Alternative Approaches Alternative Approaches to Valuationto Valuation

99ChapterChapter

Chapter 9-2

Introduction to Valuation Valuation critical in M&As

• Aids evaluation of acquisition candidates• Helps to set goals and benchmarks

Framework essential to discipline valuation estimates• Comparables (Companies, Transactions)• Discounted Cash Flow (Spreadsheet, Formula)• Use of multiple methods offers differing

perspectives Valuation should be guided by a business

economics analysis of the firm and its environment

Chapter 9-3

Comparables Approaches

Comparables Analysis• Use companies (or transactions) comparable in:

– Size and products– Recent trends and future prospects

• Key ratios calculated for each company• Key ratios are averaged for group• Average ratios applied to absolute data for

company of interest• Applying ratios yields indicated market values • Valuation judgments are made

Chapter 9-4

Comparables Approaches Advantages of comparables

• Common sense approach• Marketplace transactions are used• Widely used in legal cases, fairness evaluation,

etc.• Allows valuation of private firms

Limitations• May be difficult to find companies comparable

by key criteria• Ratios may differ widely for comparables• Different ratios may give widely different

results

Chapter 9-5

Comparable Transactions Example

Valuation based on companies involved in similar merger transaction

May be difficult to find truly similar transactions within relevant time period

Illustration of comparable transactions for Exxon Mobil merger• Average ratios suggest value of $56.8B

for Mobil (deal was for $71.4B)• May not take into account synergies and

other unique factors

Chapter 9-6

Comparable Transactions Example

Comparable Transaction Ratios

Amoco Texaco Conoco Average

Total Paid/Sales 1.38 0.77 0.37 0.84

Total Paid/Book 3.00 2.79 2.29 2.69

Total Paid/Net Income 22.46 15.46 7.60 15.18

Premium Paid, % Target 22.3% 17.7% 0.0% 13.3%

Premium Paid, % Combined 7.7% 6.3% 0.0% 4.7%

Chapter 9-7

Comparable Transactions ExampleApplication of Valuation Ratios to Mobil

(Dollar Amounts in Billions)

MobilValue of Equity

LTM Sales $63.0 $53.0

Book Value $19.0 $51.2

LTM Net Income $2.9 $43.8

Market Value Target* $58.7 $66.5

Market Value Combined** $233.7 $69.6

Average = $56.8* Value of equity = market value target x (1 + average premium paid, % target)** Value of equity = market value combined x (1 + average premium paid, % combined) - market value buyer

Average Transaction Multiple

13.3%

4.7%

0.84

2.69

15.18

Chapter 9-8

Comparable Transactions Example Previous results similar to those of advisory

investment banks Comparables often fail to arrive at definitive

values – companies differ in:• Revenue growth rates• Growth of cash flows• Riskiness (beta) • Stage in the life cycle of industry or firm• Competitive pressures• Opportunities for expansion• All of the above are difficult to assign a ratio

for appropriate comparable valuation

Chapter 9-9

Capital Budgeting Decisions

Process of planning expenditures whose returns extend over a period of time

An acquisition is fundamentally a capital budgeting problem: negative NPV mergers do not make sense (usually)

tperiodin outlays investmentperiods ofnumber

capital ofcost periodin flowscash

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t

t

n

t

n

tt

tt

to

In = k =

tCFk

I

k

CFNPV

Chapter 9-10

Real Options Analysis NPV may not recognize flexibility of

postponement, abandoning, etc. Value of flexibility may make some negative

NPV project positive Example: Negative NPV project

Postpone $ 50 million investment until Year 2PV of incremental cash flows = $40 millionCost of capital = 10%

million 322.1$

322.41$40

)8264.0(50$40$

21.1

50$40$

)10.1(

50$40$

2

NPV

NPV

Chapter 9-11

Real Options Analysis

Example: View as a call option

Real Option Variable Call Option Value

Present Value of Incemental Cash Flows S Current Stock Price $40 million

Investment to Create the Option X Exercise Price $50 million

Volatility of Cash Inflows Stock-Price Volatility 20%

Life of Option T Life of Option 2 years

Risk-Free Rate of Return rF Risk-Free Rate of Return 3.70%

million 3.1$)()( 21

CdNXedNSC TrF

Chapter 9-12

DCF Spreadsheet Methodology Procedure

• Historical data for elements of financial statements are presented for 5 to 10 years

• Financial analysis is performed to determine ratios and patters

• Analysis of business economics of industry• Based on analysis, relevant cash flows are

forecast• Cash flows are then discounted to obtain

present values• These present values are summed to arrive at an

Net Present Value (NPV)

Chapter 9-13

DCF Spreadsheet Methodology Advantages

• Spreadsheets allow great flexibility in projections

• Expresses calculations in recognizable financial statements

Disadvantages• Projected numbers may create the illusion that

they are “actual” numbers• May have a disconnect between business logic

and projections• Complexity of spreadsheets may obscure

important driving factors

Chapter 9-14

DCF Spreadsheet Methodology

1 2 3 Terminal

1 Before-tax cash flows (Xt) 240 288 346 3462 Less: Taxes at 40% (T) 96 115 138 138

3 After-tax cash flows [Xt(1-T)] 144 173 207 207

4 Less: Investments (It) 120 144 173 0

5 Free cash flows [Xt(1-T)-It] 24 29 35 207

6 Discount factors (1+k) (1+k)2 (1+k)3 k(1+k)3

6a Discount factors 1/1.10 1/1.21 1/1.331 10/1.331

7 Present values $21.82 $23.97 $26.30 $1,555.22

Example: Basic Valuation of a Target

Chapter 9-15

Cost of Capital Cost of equity

• Yield on equity must be greater than bond yield (usually by 3 to 5 percent)

• Capital Asset Pricing Model (CAPM) is most widely used– Required return=risk return+risk component

– Rf = risk free rate = usually return on long-term US government bonds

– Rm-Rf = market equity premium = usually long-term market return less risk free rate

– Beta = measures return on stock vs. market return

)(equity ofCost fmf RRR

Chapter 9-16

Cost of Capital

Cost of debt• Should be calculated on after-tax basis to

reflect deductibility of interest payments• After-tax cost of debt = kb(1-T)

– T = corporate tax rate– kb = pre-tax cost of debt

• Determining before tax-cost of debt– Weighted average of yield to maturity of

publicly traded bonds– Find bond rating of firm and associated yield

Chapter 9-17

Cost of Capital Weighted Average Cost of Capital (WACC)

• First, determine the appropriate capital structure of firm– Should consider book ratios, market value

ratios, and industry comparables– Target financing proportions should reflect

best judgment of firm’s financial structure in the future

• Apply financing proportions (B/V, S/V) to cost of equity (ks) and cost of debt (kb[1-T])

• WACC = k = kb(1-T)(B/V)+ks(S/V)

Chapter 9-18

Capital Structure A critical element in WACC The use of debt

• Interest deductibility encourages debt financing• But high debt levels increase risk of financial

distress, cause higher bond ratings, and increase cost of debt

Leverage and the firm’s beta• High leverage increases firm’s levered beta• Equation calculates target leverage ratio (B/S) based

on a target levered beta (ße), starting from the firm’s unlevered equity beta (ßu) (business risk of firm)

•

S

TBue

)1(1

Chapter 9-19

Capital StructureFigure 9.1

Effects of Bankruptcy Costs and Taxes on the Cost of CapitalPercent

k u

(1-T )k b

k e with bankruptcy costs

WACC with taxes and bankruptcy costs

k b with bankruptcy costs

BS

Optimal Capital Structure

Chapter 9-20

Formula Methodology Formula method is simply a compact

expression of spreadsheet method • Both use discounted cash flow analysis• Formula approach helps focus on underlying

drivers of valuation Key variables and relationships

• Revenues (Rt) – basic driver of firm value• Growth rate (g) – rate of change in revenues• Net operating income margin (m) – revenues

less COGS, selling, general and administrative expenses, depreciation expenses

• Actual tax rate (T)

Chapter 9-21

Formula Methodology Key variables and relationships

• Investment (It) – change in total capital (working capital and fixed assets) over previous period (as a ratio of revenues)

• Number of periods of supernormal growth (n) – period when firm expects to maintain a competitive advantage

• Cost of capital (k) – based on determination of appropriate WACC

• Best judgment may be that terminal period variables will differ from supernormal period values

Chapter 9-22

Formula MethodologyF o r m u l a s f o r F r e e C a s h F l o w V a l u a t i o n o f a F i r m N o g r o w t h :

0for

)1(00

k

k

TmRV

C o n s t a n t g r o w t h :

0for

)1()1(00

kgk

ITmgRV

T e m p o r a r y s u p e r n o r m a l g r o w t h , t h e n n o g r o w t h :

n

nn

tt

t

kk

TmgR

k

gITmRV

)1(

)1()1(

)1(

)1()1( 0

100

T e m p o r a r y s u p e r n o r m a l g r o w t h , t h e n c o n s t a n t g r o w t h :

)(

)1(

)1(

)1()1(

)1(

)1()1( 0

100

c

cn

cn

sn

tt

ts

s gk

g

k

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k

gITmRV

Chapter 9-23

Formula Methodology

Sensitivity analysis• Easily executed using formula methods• Can check range of alternative

possibilitiesVariable Valuation effect of increasing

g +I –

m +k –n +T –

Chapter 9-24

Formula Methodology Limitations of the formula approach

• Less flexibility in reflecting forecasts for individual years

• Calculations use financial statement data not directly shown in the formulas

• More difficult to pinpoint calculation errors than the spreadsheet approach

• In many cases, the second term or terminal value will represent the bulk of a firm’s valuation – practitioners must be careful with assumptions impacting this term