMobil Chemical • ExxonMobil, 3rd largest following BASF & DuPont • Division earned $3.428 Billion • Hypothetical – assume spin off of division. • What is the baseline valuation? (Next slide - 10) • Modify baseline to adjust for relative size. (Slide 11) • Consider growth factors (Slide 12)

  10. Equity Valuation Using PE RatiosChemical Company P/E Ratios

  11. Market Cap and PE Ratios

  12. Variation of PE Ratio

  13. Valuation of ExxonMobil • Baseline valuation • Earnings $3.428B X P/E Ratio 14.28 = $48.94 B • Modification to reflect relative size • Earnings $3.428B X P/E Ratio 15.94 = $54.63 B • Further modification • Substantial dispersion (10.77 – 23.59) in P/E Ratios even among top 4 firms indicate risk and growth potential must be considered.

  14. 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 recently acquired comparable companies. • Most accurate method whenever the transaction is truly comparable and recent. Boston Beer IPO • Major limitation is that truly comparable recent transactions are rare. 1Also called precedent method.

  15. Boston Beer Company • Founded 1984 6th generation brewer (HBS) • Drawn by European, more bitter brews. • Not looking to compete with Budweiser etc. • By 1994, largest craft brewer, grew 57%. • 7 year round and seasonal beers. • Boston Lager 63% of sales. • European standards and raw materials.

  16. Boston Beer Company • Used four contract breweries. • Four initiatives • High quality – 5 masters, “date passed, beer goes” • Contract brewing – Pros and cons? • Intensive marketing & sales – 40 ¢ of each $ • Product innovations - seasonal & private labeling • Outlook • Current growth – stagnant but craft beers grew • Niche marketing and development?

  17. Boston Beer Company • Competitors - SWOT • Majors – AB Bev; Coors, Miller • 2nd Tier – Strohs, Heileman, Genessee etc. • Tough for them to fight the Big 3 • Loss of market share • Excess capacity – How did this help BBC? • Imports – German, Holland, Canada, Mexico. Subsequent changes due to M&A ie. Molson/Coors • Craft breweries – far and away, the smallest

  18. Boston Beer Company • Craft Brewing – smallest; rapid growth -40% • Very competitive, proprietary recipes • Catered to upscale market therefore expensive • Four types • Brewpubs (12%) - product consumed on site • Micro (22%) – limited distribution < 15,000 bbls • Regional (30%)- limited distribution, capital intensive, limited marketing, brand recognition • Custom (36%) – Typically contract, less capital intensive therefore more marketing $

  19. Boston Beer Company • Recent IPOs: • Redhook – two plants, planning a third, allied with Bud in NH using distribution network. 41% growth Now Craft Brewers Alliance. $6.84 share price 10/5/11 • Pete’s – Contract brewer, allied with Strohs, planned to build brewery. Now Pete’s Wicked Brewing. Private. Affiliated with Gambrinus, importers Moosehead, Corona • Further characteristics – See previous slides • Questions and Issues from the “Market”: • Positive reception – how well/how long? Hula hoop? • Age old question of sustainable growth. • Dependence on 2nd tier breweries?

  20. Boston Beer IPO Calculation

  21. Boston Beer IPO • November 21, 1995 , BBC issues 2.9 million shares at $20 each. • Price by end of day rose 50% to $30.75. • Today’s Price $80.49. Earlier this year, $100.93.

  22. 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. • Primary advantage is the ease of use and availability of data. • Disadvantages include presumption industry multiples are actually comparable and analysts’ projections are unbiased.

  23. PEG Ratio = PE Ratio/Earnings Growth • Used to adjust relative valuation methods for differences in growth rates among comparable firms. • Many current models assumes zero or minimal growth • BES/CPS example: BES/CPS 15 & 9% respectively vs industry 12.4 & 11%. • 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)

  24. Applying the PEG Ratio An analyst is asked to determine whether Basic Energy Service (BAS) 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 as of the point in time the firms are being compared? Industry average PEG ratio:1 12.4 (PE Ratio) /.11 (Growth rate of earnings) = 112.73 BES: Implied share price = 112.73 x .15 x $2.05 = $34.66 10.1% undervalued CPX: Implied share price = 112.73 x .09 x $3.15 = $31.96 22.9% undervalued Answer: 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. 1Solving MVT = A x VITGR x VIT using an individual firm’s PEG ratio provides the firm’s current or 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 both firms exhibit the same relationship between price-to-earnings ratios and earnings growth rates.

  25. Asset-Based Methods:Tangible Book Value • Tangible book value (TBV) = (total assets - total liabilities - goodwill) • Target’s estimated value = Target’s TBV x [(industry average or comparable firm market value) / (industry or comparable firm TBV)]. • 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 • Remember impact of GAAP = historical cost

  26. Valuing Companies Using Asset Based Methods

  27. Solution to Ingram Problem • Ingram’s net tangible book value per share (VIT) = ($3.4 -$.7)/.172 = $15.70¹ • Based on risk as measured by the firm’ beta and the 5-year projected earnings growth rate, Synnex is believed to exhibit significantly different risk and growth characteristics and is excluded from the calculation of the industry average market value to tangible book value ratio. Therefore, the appropriate industry average ratio is as follows: MVIND/VIIND = .95 [i.e., (.91+1.01+.93)/3] • Ingram’s implied value per share = MVT = (MVIND/VIIND) x VIT = .95 x $15.70 = $14.92 • Based on the implied value per share, Ingram was over-valued on 8/21/08 when its share price was $19.30 ¹ Note, we are deriving tangible book value by assuming it equals equity less intangible assets (goodwill). The better approach would be to review or project NBV from financial statement.

  28. 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. Used in Chapter 7/11 Bankruptcy Cases. • While varies with industry, • Receivables often sold for 80-90% of book value • Inventories might realize 80-90% of 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.

  29. Asset-Based Methods: Liquidation Method • Nortel Networks – Canadian Company • July 1, 2011 pursuant to Bankruptcy • Sold 6,000 patents for $4.5 Billion at auction to Rockstar Bidco. • Consortium Apple, EMC, Microsoft, RIM & Sony • Google – defensive, stalking horse bid to discourage suits over Android & Chrome. • Intel – early bidder but teamed with Google

  30. 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 current market value • The unit’s equity value is determined by deducting operating liabilities from current market value Mkt. Cap • Aggregate equity value of the business is determined by summing equity value of each operating unit less unallocated liabilities and break-up costs • May be used by private equity/hedge and LBO deals.

  31. McGraw Hill Spin Off ?¹ • August 2011 – Publisher & S&P owner • Pressure from activist hedge fund Jana Partners and Ontario Teachers’ Pension Plan. • Meetings between MH (Goldman) & Jana • MH –”mini conglomerate of non related information businesses”. “Education – capital intensive and plodding growth”? • Lazard & JPMorgan Chase – breakup value $55 per share versus $41 current price. ¹ See website, McGraw Hill Faces Breakup Pressures, Business Week, August 2, 2011.

  32. 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.

  33. Weighted Average Valuation Method An analyst has estimated the value of a company using multiple valuation methodologies. The discounted cash flow value is $220 million, comparable transactions’ value is $234 million, the P/E-based value is $224 million and the liquidation value is $150 million. 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.

  34. 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) - Genzyme • 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

  35. 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 its NPV and the NPV without the real option. Art or science? • 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.

  36. Option to expand contingent on successful integration of Yahoo & MSN Purchase Yahoo online search business only. Buy remaining businesses later. Base Case: Microsoft offers to buy all outstanding shares of Yahoo Option to postpone contingent on Yahoo’s rejection of offer Offer same/lower price for all of Yahoo if board composition changes Spin-off combined Yahoo & MSN to Microsoft shareholders Option to abandon contingent on failure to integrate Yahoo & MSN Divest combined Yahoo & MSN. Use proceeds to pay dividend or buy back stock. Analyzing Microsoft’s Real Options in Its Attempted Takeover of Yahoo – “handicapping”

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