Valuation Mergers

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  • Alternative Approaches to Valuation9Chapter

  • Introduction to ValuationValuation critical in M&AsAids evaluation of acquisition candidatesHelps to set goals and benchmarksFramework essential to discipline valuation estimatesComparables (Companies, Transactions)Discounted Cash Flow (Spreadsheet, Formula)Use of multiple methods offers differing perspectivesValuation should be guided by a business economics analysis of the firm and its environment

  • Comparables ApproachesComparables AnalysisUse companies (or transactions) comparable in:Size and productsRecent trends and future prospectsKey ratios calculated for each companyKey ratios are averaged for groupAverage ratios applied to absolute data for company of interestApplying ratios yields indicated market values Valuation judgments are made

  • Comparables ApproachesAdvantages of comparablesCommon sense approachMarketplace transactions are usedWidely used in legal cases, fairness evaluation, etc.Allows valuation of private firmsLimitationsMay be difficult to find companies comparable by key criteriaRatios may differ widely for comparablesDifferent ratios may give widely different results

  • Comparable Transactions ExampleValuation based on companies involved in similar merger transactionMay be difficult to find truly similar transactions within relevant time periodIllustration of comparable transactions for Exxon Mobil mergerAverage ratios suggest value of $56.8B for Mobil (deal was for $71.4B)May not take into account synergies and other unique factors

  • Comparable Transactions Example

  • Comparable Transactions Example

  • Comparable Transactions ExamplePrevious results similar to those of advisory investment banksComparables often fail to arrive at definitive values companies differ in:Revenue growth ratesGrowth of cash flowsRiskiness (beta) Stage in the life cycle of industry or firmCompetitive pressuresOpportunities for expansionAll of the above are difficult to assign a ratio for appropriate comparable valuation

  • Capital Budgeting DecisionsProcess of planning expenditures whose returns extend over a period of timeAn acquisition is fundamentally a capital budgeting problem: negative NPV mergers do not make sense (usually)

  • Real Options AnalysisNPV may not recognize flexibility of postponement, abandoning, etc.Value of flexibility may make some negative NPV project positiveExample: Negative NPV projectPostpone $ 50 million investment until Year 2 PV of incremental cash flows = $40 million Cost of capital = 10%

  • Real Options AnalysisExample: View as a call option

  • DCF Spreadsheet MethodologyProcedureHistorical data for elements of financial statements are presented for 5 to 10 yearsFinancial analysis is performed to determine ratios and pattersAnalysis of business economics of industryBased on analysis, relevant cash flows are forecastCash flows are then discounted to obtain present valuesThese present values are summed to arrive at an Net Present Value (NPV)

  • DCF Spreadsheet MethodologyAdvantagesSpreadsheets allow great flexibility in projectionsExpresses calculations in recognizable financial statementsDisadvantagesProjected numbers may create the illusion that they are actual numbersMay have a disconnect between business logic and projectionsComplexity of spreadsheets may obscure important driving factors

  • DCF Spreadsheet Methodology

  • Cost of CapitalCost of equityYield on equity must be greater than bond yield (usually by 3 to 5 percent)Capital Asset Pricing Model (CAPM) is most widely usedRequired return=risk return+risk component

    Rf = risk free rate = usually return on long-term US government bondsRm-Rf = market equity premium = usually long-term market return less risk free rateBeta = measures return on stock vs. market return

  • Cost of CapitalCost of debtShould be calculated on after-tax basis to reflect deductibility of interest paymentsAfter-tax cost of debt = kb(1-T)T = corporate tax ratekb = pre-tax cost of debtDetermining before tax-cost of debtWeighted average of yield to maturity of publicly traded bondsFind bond rating of firm and associated yield

  • Cost of CapitalWeighted Average Cost of Capital (WACC)First, determine the appropriate capital structure of firmShould consider book ratios, market value ratios, and industry comparablesTarget financing proportions should reflect best judgment of firms financial structure in the futureApply 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)

  • Capital StructureA critical element in WACC The use of debtInterest deductibility encourages debt financingBut high debt levels increase risk of financial distress, cause higher bond ratings, and increase cost of debtLeverage and the firms betaHigh leverage increases firms levered betaEquation calculates target leverage ratio (B/S) based on a target levered beta (e), starting from the firms unlevered equity beta (u) (business risk of firm)

  • Capital Structure

  • Formula MethodologyFormula method is simply a compact expression of spreadsheet method Both use discounted cash flow analysisFormula approach helps focus on underlying drivers of valuationKey variables and relationshipsRevenues (Rt) basic driver of firm valueGrowth rate (g) rate of change in revenuesNet operating income margin (m) revenues less COGS, selling, general and administrative expenses, depreciation expensesActual tax rate (T)

  • Formula MethodologyKey variables and relationshipsInvestment (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 advantageCost of capital (k) based on determination of appropriate WACCBest judgment may be that terminal period variables will differ from supernormal period values

  • Formula Methodology

  • Formula MethodologySensitivity analysisEasily executed using formula methodsCan check range of alternative possibilities

    VariableValuation effect of increasingg+Im+kn+T

  • Formula MethodologyLimitations of the formula approachLess flexibility in reflecting forecasts for individual yearsCalculations use financial statement data not directly shown in the formulas More difficult to pinpoint calculation errors than the spreadsheet approachIn many cases, the second term or terminal value will represent the bulk of a firms valuation practitioners must be careful with assumptions impacting this term


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