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

Course Layout: M&A & Other Restructuring Activities

Part IV: Deal Structuring &

Financing

Part II: M&A Process

Part I: M&A Environment

Payment & Legal Considerations

Public Company Valuation

Financial Modeling

Techniques

M&A Integration

Business & Acquisition Plans

Search through Closing Activities

Part V: Alternative Strategies

Accounting & Tax Considerations

Business Alliances

Divestitures, Spin-Offs & Carve-Outs

Bankruptcy & Liquidation

Regulatory Considerations

Motivations for M&A

Part III: M&A Valuation & Modeling

Takeover Tactics and Defenses

Financing Strategies

Private CompanyValuation

Cross-BorderTransactions

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

– 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 / IC) x IT

Where

MVT = Market value of target company

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.

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 $40.72 $27.42 $81.77 $57.32 $51.81

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 / IRT) x IT

Where

MVT = Market value of target company TMVRT = Market value of the recently acquired comparable company RTIRT = Measure of value for recently acquired comparable company RTIT = Measure of value for target company T(MVRT/IRT) = 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 / IAF) x IT

WhereMVT = Market value of target firmMVAF = Market value of average firm in target firm’s or comparable industryIAF = Measure of value for average firm in target firm’s or comparable Industry IT = Measure of value for company T(MVAF/IAF) = 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

• 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)1

VITGR = Projected growth rate in value indicator (e.g., EPS)

• 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.

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 BAS 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/.11 = 112.73 BES: Implied share price = 112.73 x .15 x $2.05 = $34.66CPX: Implied share price = 112.73 x .09 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.

Asset-Based Methods:Tangible Book Value

• Tangible book value (TBV) = (total assets - total liabilities - goodwill)

MVT = (MVC / ICTBV) x ITTBV

WhereMVT = Market value of target companyMVC = Market value of the comparable company CICTBV = Tangible book value for comparable company CITTBV = Tangible book value for target company (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

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.

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?

Solution to Ingram Problem

• Ingram’s net tangible book value per share (VIT) = ($3.4 -$.7)/.172 = $15.70

• 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 actual share price was $19.30

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 and break-up costs

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 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.

Estimated

Value ($M)

Relative

Weight

Weighted

Avg. ($M)

220 .30 66.0

234 .40 93.6

224 .20 44.8

150 .10 15.0

1.00 219.4

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 Attempted Takeover of Yahoo

Base Case: Microsoft Offers

To Buy All Yahoo Shares

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 with option

to buy

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.

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

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