Valuationfor Mergers & Acquisitions Prof. Ian Giddy New York University
What’s a Company Worthto Another Company? • Required Returns • Types of Models • Balance sheet models • Dividend discount & corporate cash flow models • Price/Earnings ratios • Option models • Estimating Growth Rates • Application: How These Change with M&A Ipoh
Equity Valuation: From the Balance Sheet Value of Assets Book Liquidation Replacement Value of Liabilities Book Market Value of Equity
Equity Valuation: From the Balance Sheet Value of Assets Book Liquidation Replacement Value of Liabilities Book Market Value of Equity Book Value Liquidation Value Replacement Value Tobin’s Q: Market/Replacement tends to 1?
Relative Valuation • Do valuation ratios make sense? • Price/Earnings (P/E) ratios • and variants (EBIT multiples, EBITDA multiples, Cash Flow multiples) • Price/Book (P/BV) ratios • and variants (Tobin's Q) • Price/Sales ratios • It depends on how they are used -- and what’s behind them!
Discounted Cashflow Valuation: Basis for Approach • where • n = Life of the asset • CFt = Cashflow in period t • r = Discount rate reflecting the riskiness of the estimated cashflows
Valuing a Firm with DCF: An Illustration Historical financial results Adjust for nonrecurring aspects Gauge future growth Projected sales and operating profits Adjust for noncash items Projected free cash flows to the firm (FCFF) Year 1 FCFF Year 2 FCFF Year 3 FCFF Year 4 FCFF Terminal year FCFF … Stable growth model or P/E comparable Discount to present using weighted average cost of capital (WACC) Present value of free cash flows + cash, securities & excess assets - Market value of debt Value of shareholders equity
Estimating Future Cash Flows Dividends? Free cash flows to equity? Free cash flows to firm?
Value Shareholders’ Equity? • The value of equity is obtained by discounting expected cashflows to equity, i.e., the residual cashflows after meeting all expenses, tax obligations and interest and principal payments, at the cost of equity, i.e., the rate of return required by equity investors in the firm. where, CF to Equityt = Expected Cashflow to Equity in period t ke = Cost of Equity • The dividend discount model (DDM) is a specialized case of equity valuation, and the value of a stock is the present value of expected future dividends.
Or Value the Whole Firm? • The value of the firm is obtained by discounting expected cashflows to the firm, i.e., the residual cashflows after meeting all operating expenses and taxes, but prior to debt payments, at the weighted average cost of capital, which is the cost of the different components of financing used by the firm, weighted by their market value proportions. where, CF to Firmt = Expected Cashflow to Firm in period t WACC = Weighted Average Cost of Capital
Equity Valuation versus Firm Valuation • Value just the equity stake in the business • Value the entire firm, which includes, besides equity, the other claimholders in the firm • In the context of M&A or financial restructuring, we want to know the value of the firm because we’ll probably change the debt structure.
The Weighted Average Cost of Capital Choice Cost 1. Equity Cost of equity - Retained earnings - depends upon riskiness of the stock - New stock issues - will be affected by level of interest rates - Warrants Cost of equity = riskless rate + beta * risk premium 2. Debt Cost of debt - Bank borrowing - depends upon default risk of the firm - Bond issues - will be affected by level of interest rates - provides a tax advantage because interest is tax-deductible Cost of debt = Borrowing rate (1 - tax rate) Debt + equity = Cost of capital = Weighted average of cost of equity and Capital cost of debt; weights based upon market value. Cost of capital = kd [D/(D+E)] + ke [E/(D+E)]
Valuation: The Key Inputs • A publicly traded firm potentially has an infinite life. The value is therefore the present value of cash flows forever. • Since we cannot estimate cash flows forever, we estimate cash flows for a “growth period” and then estimate a terminal value, to capture the value at the end of the period:
Dividend Discount Models:General Model • V0 = Value of Stock • Dt = Dividend • k = required return
Specified Holding Period Model • PN = the expected sales price for the stock at time N • N = the specified number of years the stock is expected to be held
No Growth Model • Stocks that have earnings and dividends that are expected to remain constant • Preferred Stock
No Growth Model: Example Burlington Power & Light has earnings of $5 per share and pays out 100% dividend The required return that shareholders expect is 15% The earnings are not expected to grow but remain steady indefinitely What’s a BPL share worth? E1 = D1 = $5.00 k = .15 V0 = $5.00 / .15 = $33.33
Constant Growth Model • g = constant perpetual growth rate
Constant Growth Model: Example Motel 6 has earnings of $5 per share. It reinvests 40% and pays out 60%dividend The required return that shareholders expect is 15% The earnings are expected to grow at 8% per annum What’s an M6 share worth? E1 = $5.00 b = 40% k = 15% (1-b) = 60% D1 = $3.00 g = 8% V0 = 3.00 / (.15 - .08) = $42.86 Plowback rate
Estimating Dividend Growth Rates • g = growth rate in dividends • ROE = Return on Equity for the firm • b = plowback or retention percentage rate i.e.(1- dividend payout percentage rate)
Shifting Growth Rate Model • g1 = first growth rate • g2 = second growth rate • T = number of periods of growth at g1
Shifting Growth Rate Model: Example Mindspring pays dividends $2 per share. The required return that shareholders expect is 15% The dividends are expected to grow at 20% for 3 years and 5% thereafter What’s a Mindspring share worth? D0 = $2.00 g1 = 20% g2 = 5% k = 15% T = 3 D1 = 2.40 D2 = 2.88 D3 = 3.46 D4 = 3.63 V0 = D1/(1.15) + D2/(1.15)2 + D3/(1.15)3 + D4 / (.15 - .05) ( (1.15)3 V0 = 2.09 + 2.18 + 2.27 + 23.86 = $30.40
Stable Growth and Terminal Value • When a firm’s cash flows grow at a “constant” rate forever, the present value of those cash flows can be written as: Value = Expected Cash Flow Next Period / (r - g) where, r = Discount rate (Cost of Equity or Cost of Capital) g = Expected growth rate • This “constant” growth rate is called a stable growth rate and cannot be higher than the growth rate of the economy in which the firm operates. • While companies can maintain high growth rates for extended periods, they will all approach “stable growth” at some point in time. • When they do approach stable growth, the valuation formula above can be used to estimate the “terminal value” of all cash flows beyond.
Growth Patterns • A key assumption in all discounted cash flow models is the period of high growth, and the pattern of growth during that period. In general, we can make one of three assumptions: • there is no high growth, in which case the firm is already in stable growth • there will be high growth for a period, at the end of which the growth rate will drop to the stable growth rate (2-stage) • there will be high growth for a period, at the end of which the growth rate will decline gradually to a stable growth rate(3-stage) • The assumption of how long high growth will continue will depend upon several factors including: • the size of the firm (larger firm -> shorter high growth periods) • current growth rate (if high -> longer high growth period) • barriers to entry and differential advantages (if high -> longer growth period)
Length of High Growth Period • Assume that you are analyzing two firms, both of which are enjoying high growth. The first firm is Earthlink Network, an internet service provider, which operates in an environment with few barriers to entry and extraordinary competition. The second firm is Biogen, a bio-technology firm which is enjoying growth from two drugs to which it owns patents for the next decade. Assuming that both firms are well managed, which of the two firms would you expect to have a longer high growth period? • Earthlink Network • Biogen • Both are well managed and should have the same high growth period
Choosing a Growth Pattern: Examples Company Valuation in Growth Period Stable Growth Disney Nominal U.S. $ 10 years 5%(long term Firm (3-stage) nominal growth rate in the U.S. economy Aracruz Real BR 5 years 5%: based upon Equity: FCFE (2-stage) expected long term real growth rate for Brazilian economy Deutsche Bank Nominal DM 0 years 5%: set equal to Equity: Dividends nominal growth rate in the world economy
Relative Valuation • In relative valuation, the value of an asset is derived from the pricing of 'comparable' assets, standardized using a common variable such as earnings, cashflows, book value or revenues. Examples include -- • Price/Earnings (P/E) ratios • and variants (EBIT multiples, EBITDA multiples, Cash Flow multiples) • Price/Book (P/BV) ratios • and variants (Tobin's Q) • Price/Sales ratios
Price Earnings Ratios • P/E Ratios are a function of two factors • Required rates of return (k) • Expected growth in dividends • Uses • Relative valuation • Extensive use in industry
Ratios Do Have Meaning • Gordon Growth Model: • Dividing both sides by the earnings, • Dividing both sides by the book value of equity, • If the return on equity is written in terms of the retention ratio and the expected growth rate • Dividing by the Sales per share,
P/E Ratio: No expected growth • E1 - expected earnings for next year • E1 is equal to D1 under no growth • k - required rate of return
P/E Ratio with Constant Growth Where • b = retention ratio • ROE = Return on Equity
Numerical Example: No Growth E0 = $2.50 g = 0 k = 12.5% P0 = D/k = $2.50/.125 = $20.00 P/E = 1/k = 1/.125 = 8 Quickie Broom Co has earnings of $2.50 per share. It pays out 100%dividend The required return that shareholders expect is 12.5% (based on CAPM with Beta of 1, RF = 7%, Market risk premium 5.5%) What PE ratio should such a company have?
Numerical Example with Growth b = 60% ROE = 15% (1-b) = 40% E1 = $2.50 (1 + (.6)(.15)) = $2.73 D1 = $2.73 (1-.6) = $1.09 k = 12.5% g = 9% P0 = 1.09/(.125-.09) = $31.14 PE = 31.14/2.73 = 11.4 PE = (1 - .60) / (.125 - .09) = 11.4
PE ratio divided by the growth rate Disney: Relative Valuation Company PE Expected Growth PEG King World Productions 10.4 7.00% 1.49 Aztar 11.9 12.00% 0.99 Viacom 12.1 18.00% 0.67 All American Communications 15.8 20.00% 0.79 GC Companies 20.2 15.00% 1.35 Circus Circus Enterprises 20.8 17.00% 1.22 Polygram NV ADR 22.6 13.00% 1.74 Regal Cinemas 25.8 23.00% 1.12 Walt Disney 27.9 18.00% 1.55 AMC Entertainment 29.5 20.00% 1.48 Premier Parks 32.9 28.00% 1.18 Family Golf Centers 33.1 36.00% 0.92 CINAR Films 48.4 25.00% 1.94 Average 27.44 18.56% 1.20
Is Disney fairly valued? • Based upon the PE ratio, is Disney under, over or correctly valued? • Under Valued • Over Valued • Correctly Valued • Based upon the PEG ratio, is Disney under valued? • Under Valued • Over Valued • Correctly Valued • Will this valuation give you a higher or lower valuation than the discounted CF valuation? • Higher • Lower
Relative Valuation Assumptions • Assume that you are reading an equity research report where a buy recommendation for Viacom is being based upon the fact that its PE ratio is lower than the average for the industry. Implicitly, what is the underlying assumption or assumptions being made by this analyst? • The sector itself is, on average, fairly priced • The earnings of the firms in the group are being measured consistently • The firms in the group are all of equivalent risk • The firms in the group are all at the same stage in the growth cycle • The firms in the group are of equivalent risk and have similar cash flow patterns • All of the above
Equity Valuation: Application to M&A Prof. Ian Giddy New York University
How Much Should We Pay? Applying the discounted cash flow approach, we need to know: 1. The incremental cash flows to be generated from the acquisition, adjusted for debt servicing and taxes 2. The rate at which to discount the cash flows (required rate of return) 3. The deadweight costs of making the acquisition (investment banks' fees, etc)
Application • Fakawi Navigation plans to acquire Feng-Shui Compass Co. This would result in $25 million of incremental operating revenues in each of the first 5 years, and in $15 million of additional debt servicing costs per annum, as well as $5 million in tax shields. Fakawi expects to divest the target in year 6 for $100 million. The Treasury note rate is 6%, and the S&P return is 16%. Fakawi's advisors estimate that Feng-Shui has a beta of 1.3. For this advice they are charging 2% of the acquisition price. • What is the maximum price that Fakawi should offer for Feng-Shui?
The Gains From an Acquisition Gains from merger Synergies Control Top line Bottom line Financial restructuring Business Restructuring (M&A)
Current Market Value Current market Maximum overpricing or restructuring underpricng opportunity Total Company’s restructured DCF value value Restructuring Financial Framework structure Operating improvements improvements Potential value with Potential internal value with Disposal/ + external internal Acquisition improvements improvements opportunities Framework for Assessing Retructuring Opportunities 1 2 5 (Eg Increase D/E) 4 3
Equity Valuation in Practice • Estimating discount rate • Estimating cash flows • Application to Optika • Application in M&A: Schirnding-Optika
Optika WACC: ReE/(D+E)+RdD/(D+E) Value: FCFF/(WACC-growth rate) CAPM: 7%+1(5.50%) Equity Value: Firm Value - Debt Value = 2278-250 = 2028 Debt cost (7%+1.5%)(1-.35)
Optika-Schirnding with Synergy Case Study: Ipoh-Kelantan
Valuing a Firm – The Basics • The value of the firm is obtained by discounting expected cashflows to the firm, i.e., the residual cashflows after meeting all operating expenses and taxes, but prior to debt payments, at the weighted average cost of capital, which is the cost of the different components of financing used by the firm, weighted by their market value proportions.